May 2022 Newsletter
Decoupling Europe from Russian Gas
Whether we are financial market participants or not, we have all had to adjust to the reality that Russia invaded Ukraine. Beyond impacting our daily news reel with the sobering reality of lives needlessly disrupted and destroyed, we have also seen the prices of many commodities spike from elevated levels. Food, for example, has been severely impacted, and this will continue to have damaging effects on poorer countries that lack agricultural strength. These price shocks are hurting businesses and consumers, and demand and supply will have to do their thing. The cure for high prices remains high prices. What we would like to discuss herein are issues that we think have structurally changed for the long term.
There is considerable discussion in the financial news at least, of Europe’s dependence on Russia for Natural Gas. Stepping back, why are these Natural Gas pipelines important? As depicted below, Natural Gas accounted for roughly 22% of Global Energy consumption in 2019. Natural Gas has a wide variety of energy uses – a) as fuel for electric power generation, b) Industrial demand – chemicals, fertilizer, etc. c) Residential and Commercial heating, and finally d) Home Appliances. It’s also much harder to move than say Crude Oil. Pressure needs to be applied to move Natural Gas through a pipeline, and that makes long distance pipelines less economic, as you end up with less net energy the longer the pipeline goes. The other fossil fuels, Coal and Crude Oil, move much more easily, as they both can easily be transported on Rail and the Sea.
Source: Vaclav Smil and BP
If we look at the European Union (see below), they are slightly more dependent on Natural Gas than the World, at 25% of the Energy mix. But this varies greatly by country. Finland relies on Natural Gas for just 6.5% of energy. Italy, meanwhile, relies on Gas for 42%. As we all know very well at this point, Russia has been the giant historical supplier to the EU and other close neighbors. As you scan the table below, recognize that any country with 22% or more of Energy from Natural Gas is sourcing much of that Gas from Russia. For example, Italy has been sourcing 40% of it’s Natural Gas from Russia, and for Hungary this % has recently been 85% (source: Eurostat).
Source: BP
The map below depicts the transport networks that get Russian gas to the European consumers. Russia is a limited user of Liquefied Natural Gas infrastructure to move it’s Natural Gas. Liquefied Natural Gas (“LNG”) is a technology developed to monetize otherwise stranded gas reserves. The Natural Gas is cooled to extreme temperatures, and this allows it to be shipped in liquid form in tankers to markets where Natural Gas is badly needed. Japan, France and Spain were the larger original buyers in the 1970’s, but today Japan, China and South Korea dominate the buying. LNG Volumes have typically been sold on long term contracts. Russia (through Gazprom), has also typically sold under long term contracts, but relies more extensively on the old school technology of pipelines to move gas from A (Russia) to B (Europe). As you can see on the map below, three of the Gas pipelines to Europe from Russia move through Ukraine. These three lines have 40 bcmpa of capacity. These three lines that transit Ukraine account for 22.8% of the total Russia to Europe pipeline capacity. That is enough to supply 8% of the total Gas demand of the EU and the UK. 40 bcmpa is enough to satisfy 100% of the annual gas demand of countries such as Brazil, France and Australia. It’s a massive amount of gas. As for Western European neighbors at the end of these pipelines, this type of committed pipeline network creates a co-dependency. It’s a little like relying on your neighbor for 50% of your drinking water. You’d better get along with that neighbor, or you might go thirsty.
It is not a coincidence that Russia and Ukraine started fighting about Natural Gas long before Russian troops crossed the border. After the breakup of the Soviet Union, Ukraine accepted cheap Natural Gas supplies as payment for the transportation of Natural Gas across their country. This led to two outcomes: 1) Ukraine’s growth of energy intensive industry, and 2) resentment from Russia over the very cheap energy Ukraine was consuming, and using to drive energy intensive exports. By 2005, this disagreement broke out in the open, and led to four to five years of supply disruptions and legal challenges. Looking back, it is interesting to note that Ukraine and Russia peacefully got along about Natural Gas for about 12 years (1993-2005), while they have been fighting about this and many other things including territorial sovereignty for the last seventeen years (2005-2022).
Why would Europe settle for such dependency for their power, heating and industrial demand from Russia? Well for one thing, there was an economic incentive. As countries that were further from Russia such as Japan, France and Spain established energy connections, via LNG, with North Africa, SE Asia and Australia in the 70’s and 80’s, Eastern Europe leaned on the old pipelines. The global pricing dynamic for Natural Gas is well depicted below for the period since 2016. The shaded blue area is a good representation for the clearing price of Russian Gas in the EU. As you can see, from 2016-2020, the blue shaded area is clearly below the Asian contract (LNG) price (the light green line). If Germany, Lithuania, Hungary, Italy and Romania, all NATO countries, by the way, wanted to turn away from Russian Gas over the past 40 years, for the kind of volumes that they collectively would have needed, they would have had to pay the same price as Asian contract buyers in Japan, China and South Korea. And they did not want to. It was an economic deal. West Germany famously exchanged “pipes for Gas” in the early 1970’s. From 1973 to 1993 Russian Gas volumes to Germany expanded by 25x. In 2005, a Putin friendly Chancellor Schroder signed the Nord Stream I deal. This was despite opposition from Ukraine, the Baltic states and Poland. Germany liked the price for the advantage that cheaper electricity and industrial feedstock could provide for its industrial heartland. Nuclear power has been unpopular in Germany for a long time, but the choice to commit to shutting down the source of roughly 20% of their power in 2011 without committing to adequate baseload non-Russian sources of energy will be remembered as a very poor one.
