The energy crunch in Europe escalated into a full-blown crisis this past week after Vladimir Putin cut off the pipeline that supplies a third of the natural gas that Russia sends to Europe. Natural-gas prices soared 30% at one point, and Goldman Sachs analysts projected that Europeans will see their monthly energy bills triple this winter to an average of 500 euros, or almost $500, per family at the peak.
When the worst of it hits, utility bills could account for 15% of European gross domestic product, crowding out other kinds of spending and investment. Goldman warns that the repercussions “will be even deeper than the 1970s oil crisis.”
Europe is now on the verge of recession, if not already in one, and the worst looks yet to come. Graham Secker, Morgan Stanley’s chief European equity strategist, expects an imminent recession in Europe that will pull earnings growth into negative territory next year. Result: Europe’s stocks, already off 14% this year, could well fall another 15%, Secker says.
Plenty of investors have already headed for the doors. Withdrawals from European exchange-traded funds last month hit the highest level since the Brexit panic of 2016, BlackRock reported.
European policy makers, initially slow to respond, have snapped into action, but they have few easy options. The European Central Bank has the near-impossible task of dampening inflation while avoiding a deep recession. The ECB raised interest rates by 0.75 percentage points on Thursday, its largest hike ever, and ECB President Christine Lagarde warned of a “really dark downside scenario.”
Countries are reducing power use, mostly through voluntary measures. Thermostats in Spanish office buildings were turned above 80 degrees last month. The lights that normally illuminate Berlin’s famed Brandenburg Gate have gone dark. European Union energy ministers are considering mandatory electricity limits and caps on Russian energy prices, among other measures.
Hundreds of billions of dollars in government support—potentially exceeding Covid bailouts—will soften the blow of high prices. Germany has already authorized €65 billion to help households, and the United Kingdom capped household gas and electric bills at 2,500 pounds sterling ($2,898) a year for the next two years.
The lifeline being extended to households and small businesses may not save larger firms, however. Many are already reeling.
“If there are any shortages, it’s going to be on the industrial side,” says Jack Ablin, chief investment officer at Chicago-based Cresset Capital. While natural gas is used to produce electricity and heat homes, it’s also a key input for industrial plants.
The metals industry is facing a “life or death winter” after electricity and gas costs soared over 10 times last year’s levels, a group of chief executives wrote in a letter asking the European Parliament for emergency aid. The products they make sell for less than the cost of keeping the plant running, they argued. Half of the EU’s zinc and aluminum production has already been halted. “We know from experience that once a plant is closed, it very often becomes a permanent situation.”
Government bailouts are likely to soften the pain, but not eliminate it. “You’re talking about a ballpark of over €1 trillion of extra energy costs for people,” Secker says. “Governments will try to socialize some of that with fiscal support. They’re not going to have the ability to do all of it. The number’s too big.” Politically tricky decisions on rationing energy use could still be ahead.
As the crisis deepens, analyst estimates of corporate earnings could well prove too rosy. Analysts on average expect 17% growth in European earnings this year and 2% next year, Secker says. By comparison, Morgan Stanley sees 12% growth this year and a 10% contraction in 2023.
MSCI Europe Index,
which contains companies from 15 countries, is now trading at 11.5 times expected earnings, below its historical average of 13.5. Secker sees that dropping to 10 as stocks flag in coming months.
To understand why the outlook is so bleak, it helps to look at how the European power crisis came to be.
The problems actually began more than a year ago. Natural-gas prices in Europe had already more than quadrupled on a year-over-year basis as of last September. Demand had risen as Covid lockdowns waned, and supplies were slow to catch up. In addition, a cold prior winter had depleted the amount of gas in storage.
Russia’s invasion of Ukraine in February vastly exacerbated the problem, because buying Russian energy meant funding Russia’s war. Oil prices have been volatile since the war began, but the impact on natural gas is a bigger deal. Europe relies on gas for about a quarter of its needs, from heating to electricity to industrial production. In some countries, it makes up much more. Italy, now the “sick man of Europe,” relies on gas for 40% of its energy. Europe needs to import most of its natural gas because it has limited capacity to produce it.
Russia provided Europe with 40% of its natural gas before the war. For years, cheap Russian gas powered the economies of countries such as Germany, which was directly linked to Russian supply via the Nord Stream 1 pipeline that runs under the Baltic Sea. Germany was on the brink of doubling its imports from Russia through a new pipeline called Nord Stream 2 when the war broke out.
The war turned the energy crisis into a political one, too. European sanctions against Russia initially spared most energy sources, but European countries began to transition away from Russia regardless. And Russia accelerated the process, ratcheting down the amount of gas it sent through pipelines. The announcement from Russia’s state-controlled energy giant Gazprom that Nord Stream 1 needed maintenance and wouldn’t come back on is the latest blow; analysts think it’s likely the pipeline stays off through the winter. Europe now gets just 9% of its gas from Russia.
The crisis has been particularly acute because other sources of power have underperformed. Droughts have left rivers at a trickle, reducing hydropower by 26%. And a larger-than-usual number of nuclear plants, particularly in France, have been shut down for maintenance this summer. An increase in solar power has taken up some of the slack, but Europe remains undersupplied heading into the winter.
Russia says that Europe started the economic war by imposing sanctions, and sealed its own fate this winter. “We will not supply gas, oil, coal, heating oil. We will not supply anything,” Putin said at a forum in Vladivostok on Wednesday.
There are some positive developments, though, that should give Europeans hope for the next few months. Natural gas spiked briefly above $100 per million British thermal units on Aug. 26 just ahead of the Nord Stream shutdown—six times recent historical levels—but that price didn’t hold. By shutting off Nord Stream 1, Putin has now played his most powerful card and prices have still retreated to $60.
“In terms of power-price hikes, we’ve probably seen the worst,” says Deepa Venkateswaran, a Bernstein utilities analyst. Months of preparation have paid off. Europe vowed to fill its storage tanks to 80% capacity by the end of October, and has already hit 82%, giving it several months of spare capacity. And record cargoes of American liquefied natural gas have been making their way to Europe to fill the gaps. Venkateswaran expects French nuclear plants to come back on-line in coming weeks. Gavekal Research’s Cedric Gemehl thinks “the shortage is unlikely to prove catastrophic.”
Still, the crisis has upended power markets and put the entire electrical system in jeopardy. An executive at Norwegian utility Equinor says that utilities could be on the hook for as much as €1.5 trillion worth of margin calls, and Finland warned of a “Lehman moment” in power markets. Utilities that sell power to traders and to one another use the futures market to hedge. When prices rise, they face margin calls. Some countries have already announced bailouts. Venkateswaran doesn’t expect those margin calls to be anything like the collapse of Lehman Brothers, however, because it’s driven by a sudden spike in prices, not speculation. “It’s contained within the energy system probably,” she says.
In all, it could take months for the crisis to play out and stocks to settle. Ablin is sitting in cash, waiting for more clarity on interest rates. When the Federal Reserve’s cycle of tightening rates slows down, he expects that the euro will rise against the dollar and open up a buying opportunity in European stocks. At that point, he’ll start buying names that pay stable and growing dividends, like the stocks in the
First Trust S&P International Dividend Aristocrats
ETF (ticker: FID). Among the European names in that index are financial company
(ALIZY) and pharmaceutical giant
“What appeals to me is you’re dealing with very high-quality companies,” he says. “Their balance sheets can withstand a pretty ugly quarter. Management has been dedicated to maintaining and growing their dividend. And, as a result of that, they’re going to do whatever they can to manage their cash flow.”
Write to Avi Salzman at firstname.lastname@example.org