As a result of Russia’s war on Ukraine, already elevated global energy costs are soaring higher, and are likely to remain the norm for years—not months. Although the U.S., UK, Canada and Australia have banned Russian oil, none of these economies are particularly reliant on Russia for energy. The EU has announced a partial Russian oil ban beginning later this year and is making great efforts to pivot away from Russian gas. Russia’s oil exports are significantly down from a year ago, but its revenues have remained buoyant, thanks to elevated prices. We expect further measures to be taken to curtail foreign exchange flows to Russia for energy going forward.
The Energy Crisis Predates the War
The U.S. and Europe were both facing an energy crisis long before Russia invaded Ukraine in February this year. In the U.S., the energy crisis was driven by both demand and supply factors. With more aggressive fiscal stimulus measures in the U.S. than Europe, demand for energy rebounded to pre-pandemic levels. But supply was unable to ramp up as quickly for three main reasons. First, there has been chronic underinvestment in fossil fuels since oil prices plummeted in the so-called Thanksgiving Day Massacre in 2014. Second, the ESG movement has further exacerbated this trend, as institutional money has steered clear of the oil patch. Finally, a number of older, less productive refineries were mothballed during the first lockdown and so a bottleneck remains even with greater production.
The EU’s crisis was driven more by supply-side factors, as demand for energy remained below the pre-pandemic levels at the beginning of the year. More restrained fiscal policy in the EU left most economies with an output gap at the start of 2022. Energy supply, however, has been constrained, with Russian energy giant Gazprom reducing natural gas flows to Europe beginning last summer. The EU has been disproportionately hit by Russia’s war on Ukraine, in large part because of proximity and infrastructure. It has clearly learned the lesson that it can no longer rely on Russia for 26% of its oil, 47% of coal and around 40% of natural gas.
Steps Already Taken
The U.S., UK, Canada and Australia have all imposed an embargo on Russian oil, with the U.S., Canada and Australia also refusing to import Russian natural gas. The UK’s oil ban will take full effect later this year. On June 3, the EU announced a partial ban on Russian oil. The sanctions apply to seaborne imports of Russian crude oil as of December 5, 2022, with pipeline imports of oil exempt to appease EU member states Hungary, Slovakia and the Czech Republic, which are heavily dependent on imports via the Druzhba pipeline. The EU has also announced sanctions on shippers and insurers of Russian oil to be implemented in December. We discovered during the Iranian oil embargo that it was this latter measure that significantly reduced the amount of Iranian oil being exported.
We do not expect the EU to impose a ban on imports of Russian natural gas. The International Energy Agency has put together a plan to reduce European reliance on Russian gas, but even with a number of aggressive assumptions it only foresees Russian gas imports falling by roughly one-third this year and over half going forward. The EU has reached a deal to double natural gas imports from Azerbaijan, involving investment to increase the capacity of the Southern Gas Corridor by 2027. Azerbaijan has already increased gas deliveries to the EU by roughly 30% this year. This summer, the EU received more gas from the U.S. (via LNG shipments) than Russia for the first time ever.
That said, the EU cannot replace Russian supply with alternative sources immediately, in part due to limited global supply and storage capacity constraints. Russia reopened the Nord Stream I pipeline after its closure for maintenance. It has since reduced gas flows through the pipeline from 40% to 20% of full capacity. Even if gas flows pick up in the short-term, there is significant uncertainty around how long that will last. If Russia wants to weaponize energy, it will likely do so sooner than later to maximize impact, before Europe has pivoted away from Russia.
What to Expect Next
We expect that the U.S. and its allies will shift their focus from imposing sanctions on Russian energy to reducing energy costs at home. In late April, the White House announced it would release over 1 million barrels of oil from the Strategic Petroleum Reserve (SPR), immediately improving short-term supply of oil and supporting longer-dated futures contracts by pledging to refill the SPR later. While historic in size, the International Energy Agency estimates these SPR releases still only replace about one-third of the supply lost per day owing to Russia’s war on Ukraine.
