Russian energy embargo 3/6

Economic consequences of the embargo in the short to medium term

< < < Part 2. Energy market structure and the role of Russia

Economic consequences of the embargo in the short to medium term

As discussed earlier, Russian energy embargo will create a substantial shortage of energy resources. This shortage will be global, and not limited only to the countries imposing the embargo. To evaluate the economic cost of this development we need to consider if there are any substitution possibilities, additional supply sources and demand elasticity. We have already discussed additional supply sources – they are limited and many of them cannot be brought online quickly enough. Increased energy prices will stimulate additional developments, but supply chain constraints, equipment and specialized labor availability, and the sheer complexity of operations would impose their natural limits on the speed-up.

In the past supply squeeze in one energy market was partially compensated by other segments – possibilities for the inter-fuel switch are limited, but they do exist, particularly in the electric power and industrial sectors. When natural gas was becoming increasingly expensive in the summer of 2021, we saw some gas-fired power stations switching to fuel oil, reserve oil-fired power stations becoming a part of the baseload, and coal stations utilization going up, just like the oil crisis in 1973 forced a shift away from oil-fired power generation. Similar switches are also possible in the industrial set-up, where energy is used for heat generation and manufacturers can often choose between electric or locally generated heat, often with multiple fuels.

Oil and gas are also used as a feedstock for the chemical industry and there is also some space for a maneuver, not necessarily within the same plant, but within the industry as a whole.

What makes the upcoming situation unique, is that the shortage will occur across every category, making buyers to choose among only difficult and bitter options. As a result, the prices will go up to the extent that would create enough demand destruction and bring the demand back into balance with shrunk supply. The question is therefore how this process will develop, what would happen to the prices and to the global supply chain.

At the moment total energy expenditure comprises ~5-6% of global GDP. Many people consider energy expensive, but in reality, it is a rather small part of their budget. In fact, we live in the world of energy abundance and plenty, and many of our daily comforts are built around low-cost and omnipresent energy. There are electric motors everywhere, from salt shakers to soap dispensers and garden shears, we enjoy the death of distance with food and shopping delivered to our door by a van at a swipe on a screen, we have fresh fruit delivered refrigerated from antipodes. The price of energy is less of a function of its utility, than a reflection of the cost of production in quantum satis. Part of this utility is captured by producer cartels, such as OPEC, part is captured by the governments through modern-day gabelle, or energy taxes, but mostly it goes to the consumers. It is quite difficult to ascertain how consumers value the basics like light, warmth, and transportation vis-à-vis, say, food or clothing and how much they would be willing to give up the second in exchange for the first, but in the 1800s the expenditure for the energy-intensive basket comprised up to 30% of the total.

In 1973 sudden reduction of oil supply by 5% led to tripling of the price, which stayed roughly at the same level after the supply shock was over. What happened back then was a discovery of the true utility of petroleum to consumers and new establishment of the price anchor point. We could also argue, that during COVID lockdowns that utility went substantially down and we saw prices in the vicinity of $20/bbl (the famous negative price for a day was an artefact of the market design and not a true reflector of the value). Other supply shocks (1979, 1990) led to a doubling of the oil price. Gas market tightening by a few percent in 2021 led to an almost tenfold rise in gas prices in Europe. These events might hint at where prices might go, only to a limited extent – the looming crisis might be of a different scale and beyond limits where simple extrapolation still makes sense.

Various currently circulating forecasts from energy research agencies and investment banks mention a possible oil price range of $180-$250/bbl in case of a substantial (but not complete) reduction of the Russian oil exports, and without considering cross-effects from gas and coal markets. There are few attempts made to forecast future gas prices, as the mainstay of the European gas market consisted of guaranteed supply volumes of long-term Russian contracts with their formula pricing, based on averaging oil price over several months, and nobody ever contemplated or modeled what would happen to that market in the absence of this stabilizer.

