Phil Verleger, Denver - Jan 14, 2022

Oil industry executives and consultants have warned for decades of the damage high prices wreak on global economic activity. It’s been accepted wisdom in industry and government circles. However, the situation has changed. In 2022, economic policymakers in Europe see high energy prices not as a threat to economic growth, but rather as an opportunity to move more quickly to their goal of ending all fossil fuel use. The shift in attitude and resulting policy threaten the future of oil, natural gas and coal producers. Oil-exporting nations and others in the industry should take note and consider their alternatives.

European Union member states are leading the effort to end fossil fuel use across the globe by 2050. In July 2021, the EU introduced a massive program called “Fit for 55,” which would, if adopted, transform all parts of its economy. The program’s specific goals are to cut greenhouse gas emissions by 55% by 2030 and achieve climate neutrality by 2050.

A key element in the "Fit for 55" proposal is the Carbon Border Adjustment Mechanism (CBAM), which would impose tariffs on imports of energy-intensive goods from other countries if the energy used to produce the imports exceeded the amounts used by European manufacturers of those same goods.

Russia is threatened by CBAM. It appears to have reacted to it by reducing its gas shipments to Europe. Russian suppliers provided half of Europe’s natural gas imports in 2020, and imports accounted for almost 90% of EU consumption. The decrease in gas shipments from Russia began in the summer, just as European electric power generators boosted gas consumption to offset a drop in wind-generated power. The cutbacks reduced the gas inventories owned and held in Europe by Russian giant Gazprom to far below historical levels.

Energy Intelligence correspondent Vitaly Sokolov explained Gazprom's strategy in World Gas Intelligence: “Last year, Gazprom injected 2.4 billion cubic meters into European storage ahead of winter, leaving stocks at almost 11 Bcm. It withdrew 10.6 Bcm over winter, partly because it preferred to sell out of storage rather than pipe more gas via Ukraine. It did not actively replenish stocks in the summer as it restricted flows via Ukraine and through the Yamal-Europe pipeline across Poland. Many saw the restrictions as a tactic to keep European prices high and force speedier approval of its controversial Nord Stream 2 gas pipeline.”

Russia’s ploy to raise prices succeeded. As the table below illustrates, average gas prices as measured at the border of key European countries increased by more than 400% in the fourth quarter over 2020 levels, according to Energy Intelligence data. Russia would have expected the increases because economic research has repeatedly shown that prices rise sharply when inventories are low.

Russia’s limitation on gas supply to Europe, aimed at coercing EU countries into consuming greater amounts of gas and essentially abandoning the “Fit for 55” program, constitutes aggression. The effort has not been subtle.

Oil producers also contributed to Europe’s economic pain in 2021, by holding production back to boost prices. Those efforts were led by Russia and Saudi Arabia and caused crude prices to rise almost 80% in dollar terms for all EU nations. Again, the Russian actions seem aimed at pushing European economies into recession and fanning resistance to “Fit for 55.” As noted, policymakers in Moscow knew that the price increase would cut economic growth in the EU, as it has.

Good Demand for Non-Energy Goods

While policymakers in energy-exporting countries expect the price boosts to depress growth rates in the targeted nations from previously projected levels, the magnitude of the impact of higher energy prices on economic activity is highly uncertain. The economic literature on the issue is a muddle. Many academic studies suggest that the Russian efforts to slow European economies by pushing up regional gas prices could fail if governments and central banks act to sustain consumer demand for goods outside the energy sector.

This strategy would have been almost unimaginable in the past. However, governments and central banks worked to maintain economic activity through the Covid-19 crisis that began in March 2020. Financial support came via increased government spending, the continuation of low interest rates, and central bank purchases of government and company bonds.

Such actions are being taken today. Italy, guided by Prime Minister Mario Draghi, a Massachusetts Institute of Technology-trained economist and former head of the European Central Bank (ECB), is leading the effort. The Italian government has agreed to compensate companies that will work to limit energy price increases. To back up this pact, the Italian state budget enacted at the end of 2021 allocated more than €3.5 billion ($4 billion) to help moderate energy price rises. Germany, Sweden and Norway are taking steps, as well.

Perhaps the most significant move, though, was by the ECB. On Jan. 8, ECB board member Isabel Schnabel spoke on the issue to an American Finance Association gathering. Press reports focused on Schnabel’s inflation concerns. Ignored was Schnabel’s firm statement that the transition from fossil fuels needed to be “pushed forward” and that governments need to protect those most vulnerable to “energy poverty.” While central banks should assess where the transition threatens price stability, they should also consider where those risks “are tolerable and consistent with their price stability mandates.”

In an earlier presentation, Schnabel had asserted that the ECB was not only allowed but required to take climate change into account in its actions. Her view confirms a belief that Europe will not capitulate to the increase in fossil fuel prices but rather intensify its efforts to eliminate emissions from burning oil, gas and coal.

The EU will likely also accelerate its efforts to force other countries seeking to export goods or services into Europe to reduce fossil fuel consumption by quickly imposing and then gradually raising the CBAM. This action will make exports of goods from Russia, China and other countries uncompetitive with products produced inside the EU unless these nations follow the example of the EU and cut carbon emissions. Fossil fuel producers will be the losers.

Europe might not be alone in this approach. In the US, one survey indicated that as as many as 80% of those questioned saw CBAM mechanisms as a good idea if they were described as a tax on Chinese imports.

Abandoning Fossil Fuels

The fossil fuel industry is confronted with a problem that ultimately threatens its long-term survival. Warnings about how high energy prices threaten economic growth are no longer accepted by key economic policymakers. Instead, high prices are welcomed because they will accelerate the move to a world that has abandoned fossil fuels. Russia’s actions limiting gas exports to Europe may have hastened this shift in attitude.

Here, two effects of the EU approach should be of concern for oil and natural gas producers. First, the ECB and European governments are challenging the view that energy price volatility harms economic activity.

This position, put forward by serious and important economic policymakers, was captured succinctly in the following statements made by the International Energy Forum (IEF) at the World Petroleum Conference: “Prolonged cycles of energy price volatility are detrimental to economic growth. On the microlevel, it can affect individuals’ and companies’ costs and revenue streams, making planning difficult. At the macroeconomic level, volatile oil prices fan inflation, hinder investment, delay consumption of durable goods, reduce total economic output, dent equity returns, and entrench energy poverty.”

Beyond asserting that the IEF authors’ views are economic rubbish, the EU policymakers seem to have concluded that Europe’s energy security is best achieved by eliminating fossil energy use altogether and thus relieving themselves of the need to deal with Opec or other energy-exporting nations. While EU officials have not directly accused Russia and Opec of trying to frustrate the community’s effort to reduce fossil fuel use, the actions of the ECB and various countries suggest this is their belief. Rather than capitulate to energy producers, the EU intends to ramp up its effort to minimize the burning of hydrocarbons.

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.

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