The administration has also leaned on other oil producers to ramp up supply. In March, senior administration officials visited Venezuelan leader Nicolas Maduro, who is not currently recognized as president by the U.S. The U.S. is reportedly considering easing sanctions to boost oil imports. Earlier this month, President Biden met with King Salman bin Abdulaziz and Crown Prince Mohammed bin Salman (MBS) in Saudi Arabia, aiming to encourage increased Saudi production. President Biden left Saudi Arabia without a promise of increased production. Saudi Arabia’s state oil company, Aramco, says it can pump 12 million barrels a day, but it has only hit this rate once. Furthermore, Saudi Arabia would draw ire from OPEC+ for ramping up oil production.
To address the cost of gas more directly, policymakers are considering cutting gas taxes. This would require bipartisan support, which is hard to come by these days. The federal gas tax is around 18 cents per gallon, a drop in the bucket compared with an average price of roughly $4.20. Some of the benefit would go to drivers, but some would be captured by energy companies. Furthermore, lower gas taxes might generate more demand for gas, ultimately pushing up prices.
President Biden has also waived environmental rules for ethanol to be added to gasoline to reduce fuel prices over the summer driving season. However, only 2,300 gas stations countrywide carry the gas/ethanol mix and the increased demand for corn to make ethanol could push farmers to shift from wheat to corn production, exacerbating food inflation.
A final proposal to bring gas prices down involves imposing an oil price cap on Russian oil. Promoted by Janet Yellen and endorsed at the last G7 meeting, this is a response to concerns regarding the price of oil once the EU’s sanctions finally kick in later this year. European and British companies account for up to 90% of the insurance, reinsurance and financing of Russian seaborne oil. The imposition of the EU sanctions would reduce Russian oil exports, but according to some analysts it could also push oil price above $200 per barrel. An oil price cap could exempt Russian oil exports from the EU’s insurance and shipping embargo. It would no doubt be leaky. India and China would likely buy oil at prices just above the cap and OPEC+ would resent the cut in prices.
For Europe, the focus is also on mitigating energy costs in the face of high and accelerating inflation. A number of EU countries have already cut their energy taxes. One problem is that this distorts the pricing mechanism and encourages demand for energy. Given how much higher energy taxes are in Europe than in the U.S., this would also be difficult to reverse. Some EU countries are also contemplating outright price caps. This is possible in France, for example, where the government has had to step in and nationalize Électricité de France (EDF). Spain has also managed to cap gas prices used for electricity, given it receives all of its gas from Algeria. Finally, fiscal support has been provided, for example in the UK, where direct transfers have been deployed to low-income families.
If Russia indeed constrains or stops gas flows to Europe through the Nord Stream I pipeline, the EU would face recession. It may use its NextGenEU fund as a template for how to mutualize borrowing to spend on the green transition. Leftover funds from NextGenEU are likely to be recycled for the REPowerEU fund.
EU member states also agreed to voluntarily reduce their energy demand by 15% this winter, with the possibility of a trigger to make the reduction mandatory. Given various carve-outs, the ultimate reduction in energy demand will probably be less. But it is hard to imagine how industry can reduce its demand so significantly without causing an economic downturn.
Meanwhile, Russia will continue to export energy to China and India at lower costs. Because Chinese companies are able to self-insure, they may manage to circumvent U.S. and EU sanctions. And while Chinese companies may come under secondary sanctions, there is limited risk of the U.S. imposing secondary sanctions on fellow democracy India.
The Role of Nuclear Energy
When it comes to nuclear energy, we see significant policy efforts to move the dialogue from sanctions to nuclear expansion. Several factors contribute to this important development: first, Russia plays a significant role in the global nuclear supply chain. Next, the recent global supply shock has highlighted the need to improve nuclear energy capacity in order to promote energy diversification and address energy shortages. There is strong skepticism around the effectiveness of nuclear-related sanctions following those imposed on Iran during the Trump Administration. Finally, nuclear energy is again perceived as a cleaner and safer form of energy, as nations around the world have learned the lessons from previous nuclear accidents and have implemented stricter safety measures.
Indeed, this approach to sanctions on nuclear energy during Russia’s war on Ukraine is dominant both in the U.S. and Europe. President Biden includes nuclear power in his energy diversification strategy and avoided reference to nuclear sanctions in his public remarks and policy discussions. The EU has also avoided sanctions on Russian nuclear power. Several European nations have increased nuclear energy reliance and usage dramatically, while also providing the necessary fuel to other economies. France, for example, is using nuclear power for about 70% of its electricity generation.