Today, these choices look very foolish. These Russian natural gas pipelines will run empty in future years. The wealthier Russian Gas dependent countries - Germany, Turkey, Italy, France, Poland, etc…will all move away from buying Russian gas. Where will the Natural Gas be replaced from? The United States, Qatar, Canada and Mozambique are the closest sources of new LNG volumes in the next decade. LNG is a global market, however, and Europe will have to pay a steep price for these volumes. Australia is a massive LNG exporter, and their negotiating power has been increased immensely even if they never deliver a cargo to Europe.
Italy imports huge volumes of Russian gas. And they will be hurt by the increased price they will pay to replace it. But Italy does not have industrial champions. Germany does. The adjustment to come will be costly for Germany. Ludwigshafen, the largest chemical plant in Germany of BASF, consumes 1% of the entire power consumption of the entire country. There are three gas power plants at the site. The Rhine River transports half of the commodities in Europe.[1] See map below. 11% of the commodities shipped on the Rhine River are chemicals.[2] Much of this are chemicals shipped from Ludwigshafen up the Rhine to the industrial heartland of Germany. The cost curve for manufacturing steel, vehicles and industrial equipment in Germany has moved structurally higher. It should not be surprising then that almost ¼ of German small and medium-sized industrial companies said the high energy prices “endangered their survival”, according to a survey by the Bundesverband der Deutschen Industrie (BDI).
Source: Bloomberg
The focus of some market commentators recently has been on whether Russia will abruptly shut off the flow of Natural Gas to Germany this year. This discussion is interesting because that turn of events would most likely tip Germany, and possibly all of the EU, into recession. There are also many asking about what the EU will do without Russian oil. For us, these are short term questions. In the case of the latter question regarding oil, it is largely irrelevant for the long-term macro economy because of the ease of shipping oil and its fungible nature. The key question that is rarely being asked is what are the implications for the industrial heartland of Germany from a step change in energy costs to a permanently higher level? We believe that the likely implications are lower employment, growth, and margins for corporates within the largest economy of Europe. Note that the current contract discussions on LT gas contracts, given the current spot oil price (LNG is typically indexed to Crude Oil), are talking about LNG prices of $13-14/mBtu.[3] This is a price level that is not even on the chart (the top price is $12/mBtu) on page 6 above.
We can hope that many of the negative changes that have come since the COVID-19 outbreak of 2020 will be temporary. Russia’s invasion brought changes for the European Natural Gas supply situation that are permanent. At Ballina Capital we pay acute attention to long term structural shifts in economics as we scrutinize and select stocks from the bottom up, and we like to pay very cheap prices. One of our biggest positions is in AGL Energy, an integrated Australian utility. It happens to have very positive sensitivity to wholesale power prices. It is not a coincidence that forward Australian power prices have been increasing. As much as pundits say that the world is less global, some things are still very global.
Strategy Performance
International All Cap Value returned -0.36% on a gross basis, and -0.44% on a net basis, in May 2022 versus 1.52% for the benchmark. Year to date performance was -5.13% on a gross basis, and -5.52% on a net basis, versus -10.64% for the benchmark.
Global Small Cap Value returned 1.27% on a gross basis, and 1.19% on a net basis, in May 2022 versus 0.49% for the benchmark. Year to date performance was -4.85% on a gross basis, and -5.24% on a net basis, versus -15.09% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in May was Tianneng International Power. The Chinese electric battery manufacturer benefited from improved sentiment around long term energy technology development in China. The strategy’s top detractor in May was Resona Holdings. The Japanese bank delivered disappointing results largely due to declines in market values of USD bonds for their fiscal year ending in March 2022.
Global Small Cap Value’s top contributor in May was FIBRA Macquarie Mexico Real Estate. The Mexican Property REIT reported results ahead of expectations at the end of April. The strategy’s top detractor was Xiamen C&D Inc. The lockdowns of Shanghai in China had a damaging effect on sentiment for the movement of goods within and from China.
Disclosures:
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmark being shown for comparison purposes in the Vanguard Total International Stock ETF (VXUS). The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return. Data show is from a representative account of the International All Cap Value and Global Small Cap Composites. All returns are Gross of Fees. Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented. The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the measurement period are available upon request.
[1] Chemical and Engineering News, “A low Rhine is hampering Europe’s chemical traffic”, October 25, 2018. [2] Chemical and Engineering News, “A low Rhine is hampering Europe’s chemical traffic”, October 25, 2018. [3] The Hindu Business Line, “Petronet LNG in talks with Qatar for higher volumes at lower price”, May 13, 2022.