investment insights
Nord Stream 2 stalls on German approval as Europe looks to winter
Lombard Odier Private Bank
Key takeaways
- Approval of the new Nord Stream 2 gas pipeline linking Russia with Germany is pending
- A cold European winter will stretch already-low gas inventories, increasing competition and prices again
- We expect Russia’s economy to expand by 2.8% in 2022. The Bank of Russia’s rate hike cycle may be nearly complete
- Rising energy costs would be a drag on other asset classes, offsetting any gains from direct exposure to energy assets.
At the approach of winter in Europe, attention is focused eastward to solve the region’s energy crisis. Natural gas prices have increased as much as eight-fold since the start of the pandemic as competition with buyers in Asia created shortages across the continent. Meanwhile, the newly completed Nord Stream 2 pipeline connecting Russia and European Union remains caught up in geopolitics, pending approval by the German regulator.
The energy crisis has been long in the making. Pandemic periods of working from home and a cold spring in Europe increased demand as China slashed the use and production and imports of coal slowed as the country tried to improve pollution levels and mines flooded. This increased competition for gas, with inventories in Europe reaching their lowest levels in a decade as cold weather kicks in. While storage is replenishing, a cold winter would drain that capacity quickly and intensify competition again.
The more than 1,200 kilometre Nord Stream 2 pipeline connects Western Europe and Russia through the Baltic Sea. After three years of construction, it was completed in September and will double the existing Nord Stream pipeline capacity from 55 billion cubic metres (bcm) to a combined 110 billion bcm of gas annually. The two Nord Stream routes add to the pipelines through Ukraine which are designed to deliver as much as 146 bcm of gas. Another pipeline, running through Poland via Belarus, can carry another 33 bcm per year. The advantage of the Nord Stream pipelines is that they avoid traversing territories, including Belarus and Ukraine, which subject supplies to broader political interference.
Opponents of the Nord Stream 2 pipeline in the European Union have argued that it will increase the region’s strategic energy dependence on Russia. Eurostat, the EU’s statistical agency, estimated that Russia supplied 43% or 166 bcm of Europe’s total gas imports in 2019, worth almost USD 18 billion. That same year, in comparison the EU’s second-biggest gas supplier, Norway, provided 23% of the bloc’s needs.
Approval delay
In response to rising demand for gas, at the end of last month Gazprom said that it has increased production by nearly 17% in 2021, compared with a year earlier. In October, Russian President Vladimir Putin said that Russia would further increase supplies of natural gas once capacity through the new pipeline comes online.
On 16 November, Germany’s network regulator suspended its Nord Stream 2 approval process. A statement said that since the Gazprom subsidiary operator is not based in Germany, its certification would wait until the operator has established a legal base there. The ‘Nord Stream 2 AG’ structure is Zug, Switzerland-based, and a subsidiary of Gazprom PJSC (Public Joint Stock Company). German law gives the regulator four months to deliver a draft decision to the European Commission. As a result, the approval delay depends on how quickly Gazprom can transfer its legal entity to Germany, and the process may last right through the northern hemisphere’s winter.
After gas prices peaked in early October, inventories rose over the month, leading to a fall in prices. A cold European winter may see inventories fall to historic lows (of around 10% of capacity). On the other hand, mild temperatures in the region, in line with the 2018-2019 winter for example, would leave inventories by spring at more normal levels of around 30%.
Eventually, higher gas prices will stimulate higher supply, whether through the additional capacity of the new Nord Stream 2 pipeline once its German company registration is cleared, and possibly from the US, which has traditionally operated as the swing producer.
German hiatus
The approval process has probably been slowed by the hiatus in German politics. Until last week, Germany was negotiating to form a new federal government after a general election in September, which saw Angela Merkel step down after almost 16 years in office. Olaf Scholz’s Social Democratic Party (SPD) announced a three-party coalition with the Green Party and Free Democrats (FDP) on 24 November. If the parties each back the deal, Mr Scholz is scheduled to be sworn in as chancellor in the week beginning 6 December.
