The war in Ukraine has thrown up huge uncertainties around the role of gas in the energy system. Experts from our credit, ESG and real assets teams discuss the implications for traditional energy and renewables companies.
Read this article to understand:
- How European countries are adapting to the end of bountiful Russian gas supplies
- The impact energy security and net-zero plans are having on the outlook for gas
- The risks and opportunities for investors
Natural gas represents a quarter of the world’s primary energy consumption (Figure 1). Western opposition to the war in Ukraine, which led Russia to cease exports of gas to most of Europe in 2022, sent countries scrambling for alternatives, filling storage and building liquefied natural gas (LNG) terminals in a hurry.
Figure 1: Global primary energy consumption by source (2020)
Source: Aviva Investors, Our World in Data, 20211
Gas prices also shot up, fuelling inflation and a cost-of-living crisis across the European Union and UK. This raised urgent questions around energy security and the risks stemming from overdependence on nations that could turn hostile.
Further complicating matters, some proponents of a net-zero transition are advocating for an immediate switch to renewables, while others believe gas has a key role as a transition fuel.
How are governments reacting? Europe has benefited from a mild winter, but is its energy supply secure for next winter? Are high prices speeding up the renewables transition? What role will natural gas play in future?
To answer these questions, the AIQ editorial team brought together Lei Wang (LW), senior securities analyst; Mikhaila Crosby (MC), responsible investment associate, real assets; Luke Mulley (LM), ESG sector analyst; and Derek Foster (DF), senior credit research analyst at Aviva Investors.
What is the outlook for natural gas supplies to Europe?
LW: A lot of Europe’s supply comes from Norway and North Africa, which it is trying to increase, as well as the North Sea, Netherlands and Germany. The rest is from LNG imports, essentially the US, but also Qatar and a few others.
There is concern over the risk of sabotage that could incapacitate a major pipeline, as we saw with Nord Stream I. The major companies are all working to increase security, but overall, supply is not an issue right now. Inventory levels are good, and there is a lot of LNG supply because China has not bought much this winter.
China has started switching from LNG to piped gas to diversify
China has also started switching from LNG to piped gas to diversify. Rather than depending on LNG, it gets more supply from Central Asia. China’s reopening does mean more demand for commodities, and gas will probably get a push. But because gas prices are weather dependent, they vary across regions, so China’s reopening will not necessarily drive them higher in the US or Europe.
In addition, rather than buying most gas on the spot market, the EU is signing more long-term contracts, related to oil prices. The price of gas in such contracts ranges from 11 to 16 per cent of crude oil prices, meaning natural gas prices in Europe are around $20. That is still a great price for producers, but not as horrible as before for buyers.
DF: As Lei said, as far as northeast Europe goes, and Germany in particular, the shortfall from Russia has largely been filled by US LNG imports. The US LNG infrastructure can currently handle about 14 million tonnes per annum of exports and is not due for any large-scale increases in 2023. But in 2024 and 2025, capacity will increase by around six million tonnes, nearly all of it backed by 20-year contracts with Southeast Asian and European customers.
US production should continue to grow, especially as new export facilities come online
Furthermore, as shale-gas wells deplete over time, they become gassier, so wells drilled ten years ago are now producing more gas than oil given geological pressures. US production should continue to grow, especially as new export facilities come online.
LW: European countries remain reluctant to lock themselves into 30-year contracts, so although they are increasing those, they won’t secure the full supply they need this way. There will likely be demand destruction.2 Utilities in Europe don’t want to rely on natural gas going forward, so they are trying to find alternatives.
Figure 2: Demand to remain lower: Year-on-year change in European electricity generation (TWh)
2023 projection (Ember)
Source: Ember, as of January 31, 20233
Are European countries building more storage capacity?
DF: Europe hasn't built any incremental gas storage capabilities. What it has done is build a few floating regasification terminals that are effectively import terminals for LNG. The thing to keep in mind is that last year, Europe averaged around 150 million cubic feet a day of Russian imports. Obviously, the second half was close to zero while the first half was over 300. In 2023, it will be zero, so Europe’s ability to fill storage – from an admittedly strong level today – coming out of winter is going to be more difficult.
