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As I pointed out in previous articles lately, there are now increasingly limited odds of the Nord Stream 2 project being obstructed. The first phase of Turkstream is also a done deal, with shipments starting to Turkey at the end of the year. I also expect that Ukraine will continue to play a major role as a transit country for Russian gas, albeit a much-reduced role. Recent developments however are also leading me to believe that there is now a very real chance of Russian natural gas exports to Europe being disrupted.
The main cause will likely be an under-estimation of the strength of Russia’s position at the negotiating table, which may push the EU into taking up an overly aggressive and uncompromising position in regards to terms of transit through Ukraine. What this means is that there is a real danger of a severe economic disruption in Europe in the coming winter, which is something that investors in European ETFs such as the Vanguard FTSE Europe ETF (VGK) should be mindful of. This ETF in particular stands to be hit harder than many others, as I shall explain.
Russia’s new export options set the stage for a showdown by the end of this year
The Ukraine crisis that started in early 2014 had Russia in a very tough spot in regards to its natural gas exports. Almost all its gas was going to the EU and other European countries, including Turkey. Half of those exports were going through Ukraine, which was problematic once relations broke down. Since then however, it did sign the Power of Siberia pipeline deal with China, which is set to be finished and partly operational by the end of the year. It will have a full capacity of 38 Bcm/year. The first of the two-phase Turkstream pipeline connections will also become operational by the end of the year, with 16 Bcm capacity going to Turkey. Then there is the robust increase in Russia’s LNG export capacity.
Source: Oil&Gas Journal.
As we can see, Russian LNG export capacity has grown from being insignificant back in 2014 and is set to take another upward leap by next year. Between the two pipelines as well as the expanded LNG capacity, Russia could potentially continue exporting the same volume of gas it did in 2014 when the Russia-Western World animosity started over the Ukrainian crisis. In other words, it is in a solid position to reject a new Ukrainian transit deal, and it may do so, even if it risks losing the Nord Stream 2 project. Russia increasingly has alternative options, therefore, the EU position of forcing Russia to accept continued over-reliance on the Ukraine route needs to be reconsidered in my view.
To be clear, this is not the outcome that Russia wants. As I pointed out in a recent article, it wants to achieve a roughly 50% increase in Gazprom exports within the next few years and continued gas transit through Ukraine is part of that plan. But Russia does have all the contingencies in place for a viable plan B, which might actually not be much worse for them than plan A. It could in fact walk away from the Ukraine deal, even if it will mean that the Nord Stream 2 project will be scrapped as well.
It does have another China pipeline deal on the table. It has the option of further expanding its LNG exports, as well as its own petrochemical industry, which might under such circumstances achieve some success in displacing Europe’s impaired industry. The second leg of the Turkstream project would also become increasingly hard to stop, for it would mean condemning a number of EU countries to a severe shortage of natural gas, which would cripple their economies.
The effect on the EU economy would be potentially catastrophic
The EU position seems to be increasingly hardened against the Nord Stream 2 project even being finalized. There is a strong lobby pushing for maintaining Ukraine’s central role as a transit country between Russia’s gas and the EU. The fact that Russia can now potentially walk away from both transit options, does not seem to register with many EU leaders, as well as segments of the EU public. I don’t think that maintaining the status quo in regards to dependence on Ukraine as a transit country is in any way shape or form acceptable to Russia. If we take a step back, we can see that the very fact that there are some who believe that dictating to Russia on the routes of transit for its gas, is not a reasonable position by any means, therefore, it would be flawed to assume they will accept it if forced into it.
The recent decision by Denmark to delay issuing the needed permits to complete the last section of the Nord Stream 2 pipeline by demanding of the consortium to consider and assess a third route seems to be related to the thinking of a second camp within the EU political scene, which wants to have it both ways. In this camp, we have semi-realists who do recognize the fact that Nord Stream 2 will be needed for parts of Europe to achieve certain economic goals, and partially satisfy the increasingly aggressive green lobby.