The US and Germany differ over the new pipeline. While Germany’s government has supported its construction, the Biden administration continues a more adversarial tone in relations with Russia than its predecessor. Last week, the US imposed new sanctions on a ship involved in constructing the Nord Stream 2 pipeline. The US began imposing sanctions on Russian government officials and businesses in 2014, with travel restrictions and asset freezes on a list of more than 700 firms and individuals, according to Bloomberg. “We continue to work with Germany and other allies and partners to reduce the risks posed by the pipeline,” US Secretary of State, Antony Blinken said in a statement last week.
Presidents Joe Biden and Putin may meet one another again early next year after a June 2021 summit in Geneva. Tensions between Russia, the EU and US have been high since Russia annexed the Crimean peninsula in 2014 in the wake of the Ukrainian revolution. In recent weeks, the US and European Union have raised concerns over Russian troop movements on the Ukrainian border. Any escalation in the stand-off over Ukraine looks unlikely for now, since it would risk undermining approval for Nord Stream 2. Meanwhile, migrants massing on the Polish border are trapped on the Belarus side, creating a humanitarian confrontation with the EU. Belarus President Alexander Lukashenko has said that he will not force the migrants, mostly from the Middle East, to leave.
Energy dependence
Of the globe’s major economies, Russia is unique in being a net exporter of oil, natural gas and coal. As the world’s second-largest oil producer and biggest natural gas producer, energy production and prices are a cornerstone of Russia’s economy. A decision by the Organization of Petroleum Exporting Countries (OPEC), plus Russia, to raise oil output next year may come under pressure from a US decision to release 50 million barrels of crude oil from its strategic reserves. The cartel, which historically waits for demand to rise before increasing output, is next scheduled to meet on 2 December. Increasing Covid infections, a new variant and renewed restrictions in many markets including central and Eastern Europe, may begin to undermine demand for oil.
Russia’s fiscal situation is strong and the government’s three-year budget anticipates surpluses in 2022-23. Still, the country’s low vaccination rates, rising Covid infections and public health measures will be reflected in 2022’s growth. We expect the economy to expand by 2.8% in 2022 as little fiscal spending and the country’s high interest rates act as brakes. Since March 2021, the central bank has increased Russia’s benchmark rate by 325 basis points to 7.5%. With inflation at 8.1%, the rate hike cycle may be nearly complete; we expect the benchmark rate to peak as high as 8.5% next year.
Russia's central bank surprised investors this year with its hawkish bias. By suggesting that a neutral key rate of 5-6% will not be achieved before 2023, market expectations for three-year rates rose above 8%. This is higher than the central bank’s own guidance and suggests that rate hikes are built into current yields. If new pandemic disruptions delay a global recovery, the resulting fall in energy demand and a slowdown in Russia’s economy may support rouble-denominated bonds, providing an interesting entry point for investors.
Of course, a key risk remains geopolitical volatility and any outflows of foreign investors. However, the share of foreign ownership in the domestic government bond market is already close to an all-time low, reflecting geopolitical tensions. In this context, any further international strains should prove less market disruptive than in the past.
Driven by higher oil prices, Russian equities have been one of 2021’s best-performing stock markets in US dollar terms, outperforming wider emerging markets by almost 20%. Valuations have been lower against emerging markets for a long time and improving earnings expectations could further support this strength. The oil and gas sector represents 47% of market capitalisation. Including banks and mining that share rises to more than 75%, making it sensitive to global growth. The biggest risks for Russian equity holders are any further sanctions and energy price volatility.
The Russian rouble should be supported by higher energy prices which in turn are boosting the national current account. Against the US dollar, the exchange rate should remain stable at around 69-74 roubles. The main risk to this view is any deterioration in US-Russia relations.
For globally diversified multi-asset portfolios the potential risk is that a significant and persistent increase in oil prices and energy costs would be a drag on other asset classes. This impact would more than offset any gains from direct exposure to energy assets that benefit from rising prices.
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