LM: The storage picture varies. In northern Europe, Germany has built floating regasification units because it is short on storage and reliant on gas, whereas Spain’s gasification units are fit for purpose but not well connected to the rest of Europe, creating a logjam.
DF: To add to this, European industrial demand for gas is down roughly 30 per cent this winter. Some of that is rationing and smarter usage, but cutting gas consumption by 30 per cent in the industrial sector can't be maintained over the long term without risking deindustrialising Europe. Industry doesn’t necessarily need to go back to 100 per cent of 2021 gas consumption, but continuing at 30 per cent lower is not sustainable.
LM: We would be concerned by that level of industrial demand continuing. BASF, the big German chemical company, says it will have to move production to China because it's not cost-competitive to produce in Europe, and that seems to be the overwhelming theme.
The UK is running a risky approach in terms of storage
As Derek said, it's not sustainable, which is why narratives are building around a potential European Inflation Reduction Act (IRA) equivalent to try and create a more competitive environment.4 It is starting to look ugly from a competition standpoint, with Europe trapped between the US IRA and cheap power in China.
LW: As for the UK, it is running a risky approach in terms of storage. So far, it has been lucky because the weather has been mild, but that can change next winter. It also makes the UK dangerously dependent on Norway and France.
LM: The UK is in a difficult position. Because it shut the Rough facility early, it is far behind the rest of Europe in terms of storage capacity, but any significant change would have to be driven by policy. This is not happening, as the government is prioritising diversification of supply over strategic storage, and that creates two problems.5
Firstly, when your electricity system is dependent on the gas price and your homes’ heating system is one of the most dependent on gas in Europe, favouring the LNG spot market for supply is an expensive gamble to take with consumers’ pockets. Secondly, by the time the UK builds a large storage system, it will not need it as much, so it is “damned if you do, damned if you don’t”.
What impact is energy security having on investments?
LM: Every energy source is compromised on security; it's not just an issue with natural gas or Russia. The big narrative against the renewable transition is the dependence on China it creates. Over 80 per cent of polysilicon for solar panels is made in China, and Chinese wind turbine manufacturers are battering European ones, who are burning cash to compete.
On the battery side, the majority of lithium, nickel and cobalt refining capacity is also in China. Even though Australia produces 55 per cent of the world’s lithium, 90 per cent goes to China to be refined; it's cheaper there because China uses lots of cheap coal. It then comes to Europe and the US and is used in batteries (see The economics of renewables: Challenges and solutions).6
Even with the IRA, China got there early and is so dominant that, given the time it will take to scale up, we will not be looking at a majority Western supply chain before 2030 and probably even later.
There is a big problem with the security of energy supply, but it’s not just a case of removing the dependency on Russian gas. Some ugly trade-offs need to be made across the energy mix.
DF: There are other supply chain concerns. The latest one has highlighted Russian leverage over Europe on gas, but if you look at Russia's revenues, 80 per cent come from oil and twenty per cent from gas. Therefore, gas was easy to weaponise, whereas oil is much more difficult given its larger contribution to Russian coffers. If Vladimir Putin really wanted to inflict pain on Europe, but also himself to an extent, oil would be next. He has threatened it, but he does have a survivor instinct, so we'll see if he does it.
For alternatives enabling a transition away from fossil fuels, rare earths in China, cobalt in the Democratic Republic of Congo and palladium in Russia are a few of the many bottlenecks that mean we can’t move as fast as we would like. Some of these minerals are so rare there are only a few large deposits around the world. Lithium mining is also not something you want to bring into your backyard unless you have to.
People have seen how much leverage Russia was able to use, but luckily Europe and its allies have stuck together
That extends the useful life of a lot of legacy assets, whether they're infrastructure, power or even older fossil-fuel exploration and production fields in the North Sea and other mature basins.
People have seen how much leverage Russia was able to use, but luckily Europe and its allies have stuck together, so it isn’t necessarily as appealing for other countries to try and use those supply chains as leverage in future.