U.S. and European companies have recently signed agreements that increase the sale of nuclear fuel to European power plants, especially those in Ukraine and other Eastern European nations with ex-Soviet nuclear power. Currently, around 10% of EU power plants are dependent on supply of Russian fuel.
As nuclear energy appears to be playing an important role in the U.S. government’s long-term energy strategy, it is important to highlight the risks to the nuclear energy supply chain around the world in order to better understand the emerging nuclear approach in response to the crisis and beyond.
Russia has long been a major supplier of nuclear-related products and services to the U.S. and other Western nations. Potential nuclear-related sanctions would disrupt the market and increase prices, all while the U.S. is looking for new local and international sources. According to the 2022 World Nuclear Association, Russia is the seventh-largest miner of raw uranium and plays a large role in the uranium mining operations of other economies. Additionally, Russia is heavily involved in other phases of nuclear energy production in global markets, accounting for nearly 40% of global conversion services in 2020 and more than a 40% share of global enrichment capacity in 2018. Above all, many of the current existing reactors, or ones under construction, are Russian-designed, and Russian service companies continue to supply components and services to those nuclear power plants.
Nuclear energy policies have been inconsistent in recent years in the Western world, primarily due to safety concerns. We have seen international litigation and arbitration cases result from sudden economic impact experienced by nuclear energy-related companies following policy changes. German energy companies have fiercely litigated against the German government, for example, following such inconsistencies. It would be prudent for the private sector to monitor the efforts of U.S. and other Western nations to ensure better coordination on nuclear policies to minimize economic losses.
Change to nuclear energy policies would ultimately have an impact on the investment in other renewable energy sectors. An example of such an outcome is the U.S. nuclear conversion facility Metropolis Works, which closed in 2017 following reduced demand from Germany and Japan resulting from new nuclear policies. While the facility announced renewed investments and reopening plans for 2023, any subsequent sanctions on the nuclear energy sector would impact the profitability and stability outlook of such an investment.
Besides banning oil or nuclear exports, there are other ways new market dynamics can shape the state of the Russian energy sector (which made up 45% of the country’s federal budget in 2021), with global consequences. Major energy companies have already pulled out of Russia, cutting off access to critical funding and advanced technology necessary for the maintenance and development of its aging infrastructure.
The U.S. and Europe have responded to Russia’s war on Ukraine with swift and severe sanctions, including some on energy. While there may be additional sanctions to come, we expect that the focus will shift to mitigating energy costs, disproportionately and adversely impacting Europe (particularly if Russia chooses to turn off the taps of natural gas). Unfortunately, because the oil market is a global one with real supply constraints, there are no quick fixes to replace Russian gas.
The clear solution is for the U.S. and Europe to wean their economies off of fossil fuels and accelerate the green transition. In the short-term, however, this may falter. Germany and Italy have reopened a number of coal mines to plug the energy gap in the meantime, and there is pressure on the U.S. government to reopen the Keystone Pipeline (which is unlikely to happen).
Most analysts are focused on the supply of energy, but increasingly the West and emerging markets will also need to address the demand. As Europe suffers a sweltering heat wave and households finally install air conditioning, they are of course exacerbating the exact cause of what are now annual heat waves. In the medium-to long-term, the push to develop and use renewables will be even stronger.
There are several key takeaways to be considered by the private sector and global citizens. First, companies should examine their exposure to fossil fuels—both directly and indirectly—and seek to limit both transition and physical risk. Second, the mixed approach toward energy sanctions should remind institutions to stay flexible and adjust their operations to an ever-changing sanctions regime as policy makers are shifting to reduce energy costs. Third, investors should assess the long-term impact of the recent decline in the public market’s multiples in the renewable energy sector on investment levels, demand and profits. Fourth, the nuclear exception in the current sanction’s environment should highlight its economic potential, especially for traditional fossil energy investors. Finally, the emerging decline in energy demand resulting from economic slowdown in various markets (such as China), combined with consumers’ preferences, might in the medium to long-term soften the negative impact of the current sanctions for the West.