Several elements of the post-embargo regime are already clear. It is clear, that the prices will go up substantially, the only question is by how much. It is also clear that many energy-heavy industries will have to stop their operations – such as fertilizer manufacturers, steel and concrete makers, glass works,  and chemical plants. We had some examples of this last summer with hard to foreseen consequences, when it turned out that a stopped ammonia plant was also making food-grade CO2, needed to keep foodstuffs refrigerated and also used in protected atmosphere food-packing plants and abattoirs. Most likely, this would not be enough and certain rationing measures, including in residential sector, will be required.

All previous oil price and availability shocks since 1973 immediately preceded recessions, and it would be reasonable to expect one after a new oil crisis.

What’s worse, the energy shortage and price hike will likely be global, so we might expect initial stoppages of energy-heavy industries on the global scale, until the new price levels and demand levels for their output could be established. At the same time, transportation will become much more expensive (in addition to already disrupted supply chains, caused by the need to avoid Russian and Ukrainian air space), further disrupting global supply chains.

Food production might be one of the harder-hit sectors. Modern food production chain is extremely energy-dependent, based on extensive use of machinery, power for glasshouses, refrigeration and transportation and on large amounts of fertilizers, produced from natural gas. Fertilizer prices have already gone up fourfold following the last summer shortage, which would probably lead to reduced use and smaller harvests. There are expectations of grain and cooking oil shortage due to reduced exports from Ukraine and Russia, which are major players in these markets, due to war-caused disruptions to logistics and seeding season. This food shortage may have strong socio-economic outcomes in the developing world. In the past, curtailment of Russian grain exports after a draught in 2010, caused wheat and flour price hikes in Arabian countries, which were considered to be the major triggers of Arabian Spring revolutions across North Africa and Middle East.

Energy embargo effects on Russia

Energy exports bring up to 75% of Russian hard currency earnings with a large share of the rest derived from exports of energy-intensive goods, such as metals and fertilizer. Russia would probably keep at least part of its hydrocarbons exports, diverted to Asia. Pipeline exports to China (1 mbd) seem to be next to impossible to disrupt, as well as up to 38 bcm of pipeline gas from East Siberia. It is reasonable to assume that Russia would manage to export at least 1.5 more million barrels per day from its seaports, thus reducing its oil and oil products exports by 70% from pre-war levels. It is also reasonable to assume that Russia will continue to export at least 30 bcm equivalent of LNG  (down from the current 40 bcm equivalent)  from the Far North and Sakhalin in the Far East, half of its current coal exports that currently go to China, and at least some of its metals and fertilizer. In this scenario in the short run (up to 18 months), until there is supply and demand adjustment, Russian foreign exchange earnings may stay similar to the pre-war levels on much-reduced sales volumes due to substantial increase in prices, even if the Western powers would manage to establish strong embargo regime with controls over funds transfer and with heavy discounts to crisis-driven prices in place. Much of this trade would be going to China and the revenues would be used to pay China back for its goods, so these transactions may switch to yuan and avoid any scrutiny of embargo enforcers.

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In this chapter, I wanted to lay down the economic background of the possible unraveling of the economic war between Russia and Europe and to describe the facts on the ground that the adversaries may be facing. I will analyze longer-term effects and possible strategies of various players in the next chapters.

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PS The article in ECONTribute postulated that the economic effect on Germany (and by extrapolation on Europe as a whole) from the stop of energy imports from Russia will be rather small, a few hundred euros per person per annum. This analysis was performed on a Baqaee and Farhi macroeconomic model, which looked at the cost of substitution of Russian energy exports and some products produced in Germany with Russian energy. I believe this analysis makes an assumption that the rest of the world keeps the pre-embargo state, when it comes to energy prices and availability and does not take into account the ensuing global shortage of energy goods and resulting cascading effects, and thus severely underestimates the outcome.

Part 4. How vulnerable is Russia to an energy embargo? > > >