LW: Windfall taxes also disincentivise investments in European gas production. They are making it difficult for oil and gas producers to invest in new exploration and production, so Europe is shooting itself in the foot with those. European energy supply will probably get even greener because we need more self-sufficiency, whereas nobody is rushing to put more investment in declining gas fields. The only country with growing gas production is Norway, encouraged by the government. Some parts of Africa might also see production rise, but the situation there is more unpredictable.
DF: Europe’s response to Putin's move was to give more leverage to Organization of the Petroleum Exporting Countries, which the US is also doing. It seems short-sighted when you have alternatives, both renewable and fossil-fuel based.
Have net-zero plans been reinforced or threatened by high energy prices?
DF: It's dependent on geographies. In the US, it hasn’t changed much. The price moves have shown faults in the assumptions net-zero pledges made about ever-falling costs and mostly free money with low interest rates. Alternatives are more expensive than they used to be, and investments will be more difficult to get off the ground. While we expected a difficult transition, some of these plans, whether corporate or sovereign, will be even more difficult and more uncertain than they were 12 months ago.
Some of the biggest risks to investment are permitting and regulatory and political uncertainty
MC: European and UK policy is understandably focused on energy security and the need to accelerate the transition and funding for things like hydrogen or carbon capture, utilisation and storage (CCUS), and to replace or upgrade existing gas infrastructure to enable lower-carbon gas blends in pipelines (see Figure 3). But some of the biggest risks to investment are permitting and regulatory and political uncertainty. There is a lot of talk about wanting to mobilise private capital to help the transition, but there is no clear policy.
Figure 3: Difference in total energy supply – WEO 2022 STEPS versus WEO 2021 STEPS
Source: IEA World Energy Outlook, 20227
LM: We have also started to hear about the “mid transition”, which is the idea neither the renewables capacity nor the fossil-fuel infrastructure is now able to supply all the demand, so they must work together despite competing objectives. That is creating confusion between the necessary top-down management of declining fossil-fuel infrastructure and the massive ramp-up of renewables (see Figure 4).
Figure 4: Wind and solar investment needs and gaps
Source: International Institute for Sustainable Development, 20228
LW: It is providing relief to oil majors because we need fossil fuels to get through the war and the high gas price is making it easier to invest in renewables. They have the dry powder. But the tone has changed; before the war, because of all the Environmental Social and Governance (ESG) pressure, they were all talking about shrinking fossil-fuel operations.
All oil majors announced they would increase capex and aim at increasing production
Recently, all oil majors announced they would increase capex and aim at increasing production. They are also open to M&A of oil and gas assets. BP also announced it would slow down its renewable progress and increase focus on its fossil fuel business. And thanks to its cashflows, the transition will be easier for BP because it will be leading the major projects. How fast it can do it is harder to say because these projects take a long time.
Permitting is a major bottleneck and the oil majors are also cautious about where to invest in renewables because electricity prices are set locally. They won’t go to EM countries because the local electricity price in some is nowhere near as high as in developed countries.
Is there a switch in new projects from fossil fuels towards renewables?
LM: It's difficult to say. Renewables are going to be deployed as fast as possible but the International Energy Agency projects electricity demand growth to be about three per cent globally in the coming years. With growing demand, new renewables will first supply new demand, and only the leftover incremental capacity can penetrate the grid. That means it will take a long time to get to big renewables penetration in power generation.
However, before bringing any new project online, companies do a simple excel look-through of what the project is going to generate, and renewables prices are much lower than fossil fuels. Gas prices in Europe are certainly going to be elevated for the next five years, as will coal to an extent – and everyone is keen to phase coal out as well. Add a carbon price, and it makes coal even less competitive. That is happening already.9
One of the key challenges in moving more quickly to renewables is constraints imposed by planning processes
MC: One of the key challenges in moving more quickly to renewables, and something we see in real assets, is constraints imposed by planning processes. The UK and EU have huge ambitions for renewables, but the planning process is prohibitive when it comes to deploying capital and delivering on projects. It can take three to five years, for example, before you can start to build an onshore wind farm – and that’s a best-case scenario.
One of the key recommendations of the recent Mission Zero report (the independent review of the UK's net-zero strategy) was for the government to prioritise overhauling the planning and procurement processes for renewables projects.10 Hopefully, this year will see the government publish a firm plan to deliver this faster.
