(Icy) regards from Moscow

Soaring energy prices in Europe are fueling inflation, depressing business and consumer sentiment, and pushing the economy to the brink of a recession. If Russia completely shuts off natural gas shipments in the near future, that would further darken an economic growth outlook that is already gloomy. But if Vladimir Putin uses this “nuclear option,” he would find himself on the losing end in the long run.

Yet another shock from Putin

The war in Ukraine first and foremost is causing human suffering, but its (in)direct consequences also include a looming famine catastrophe in several developing countries and soaring energy prices, particularly in Europe. Sky-high energy bills have already hammered business and consumer sentiment. And now, at the height of midsummer, Russian President Vladimir Putin has dealt yet another shock to this already tense economic situation: Russia cut natural gas shipments through the Nord Stream 1 pipeline by 60% in mid-June. Uncertainties about the natural gas supply situation for the coming winter season surged massively, as did natural gas prices. The benchmark European natural gas futures curve to spring 2023 shifted upward by 50 euros. Assuming a typical consumption behavior pattern, such a price increase implies an extra gas bill amounting to EUR 220 million for the Eurozone (equal to 1.5% of the EU’s annual economic output) for the next twelve months.

Renewed price stress | The natural gas market is anticipating shortages

Futures price and futures curve for benchmark European natural gas (TTF), in €/MWh

 Sources: Bloomberg, Kaiser Partner Privatbank

Putin’s response to Western sanctions isn’t having uniformly severe repercussions everywhere in Europe. Among the large countries in Europe, it’s mainly economic powerhouse Germany and Italy that are especially exposed because they source the bulk of their natural gas imports from Russia. To avert a cold winter and to prevent production stoppages in the manufacturing sector, policymakers particularly in those countries are doing everything they can to ensure that gas continues to flow to end customers and to cushion price shocks. Above all, though, governments are trying hard to provide as much relief as possible for private households, which are already struggling to contend with inflation as is. But even if such interventions are able to slow the immediate increase in natural gas prices, higher costs will definitely come due, if not for today’s consumers, then as a burden on future taxpayers. Russia is using Europe’s energy dependency to test its solidarity with Ukraine and to send the costs of that solidarity soaring. Will Putin even reach for the “nuclear option” soon? If he does not significantly ramp up gas shipments again through the Nord Stream 1 pipeline soon now that the maintenance work on it has been completed, this would further darken an already gloomy economic activity outlook for Europe. Developments in the last week of July do not bode well in this regard.

Russian energy resources… | …as a weapon

Daily volume of natural gas supplied via Nord Stream 1 in millions of cubic meters

Sources: Bloomberg, Kaiser Partner Privatbank

Well on track to date | Too fast for Putin(?)

Fill level of natural gas reserves in Germany

Sources: Gas Infrastructure Europe, Kaiser Partner Privatbank

Bad and even worse scenarios

As of mid-June, the European Union and Germany were well on track to fill their natural gas reserves to respective target levels of 80% and 90% of total storage capacity. If they succeed in doing that, it would be possible to get through next winter without having to ration gas, even if Russia completely shuts off the gas valve during the course of the winter. If Nord Stream 1 resumes delivering gas at a rate of at least 40% of its normal capacity after the summer pause, the EU would still be able to get through next winter without any serious supply difficulties, but would have to pay (very) high prices. But alongside this already bad scenario, there are ones that are even worse. If Nord Stream 1 is restarted with a much smaller volume of gas in the weeks ahead or is even kept turned off, natural gas reserves in the EU could be completely depleted toward the end of next winter. To stay on the safe side, natural gas would have to be rationed well before then primarily in industry, though less for private households. If Russia also shuts down other pipelines to Europe, the consequences would be even more drastic. Some industrial gas customers would probably have to completely halt production. In this worst case, the EU would slip into a deep recession (GDP contraction by up to 2%) and Germany would plunge into an even deeper one (GDP contraction by up to 3%). In the case of Germany, the chemical industry and the metal production and processing sector, which have a relatively high importance for the country’s national economy, would be particularly hard hit. But not only industry would suffer. A further ratcheting up of inflation pressure would also put a bigger dent in consumer spending. Against the backdrop of the scenarios described above, the current consensus estimates for economic growth in the Eurozone glaringly look exceedingly optimistic and do not adequately reflect the heightened risk of a recession in the Eurozone, the probability of which we now estimate at 50% or more (within the next twelve months). Meanwhile, estimates for the inflation trend, which are a bit too restrained as is, would have to be adjusted further upward.

Even higher inflation, even lower growth? | Consensus estimates are still overly optimistic

Bloomberg estimates for growth and inflation in the Eurozone, annual rate

Growth

Inflation

Sources: Bloomberg, Kaiser Partner Privatbank

Geopolitical consequences and repercussions for monetary policy

Whether Putin concedes the somewhat less bad scenario to Europe remains to be seen. The West can do nothing other than prepare itself as well as possible to face the worst-case scenario. One thing that’s clear, though, is that Russia itself will also pay a high price for its conduct. The EU is pursuing an energy transition away from Russian natural gas and is doing that quickly now. If Putin keeps the gas valve turned off, the EU would redouble its efforts and would soon completely cease to import Russian gas altogether. Russia would lose important revenue for good because the country’s natural gas cannot be stored or exported anywhere else on a massive scale on Moscow’s whims.

The monetary-policy outlook for the Eurozone, in contrast, is hardly likely to change much even in the adverse scenario. The European Central Bank is under enormous pressure to finally raise its policy rate to above zero in September, as it has hinted it will. The speed of rate hikes afterwards and the final level of the policy rate are likely to be the only mutable variables if sentiment collapses further against the backdrop of a gas shutoff in autumn.