Winter is coming and Europe is running scarily low on gas

Europe has an energy problem, and it could get worse once winter grips the continent. Gas and electricity prices are soaring, windmills are standing idle for lack of wind and shuttered coal-fired power plants are being brought back into use. There are even suggestions to use diesel generators for private generation. But oil isn't the solution to the continent's energy woes.

High natural gas prices are creating incentives for fuel substitution that could boost oil demand, according to Jeff Currie, global head of commodities research at Goldman Sachs. Although that's true on a global scale, it may not provide much respite for European consumers, who have little scope to switch generators from gas to liquid fuel.

On the face of it, Europe has a well-diversified mix of electricity generation, with healthy amounts of gas, coal, hydro and nuclear capacity and a significant proportion of power coming from renewable sources such as wind and solar.

If you look closely, however, there is a clear hierarchy of fuel sources when it comes to power generation, which varies from country to country. And gas plays a pivotal role in some of the continent's biggest electricity markets (see chart below).

In some, gas provides a significant proportion of the baseload electricity supply. In others, the flexibility of gas-fired plants to be switched on and off makes them ideal for providing power during periods of peak load, or for filling in the gaps when other sources aren't delivering as much as expected. Gas is also a major source of fuel for domestic heating in countries like the U.K., where 85% of homes are connected to the gas grid.

The problem is, gas is anything but plentiful in Europe right now. 

As we head toward winter, the continent's natural gas stockpile stands at 75% of the level it was at this time last year — the lowest for the time of year since 2013. That's raising prices and stoking concerns about shortages and power blackouts over the coming months.

An unfortunate combination of factors lies behind the low stock levels.

First, last winter was long, with cold weather extending through April and preventing the start of rebuilding inventories. Second, gas demand is rising as economies are recovering from the depths of Covid-19. More gas is needed to power production, while the return to offices and reopening of the leisure sector is boosting electricity demand.

Third, renewable sources for power generation are struggling, with low wind speeds reducing the amount of electricity from turbines. That's a particular problem for the U.K., where wind accounts for nearly one-quarter of generating capacity. A fire that has shut down a major electricity supply cable from France has only increased the pressure on the country's gas-fired electricity generation.

Importantly, Europe's own natural gas production has been in a long-term decline. Output is past its peak in each of the region's three big producers — Norway, the U.K. and the Netherlands. Dutch and British supplies in 2020 were down by 75% and 65% respectively from peaks reached at least 20 years earlier. Norway's output is in its fourth year of decline, with heavy maintenance hitting flows this summer.

Imports haven't made up the shortfall. Europe relies on piped supplies from Russia for more than half of its external gas. Contracts with state-owned Gazprom were designed to meet the continent's normal needs, not the extra required to rebuild depleted stockpiles.

And Russia has been in no rush to deliver additional gas to Europe via traditional overland routes through Belarus, Poland and Ukraine, pressing instead for the completion of the Nord Stream 2 pipeline which bypasses these transit countries. Construction of the line has now been completed, after the easing of sanctions imposed by former U.S. President Donald Trump.

Whether the conduit will come into operation soon enough to have an impact on gas supplies to Europe this winter may depend on how quickly its operator is certified by the European Union as an independent carrier. One thing is certain, though: Flows won't begin as planned on Oct. 1.

So Europe's gas supplies are likely to remain tight this winter.

And while diesel generators may be a solution for some industrial electricity customers, they aren't going to keep the lights on, or the homes warm, for European citizens. We'd better hope that the EU  forecasts of a mild winter are right. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Julian Lee is an oil strategist for Bloomberg. Previously he worked as a senior analyst at the Centre for Global Energy Studies.

Julian Lee is an oil strategist for Bloomberg First Word. Previously he worked as a senior analyst at the Centre for Global Energy Studies.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.