As real assets investors, we like to support renewables projects, but there are not always enough to go round because of pricing competition and because supply is significantly impacted by the planning process.
DF: When the IRA was passed, the other side was supposed to be an infrastructure reform bill Senator Joe Manchin proposed for legacy and renewable infrastructure, which included an overhaul of the permitting process. But it didn't make it through Congress, so that continues to be a huge bottleneck in the US as well. The IRA may give stronger economics to projects, but they still can't go faster until permitting gets fixed.
LW: On the credit side, many renewable companies have cost overruns, reporting larger losses than expected. To put capital to work, you need some free cashflow, but they are burning cash and keep on needing to raise capital.
How do you see the competition between gas and renewables playing out over the medium term?
LM: Solar and onshore wind levelised costs of energy (LCOEs) are currently at $45 to $50 per MW hour, according to BNEF (see Figure 5). Natural gas is globally at $90, although it varies regionally. Prices have been much higher than the global average in Europe, but much lower in the US, where supply has not been an issue.11
Figure 5: High commodity costs push up power prices ($/MWh, 2021 $)
Source: BloombergNEF, as of December 27, 2022
In Europe, Rystad forecasts the title transfer facility (TTF), a proxy for European gas prices, to be around €31 per MW in 2030, equating to an LCOE of around €150 per MW hour. Although these are only estimates, if solar LCOEs remain around €50, that is three times cheaper, which shows that, not only is new gas not cost-competitive versus renewables today, but it likely won’t be even out to 2030. That makes it difficult to bring a gas project online on a pure cost basis.
In the US, NextEra, a big utility, stated costs are 40 per cent cheaper for new solar and 70 per cent cheaper for onshore wind than natural gas, a difference heightened by the IRA tax credits. There are ten big regional electricity grids in the US, and on an LCOE basis, it's cheaper across all of them to run solar and onshore wind than natural gas.
That's not to say grid operators won't want some gas in the mix because of the flexibility it provides, but as gas is also more carbon-intensive than renewables, we are starting to see it used to complement other sources at peak demand times.
In developing nations, Chinese and Indian grids are still coal dominated. Because coal represents 75 to 80 per cent of global electricity emissions, 25 to 30 per cent of emissions come from China and seven to ten per cent from India, so they need to prioritise phasing coal out. The question is how fast, and whether they will move straight to renewables or via a switch to gas.
The answer is likely to be both. As much renewable capacity as possible will be brought online – as shown by the size of China’s investments, the largest by far globally in 2022 – but if countries are to decarbonise electricity supply whilst meeting demand, there will have to be a significant coal-to-gas switch.12
There is a big difference between developed nations, which are looking at phasing out gas and increasing renewables, and developing nations, where the main switch will be from coal to gas plus some renewables.
DF: I would push back quite quickly on the notion of developed nations reducing gas consumption in the near term; in fact, US gas consumption reached all-time highs this past winter despite high prices. On renewables, reliability is improving thanks to technology advancements, but remains an issue. As Luke outlined, gas currently provides the best peaking capability. Affordable and scalable on-site battery storage could tip that in renewables’ favour, but for the foreseeable future, reliability is going to be gas’s largest advantage. This is especially true when it comes to baseload generation, with combined cycle gas turbine (CCGT) baseload LCOE (inclusive of subsidies) well below that of most renewable sources.
There is no silver bullet when it comes to emissions
There is no silver bullet when it comes to emissions, and gas as a bridge fuel could present a strong opportunity globally to aggressively decarbonise. Over the last decade, the US has significantly reduced electricity production’s emissions, largely by switching from coal to gas.13 As General Patton famously said, “A good plan executed now is better than a perfect plan next week” if we have an ability to cut carbon emissions by 50 per cent tomorrow by switching from coal to gas, we need to continue to push down that avenue, especially given the reliability of gas.
As renewables become more efficient, that may change, but we are seeing large investments in the US and Asia into natural gas infrastructure at least for the next decade, even though European plans continue to be more of a puzzle.
