Crisis in Europe: Rising Inflation, Falling Gas Supply and Recession

Helima Croft is joined by Peter Schaffrik, Chief European Macro Strategist, to talk about the unfolding energy crisis in Europe and how recent events could tip the balance.

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Published November 10, 2022 | 4 min watch
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Key Points

  • OPEC’s approved cut to oil barrel supply is a major concern on both sides of the Atlantic.
  • But for Europe, the central concern is around gas supply and pricing.
  • Interest rates play a key role, both in how they influenced the OPEC’s decision and in the interplay with energy prices that is pushing Europe towards recession.
  • The big question is, if energy and inflation can’t be tamed this year, what happens in 2023 when energy supplies are low but the economy is already in recession?

OPEC met in person for the first time since March 2020 and came to a decision widely viewed as controversial given the growing energy crisis across the world. The producer group announced a headline production cut of two million barrels a day from its targets, which will likely result in an actual cut of about a million barrel a day due to serial underperformance of a number of producers.

Helima Croft, Head of Global Commodity Strategy and Middle East and North Africa Research at RBC Capital Markets, said the cut was anticipated because of how far oil prices have fallen amid fears of a global recession, but the level of the cut was something that the Biden administration campaigned against.

“The White House and a number of other Western governments are very concerned that this million-barrel-a-day net adjustment will cause energy prices to rise as we head into a very serious inflection point in the market with the launch of the sixth package of EU sanctions on December 5th, which will essentially embargo Russian oil coming into Europe,” said Croft.

“The real question is, will OPEC deploy those barrels if there’s a shortfall come December?”



Why gas is the central issue for Europe

Without additional supplies from the Middle East to balance the Russian losses, Europe could face a dual supply disruption, with potential shortages in both oil and gas. Europe is facing a crisis on two fronts from the fall in gas supplies from Russia, according to Peter Schaffrik, Chief European Macro Strategist at RBC Capital Markets.

“The first one, and that's probably the easier one to tackle, is the impact of the relatively high gas prices, because what that means is it obviously creates inflation, and it creates a reduction in disposable income, particularly for the lower income brackets. And that means we're almost certainly heading into a consumer-driven recession,” he said.

“The second issue, and that's actually the much more dangerous one is what happens if there's simply not enough gas to go around. Because if that's the case, what most likely would happen is a gas rationing.”



Governments will try to balance the rationing of gas for households and the industrial complex, but there’s a real danger that they will be forced to shut down energy-intensive industries. Any shutdowns will lead to a much deeper recession than one that’s only consumer-driven, and one that’s much longer.  

What’s also concerning is that this could turn into a multi-winter crisis. European leaders are working hard to secure new supplies of gas from producers like Canada, the US, and North African countries, while at the same time trying to reduce demand. But these supplies won’t be cheap, LNG is much more expensive, and that could reduce the competitiveness of European companies.

It’s also difficult to replace the gas at scale, particularly for some countries.

“I think about Italy, and they're really basing a diversification strategy on getting more volumes from Azerbaijan, Algeria, Libya, and several of these countries have had profound political, social and security issues that have impacted security of supply,” Croft points out.

“Libyan volumes have fluctuated wildly since the Arab Spring. And so when I think about countries like Italy, it's not necessarily going to be so easy to have stable, reliable gas supplies going forward.”



How interest rates are interacting with energy

Rising interest rates and increased energy prices are combining to push Europe into recession. Energy costs are fuelling inflation in a way that takes it beyond the temporary problem that central banks first thought it would be. Now, they have to raise rates much faster, and raising them too much, too fast could jeopardise financial stability. The rate-hiking environment is also part of what drove OPEC’s decision to cut oil production, as an impending recession reduces demand for oil.

“His Royal Highness Prince Abdulaziz bin Salman, the Saudi oil minister, really talked about the concerns over the rising rate environment and the global economic outlook that would come on the back of that. And so I do think that played a role in the decision of OPEC to withdraw two million barrels from the market,” Croft said.

Looking ahead, Schaffrik anticipates potentially larger problems next year. If we reach a point where inflation hasn’t been adequately tamed and energy supply and prices remain uncertain heading into next winter, but Europe is in recession, what next?

“What most of the central banks, from the US to the European ones, have said is that they want to go to neutral, or the Fed has said even beyond neutral, in order not to stimulate the economy anymore. So we expect that at one point, and nobody really knows exactly where that point is here in Europe, because the guidance hasn't been that strong and that firm, that they will pause.

And then the question is, in 2023, how do we come out of that recession? Or if we come out of that recession, and how is inflation going to develop? Most likely, we will still be above target and going into next winter, that would put central banks in a similar position to where they are this year” said Schaffrik.

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