Citi: Worst-case scenario for energy just around the corner – Gas rationing likely in two weeks

Her Eleftherias Kourtalis

In two weeks, some European governments may have to activate emergency gas rationing plans if Russian gas supplies are not restored, Citigroup points out. Without reducing consumption, there may not be enough gas to heat homes in winter. At the same time, the end of Russian gas supplies will lead the Eurozone from stagnation to (mild) recession, while inflation will jump further and the price of natural gas may climb up to €250/MWh.

In more detail, the American bank points out that on July 22 or shortly thereafter, it will be clear whether the supply of Russian natural gas will return and to what extent. If it doesn’t come back, the governments of Germany and Italy, and possibly several others in central Europe, will have to activate contingency plans to secure gas supplies for sheltered customers, such as households, for the winter. This, Citi points out, will almost inevitably lead to an energy handout for the industrial sector, particularly for energy-intensive chemicals and metals companies. However, energy production and households should also help reduce consumption, due to higher prices as well.

In early March, following the escalation of the conflict in Ukraine, Citi revised down its forecast for euro area growth in 2022 from 3.3% to 2.2% at the time to reflect (1) a potential additional price shock that reduces household spending power, (2) additional supply disruptions, (3) the shock to business confidence that weighs on investment, and (4) the shock to trade from the sanctions imposed on Russia and Belarus. It also estimated that if the supply of Russian natural gas was cut off immediately, it would reduce GDP growth in 2022 to just 0.7% or 1.5%, mainly due to rationing.

Unfortunately, however, the worst-case scenario has become much more likely since early June, as:

– Russia has cut the flow of natural gas through the main Nordstream 1 pipeline, which in 2021 supplied around 10% of the EU’s gas consumption, by 60%, on top of existing cuts through Ukraine’s pipeline network.

– As a result, the TTF price of natural gas in Europe has more than doubled from around €80 to €170 per MWh.

This also caused increases in electricity next month in key EU economies from 85% (Italy) to 118% (Germany) from 1 June.

– With the upcoming regular maintenance starting on July 11 and lasting for two weeks, the fear is that supply via Nordstream 1 will not be restored. German Economy Minister Robert Habeck (Greens) warned that Russia’s failure to restore natural gas deliveries from the end of the maintenance period on July 22 “would not be a surprise”.

– Germany’s government escalated its natural gas emergency plan to the second of three levels, accelerating alternative supplies to increase gas storage levels while preparing to replace natural gas with coal in electricity generation. The third level will include ticket application.

However, there were also some positive developments, Citi points out:

– Natural gas storage levels have recovered: Gas storage levels have risen from less than 30% in February to more than 60% now, including in key countries such as Germany and Italy. This is about normal for this time of year despite the decline in gas flows from Russia. European gas storage now holds a total of 64 bcm of natural gas, including Germany’s 15 bcm (enough to offset more than four months’ supply via Nordstream 1) and Italy’s 11 bcm.

– Dependence on imports from Russia also decreased. The share of natural gas from Russia via the Baltics, Poland, Albania and Austria to Germany and Italy fell from over 50% to around 35% as both countries managed to increase supply from alternative sources. The lowest storage levels are now in south-eastern Europe.

The bond will start immediately and lead to a (mild) recession

While Citi’s estimates suggest that winter gas shortages can be avoided even if Russia completely cuts off natural gas, the restriction and additional squeeze on household incomes will drive Italy and Germany – and possibly the eurozone as a whole – in recession in winter (4th quarter 2022 – 1st quarter 2023). This is likely to be mitigated by further fiscal intervention, on top of the more than €200bn or 1.7% of GDP already committed by governments.

In terms of inflation, overall, the impact of the latest jump in gas prices inevitably adds even more upward pressure to eurozone inflation, both in 2023 (due to the delayed pass-through of higher gas prices) and 2022. Therefore, Citi “raises” its forecasts for inflation to 8.1% in 2022 (from 7.9% in June) and 4.7% in 2023 (from 3.6%).

Regarding the price of natural gas, Citi points out that it is difficult to know to what extent current prices already discount the full cut-off scenario. Its analysts believe the TTF could rise to €200/MWh if Russian imports are zeroed out, possibly even higher to €250/MWh if this is combined with other supply disruptions (such as recently at LNG terminals). In the baseline scenario, prices will move to €130/MWh (where Russian exports decrease, but not to zero) while in the positive scenario, they will move to €100/MWh.

One day before the end of Nordstream’s maintenance period, its Board of Directors European Central Bank is set to raise interest rates by 25 basis points. If gas flows do not resume by the end of July and Germany and Italy start rationing to prepare for winter, the conundrum of weak growth and high inflation for the ECB would be even harder to solve. As Citi estimates, interest rate hikes may continue, perhaps even accelerate, but when the recession starts and governments need to support the economy, monetary-fiscal coordination may return and interest rate hikes may stop, at the latest until the end of the year.