LM: The renewables transition is happening, which is great, but gas will still be needed for three key demand areas: flexibility in power generation; hard-to-decarbonise industries, where gas is used as a feedstock for its chemical properties as opposed to just for energy generation; and buildings, since the cost of heat pumps raises doubts as to their ability to replace boilers.
In the theoretical 2050 scenario, there is a role for gas, clearly outlined in the EIA’s World Energy Outlook. It forecasts demand ticking up by 0.4 per cent per annum to 2030, then tailing off slowly. I suspect it may tail off faster, but natural gas will still be in the mix into the 2040s (see Figure 6).
Figure 6: Global gas power capacity (gigawatt)
Source: International Institute for Sustainable Development, 2022
Where do you see the biggest risks and opportunities for investors?
MC: Stranded asset risk is a key consideration. We would lean towards existing gas infrastructure, such as pipelines and distribution networks, rather than deals involving new construction. We ideally don't want to be adding more emissions to the grid through the additional gas pumped or those generated by building a new plant.
Emerging markets may need to use more gas to transition away from coal and we assess every opportunity case by case
That said, emerging markets may need to use more gas to transition away from coal and we assess every opportunity case by case. It would be preferable, but may not be feasible, for emerging market nations to leapfrog gas and transition straight to renewables, but the right incentives and support are needed for this to happen.
Regulation is also something to consider for any gas-related asset, particularly around methane, whose global warming potential is over 80 times more potent than carbon dioxide’s over the first 20 years.14 Adding new gas capacity to the grid will inevitably also add methane (see Figure 7) via leaks and production, and we are expecting new regulation to come in, notably in Europe, where a directive has been proposed and could be adopted as early as this year.13
Figure 7: Methane sources (MT)
Source: Aviva Investors, IEA, 202014
The EU’s proposal is energy-sector-specific, and would establish a new European legal framework requiring companies in the oil and gas sectors to measure and quantify asset-level methane emissions at source. They would also have to carry out comprehensive surveys to detect methane leaks within their operations and repair them within five to 15 days. The proposal includes fines and periodic payments for any breaches, and that could significantly impact any project we look at in Europe.
We have seen interesting projects for gigafactories and lithium refineries in Europe
In terms of opportunities, we are positive on battery storage systems. In Europe, we have seen interesting projects for gigafactories and lithium refineries, which would help Europe and the UK reduce their dependency on imports for EV batteries, for example.
We would also consider existing gas infrastructure projects (transmission and distribution networks) that aim to invest in R&D for low-carbon gases or hydrogen blends within the gas network. But this would be on a case-by-case basis as the merits and risks of each deal will be different. We would like to see CCUS coming through as well, because many governmental commitments and policies seem to be reliant on it to reach net zero. Although the technology has been around since the 1980s, we are still some way off being able to deploy it at scale.
Finally, we are still seeking opportunities in renewables, although they are quite competitive, and in biomass, albeit only with emissions reduction and mitigation measures.
LW: Recession is probably the biggest risk if it reduces investment. I am concerned about the demand side. Another risk for oil and gas companies is, if this war ended, the oil price could fall with the return of Russian oil to the market. That probably won’t happen anytime soon, but if it did, the whole market might rally but oil and gas might fall.
DF: As far as opportunities, US LNG export facilities remain our preferred area in both credit and equity. US gas producers are in a strong position, particularly on the equity side given their long inventory runway and our view of structurally higher demand going forward for US gas. We are also interested in any way to play CCUS; for now, that is largely through the majors.
We continue to believe in replacing legacy coal-plants with new CCGT gas turbines where that makes sense
We also see stranded assets as a key risk, but prefer new rather than old infrastructure, particularly on the fossil-fuel side because most of it will carry a much lower emissions profile than something older, with lower potential carbon costs. We continue to believe in replacing legacy coal-plants with new CCGT plants where that makes sense, for example.
The other risk we are concerned about is renewables’ valuations. As an illustration, ExxonMobil year-to-date has an ROIC of about 16 per cent, and it has fluctuated between eight and 25 per cent over the last 20 years. NextEra Energy’s ROIC is one to 1.5 per cent. Investors just aren’t making money in renewables. And when money is not free, we are concerned about those businesses’ growth prospects.