Prepare for a Winter From Hell

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At some point in the future, historians will describe December 2022 to April 2023 as “the winter from hell,” for Europe particularly, but also spreading around the world. The energy system is already stretched to breaking point. No excess capacity exists today in the sector — none. Rivers are dry. High temperatures are boosting electricity demand, which in turn requires increased amounts of natural gas at the margin. This has prompted a switch back to coal where such capacity still exists and supplies are available. Large and small consumers are also looking to switch to diesel or distillate when they can, but refineries are producing as much diesel as they are able, with no surplus capacity. Policy efforts so far have failed to address this deep malaise and the consequences could be catastrophic — including government interventions in energy markets of a magnitude not seen since World War II.

The pending catastrophe began more than a year ago when Russia stopped filling natural gas storage in the region. But natural gas may be the least of Europe’s energy problems this winter. A prolonged drought has dried up rivers, constraining barge commerce. In France, nuclear power plants have been shut down to address corrosion issues. Normally an electricity exporter, France will now have to import it. Norway, also an electricity exporter, has warned that it will limit exports in the coming months due to low reservoir levels behind its hydroelectric dams. At the same time, Germany still plans to decommission three nuclear plants at the end of the year.

Energy price rises are slamming consumers. An end-July working paper by International Monetary Fund economists provided an indication of the magnitude. They estimate that the increase in fossil fuel prices will raise European households’ expenditure on energy in 2022 to around 7% of total spending on average, a near doubling of the 3.8% spent in 2019. This three percentage point increase compares with increases in US household energy expenditure of less than one percentage point from 1974 to 1976 or 1979 to 1981, which contributed to recessions there.

Household Income Spent on Energy
Country 20192020%Chg.

EU planners intend to meet part of the energy supply loss by substituting distillate fuel oil for electricity and natural gas — despite Europe’s forthcoming ban on importing Russian distillate and diesel fuel. But Europe’s problems will not remain in Europe. The crisis will metastasize. Already spot LNG prices are being pushed to record highs, and we now are seeing warnings of very tight distillate markets this winter.

Competing for US Supplies

The US will be thrust into the role of the world’s incremental fossil fuel supplier this winter. Buyers in Europe will seek supplies of US distillate fuel oil, especially low-sulfur diesel. They will compete with consumers from South America who already purchase significant volumes. LNG buyers in Europe will also compete with customers in Asia for US gas exports. And firms seeking to ship natural gas out of the US will compete with domestic customers. Consequently, US domestic natural gas, distillate and diesel fuel prices could rise substantially in the coming months. The increase could be extraordinary, especially since inventories remain very low — providing no real cushion in the event of a major hurricane disrupting natural gas production in the Gulf of Mexico and/or refining operations in Texas and Louisiana.

Energy markets are also being disrupted by credit constraints. Months ago, energy traders called on central bankers to provide liquidity for transactions and were rebuffed. Although subsequent declines in oil and gas prices, combined with seasonal reductions in energy consumption, have eased those pressures, the relief may be temporary. Energy forecasters now warn about dramatic price increases this fall, and credit issues will re-emerge if prices stay at those levels for long. The capital constraints limiting trader activity could also magnify a hurricane’s price impact.

Energy Savings

The supply threats can be met with conservation. However, experience shows that such efforts have limited success unless accompanied by harsh financial penalties for noncompliance. The EU is attempting to reduce natural gas use by 15%. In response, landlords who control the heat on their properties intend to turn down their thermostats this winter. The managers of government and private office buildings will do the same. Large industrial consumers like BASF in Germany will cut production to reduce their gas use. History shows that conservation programs are difficult to implement in the short run. Further, most programs fail to achieve their goals because measurement is difficult and systems for monitoring success are lacking.

High prices will also force many consumers to cut energy use. In the UK, for example, the Office of Gas and Electricity Markets, which regulates the UK electricity and downstream natural gas markets, has announced that the cap on what consumers must pay per year for power and gas will increase from £1,100 ($1,300) in October 2021 to £4,300 ($5,086) in October 2022. Experts have warned that this hike could impoverish British citizens who have a median household income of around £31,400 ($37,140) after direct taxes. The magnitude of the raise is striking. It is by far the biggest increase imposed on consumers from 1973 to 2022. If sustained, this would push the UK into a severe recession.

Some governments are protecting consumers by lessening the burden of high prices. France, for example, will not pass on the high cost of imported electricity. Instead, the government is renationalizing power company EDF. President Emmanuel Macron clearly wants to avoid another “yellow vest” protest. In similar fashion, Germany will increase the compensation offered to consumers to offset prices. Most other EU nations have adopted like measures. These actions, while understandable, will reduce the incentive to conserve energy.

Financial Contagion

Political efforts, however, will not address the finite supply of electricity, gas and oil in the coming months. Prices will rise to clear markets. In some cases, governments will initiate further interventions, attempting to allocate scarce supplies, despite the poor records of these programs. Such efforts will likely not have much impact on prices. Instead, the chaotic market conditions associated with higher energy prices over the next six months will probably cause some type of financial failure within the energy system, just as the subprime mortgage lending program led to collapse in 2008.

Serious financial problems brought about by the worsening energy situation lurk somewhere over the horizon. The first question is where? The second relates to the uncertain magnitude of the economic consequences. The financial problems will be made worse by increased government spending to protect consumers from high prices, especially as central banks struggle to control inflation. The winter of 2022-23 truly promises to be one from hell.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Macroeconomics , Oil Supply, Diesel/Gasoil
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