They also figure that the delay tactic will achieve the goal of partially satisfying the anti-Russian camp, by pushing Russia into agreeing to a Ukraine gas transit deal by the end of this year, which will be very advantageous economically and strategically to Ukraine. It seems this camp is also less than realistic in regards to Russia’s willingness to accept such a deal and the potentially negative outcome for the EU economy.
If Ukraine transit deal falls apart, anti-Russia group will most likely push for permanent obstruction of Nord Stream 2, with resulting severe consequences for the EU
Unless Ukraine will agree to sign up to a new gas transit deal which will be agreeable to Russia, in other words, much-reduced volumes and at a competitive transit cost, I do believe Russia will walk away from such a deal. The fact that Nord Steam 2 will not be completed by the end of this year will not prevent Russia from doing so. The ball will then be back in the EU court, where they will be left with two choices: The first will be to swallow their pride and scramble to help complete the pipeline as soon as possible.
The second, which is the more likely one to happen in such circumstances will be to choose defiance and reject the pipeline altogether and opt for a surge in more expensive LNG imports instead. The reason I believe this will be the more likely outcome is because it would empower the argument of the anti-Russia political forces, namely that Russia will be responsible for the crisis and therefore it should not be trusted as an energy supplier.
Within current market conditions, LNG tends to be about 20-30% more expensive compared with the average price of Russian gas sold in the EU. If the EU will add about 50-60 Bcm in LNG demand starting next year however, it would most likely lead to LNG prices being bid up much higher. At times, the price of LNG in some markets was about double the price of Russian imports, and I do believe that in the event of such a surge in demand it will get there again. That in turn would most likely devastate Europe’s already fragile economy.
In the first wave of damage would be the petrochemical industry as well as other industrial activities in Europe. I should point out that the Vanguard FTSE Europe ETF does have some significant direct exposure through its relatively high portion of industrial companies in the bundle.
Source: ETFdb.com.
While the EU’s industry would be the first victim of higher gas prices or outright shortages, the effect would then extend to households, therefore consumer spending would suffer a great deal.
As far as regional exposure, the ETF would also be particularly hard hit by the abandonment or obstruction of the Nord Stream 2 pipeline, because about 2/3 of the country exposure is in fact in the same area which would see natural gas supplies not meeting emerging demand. This would leave German, UK, Dutch and French consumers all bidding up the price of pipeline gas, perhaps to the price level needed to make LNG imports viable. Current plans to use Russian gas in order to replace coal and nuclear power generation in order to satisfy the powerful environmentalist movement would also have to be scrapped. This could lead to social upheaval, given the passionate nature of environmental activists.
Social upheaval could become a serious economic issue in the region, given the already charged and tense environment we are seeing. The Yellow Vest protests in France, which were ignited by the environmentalist policy of an extra levy on motor fuel is the most well-known manifestation of socio-economic discontent that is rather common in European society today. As is the case right now, the movements of economic discontent would most likely end up clashing with the forces of environmentalist discontent, making for an explosive situation. This would leave the leaders in the region with no way of satisfying either side.
Such social upheaval will likely have a sizable negative and disruptive impact on the economy in the region, which will only compound the initial effects of a potential natural gas supply disruption, which can be caused by the current geopolitical path chosen by the EU leadership. This would in turn lead to a significant reversal in the fortunes of this ETF, which has been performing rather well so far this year, with the fund being up almost 15%.
While most people may be worried about the more famous geopolitical event that is taking place in the region, namely Brexit, I think most investors do not even realize that the current Russia-EU natural gas situation is reason to worry about a crisis erupting potentially within months. In my personal opinion, this risk should be considered more potent and severe than any fallout from a no deal Brexit. But then again, both could happen, so perhaps investors should worry about both events producing a one-two punch. Or perhaps neither scenario will happen, in which case the fund needs to be evaluated based on current conditions, in other words, it will be business as usual.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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