The European energy squeeze – What does it mean for Australia and the AUD?

As kids growing up, many of us would have played the game of chicken; where you and a friend do something dangerous, and whoever backs out first loses. The energy markets feel just like this at the moment - except the game is on steroids and the stakes are the highest they have been since World War 2.

The current energy crisis in Europe is extremely complex, with so many layers ebbing and flowing, that have exposed the weaknesses of many historical decisions. The crisis is pulling at the very fabric of the European Union, and Russia knows it. Divide and conquer is Putin’s mantra as the game of chicken escalates into a 4-dimensional game of chess between East and West. So, what is going on and how will the squeeze affect the Australian economy and AUD and where will the opportunities lie for traders?

To help us, we include insights from Naeem Aslam, chief market analyst for forex trading in Australia with AvaTrade to weigh in on the likely effects on the Aussie market.

The cause of the European energy squeeze

As the northern hemisphere eases away from summer on its lonely journey toward winter, temperatures are falling. Winter means rugging up and staying indoors, and with the news breaking that Russia will stop pumping gas through the Nordstream pipeline to

Germany, the coming European winter could be very painful. With short days and long, cold nights, household gas and electricity usage will be at its highest.

With the ongoing war in Ukraine, sanctions are hurting Russia’s economy and Russia is fighting back. It is weaponising its gas supply. It controlled 40% of European gas usage prior to the Ukrainian invasion. With careful EU planning, Gasworld reports this has now reduced to 9%.

In line with the war, the EU began importing Liquid Natural Gas (LNG) to replace the natural gas from Russia, despite the extra expense. During the summer, the EU built up the storage capacity of LNG with recent analysis showing that steady supplies of LNG globally continue to arrive in Europe. The volumes now in place exceeding with the target of having storage inventories filled to 80% by November. Reuters reports the storage inventories are currently over 85%.

Naturally, this increased demand for LNG has pushed up its price as global producers ship LNG to those that are prepared to pay the highest price. So why are natural gas and LNG so popular?

The transition to renewables

The UN’s long-term goal is to transition away from using fossil fuels towards renewables for power generation. There are, however, challenges:

• Renewables rely on new technologies that take time to mature.

• Renewable energy only performs when nature allows.

• The lead times to deploy renewables is long.

Combined, renewables alone are just too early to provide the certainty required for electricity production.

Natural gas is cleaner than other fossil fuel sources and is a transition fuel from Fossil fuels to renewable energy. The challenge, however, is that Russia decided overnight to cut gas to Germany. Renewable energy cannot be deployed quickly enough to plug the gap, which means there may be shortfalls, which means the potential for rationing and blackouts.

Government priorities

Protests are on the increase in Europe over rising electricity costs. These protests will get even worse if there are blackouts. Governments across Europe face a delicate choice between social unrest and recession if gas restrictions apply to industry. A second recession will severely test companies already weakened by the pandemic.

Inflation is likely to get much worse

The energy squeeze could see prices for LNG explode. Not only are global supplies already limited through pre-committed long-term contracts, but also any ramping up of LNG production will involve significant costs. Rising LNG prices will compound already rising inflation, which is pressuring governments to further raise interest rates. The harsher the winter in Europe, the greater the chances of rationing and the greater the chances of recession and inflation - ie stagflation.

What does this mean for Australia?

Naeem Aslam, chief market analyst with AvaTrade gave us his thoughts, which are provided as guidance and should not be considered financial advice.

How are we fixed for natural gas? “In Australia, we have 160 natural gas power stations powered by locally produced natural gas.

The European energy squeeze is unlikely to affect Australia directly. With Russia closing off their gas supply to Europe, they need to find alternative buyers, who will need discounts, supported by the latest proposed EU price caps.”

Inflation - Australia is fairly cushioned from the supply side shock of LNG - so any addition to existing inflationary pressure is likely to be soft.

Interest Rates - European interest rates are likely to rise with increased inflation, and we may see some upward pressure on Aussie rates to remain competitive.

The major AUD pairs over the next six months

- The Euro is likely to weaken in line with the depth of any recession.

- The USD is likely to maintain its strength, so we will probably see some softening for the AUD/USD pair.

Are we going to avoid recession?

This is really hard to judge. We have to weigh up the positive benefits of exporting increased levels of LNG which will help the Aussie economy, against interest rate rises in line with international markets. It is more likely we will have a soft landing here in Australia.

Volatility

Expect the FOREX markets to be extremely volatile over the next 6-9 months as the news cycles amplify both positive and negative news. Either way, it will present traders with great opportunities.

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