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Energy Crisis: “Cold Cold Winter”

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The European Energy Crisis and the Role of Russian Resources

What are the sources of the energy crisis? There is a supply-based energy crisis in the world, especially in Europe, and the reflection of this is seen in a multi-factorial way, from the risk of economic recovery to the increase in inflation. While the Covid-19 crisis collapsed the demand phenomenon in the world in the period when the pandemic was felt the worst and caused the most damage to the economic situation, its reflection on the energy market was in the form of a very low price. In the period when the effects of the pandemic eased, activity in the economy increased with the easing of restrictions, income generation was possible even if it was not in the old normal, and the demand, supported by the economic recovery, increased prices again. While a normalized market is expected, this time a supply problem has been encountered, which came after Covid-19. While the oil, natural gas and other fossil fuel groups experienced price increases due to both the increase in end-use demand and the acceleration of production; The main problem was the supply, which could not keep up with the demand. Request; This is how we summarized the factor that created the global inflation spiral stemming from the energy crisis.

 

Factors shaping prices… Rapidly increasing demand will push the price equilibrium higher in a steady or declining supply cycle. On the other hand, rising production costs will increase inflationary pressure and create the demand paradox in the next stage. On the one hand, since the price increases exceed the purchasing power, the market will enter a slowdown cycle, and on the other hand, supply sources that cannot be replenished quickly due to the slowing stock turnover rate will slow down the production line. Approaching the winter season also means an increase in the end-use demand of energy. Therefore, matching the energy needed with the inadequacy in supply affects the rate of price increase and increases the inflationary pressure. Considering that the harsh winter will increase the consumption in an inelastic way; this is an indication that individuals and institutions will incur higher costs and that the situation will be challenging enough.

 

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Brent oil (white) vs. natural gas (blue) spot price comparison… (Source: Bloomberg)

 

Characteristics of the market, energy transportation alternatives… Since natural gas is difficult to transport and transport; natural gas prices tend to be determined locally or regionally, not globally as in oil. Here we can talk about two types of gas transport. First; The contract price of the natural gas transported and traded by pipeline can be determined by negotiation, regulation or open market mechanisms. This type of transported natural gas; accounts for approximately 55% of total trade. The rest of the natural gas trade is done by ships as Liquefied Natural Gas (LNG). In the LNG market, natural gas is sold at fluctuating prices indexed to cost or on a long-term contract basis at prices indexed to oil or other commodities. Here, too, a complex formula emerges for determining a standard natural gas contract price: A standard contract (for Europe) is priced by weighting the monthly price at which the gas is purchased from the producer and the 3, 6 and 9 month average prices of products such as heating fuel, diesel, and oil. Although it seems useful in terms of diversifying the product price risk, the simultaneous increase in the pricing of the relevant spot products also increases the cost of the contract. However, most gas is priced relative to other energies such as petroleum products, coal and even electricity, and the majority are explicitly linked to formula under long-term contracts. The link also creates the perception that energy products are interchangeable and that when the price of the substitute energy product changes, the gas prices depending on the formula will also change. When oil is wanted to be substituted with gas or vice versa, the product-based sliding demand curve may cause the price of the other commodity to increase.

 

Dutch TTF vs UK NBP gas price comparison… (Source: Bloomberg)

 

The role of Russian gas… The regional price competition in energy and the superiority of gas over other gas are the decrease in the decisive actors of Russia and Norway in the European market and progress towards liberalization. However, Europe’s dependence on Russian gas and the strengthening of this position with Nord Stream still bring along a certain amount of price oligopoly. Eastern European countries, which are geographically close to Russia, are more dependent on Russian natural gas; We see that 24% of the gas used by the union of 27 countries is supplied by Russia. Dependence on Russian natural gas decreases as we go to the west of Europe, and the West obtains some of its needs from Norway. Europe is starting the heating season with the lowest gas stocks in more than a decade, raising concerns about the reliability of winter supplies. Extra Russian gas is seen as the only way to avoid an even deeper shortage of supplies in the middle of winter.

 

The start of Russia’s controversial Nord Stream 2 gas pipeline faces a new hurdle after Germany suspended an important step in the approval process.Germany’s energy regulator has halted the certification process necessary for the new link between Russia and Germany to start operating. The move came when the operator of the pipeline, Nord Stream 2 AG, decided to establish a German subsidiary to meet European Union requirements.

 

Gas supply from Russia to the European Union… (Source: Bloomberg)

 

Reflection of the energy crisis in Turkey and inflation effects… Global energy prices are rising. With the approach of the winter season, we see that supply-related problems will intersect with the impact of higher demand in a few months. This complicates the situation of Turkey, which depends on imports for almost all of its natural gas. Turkey imports natural gas in the form of boat line gas with long-term contracts, LNG with long-term contracts and LNG purchases from the spot market. Turkey’s main suppliers are Russia, Algeria, Azerbaijan and Iran.

 

Comparison of Import-Production-Consumption Quantities in 2020 (January-July) and 2021 (January-July) periods and the shares of July in these values (Million Sm3)… (Source: EMRA)

 

The increase in global oil and natural gas prices also increases the energy bill that Turkey pays. In addition, the exchange rate effect will also come into play in the renewal of some of Turkey’s contracts that will expire as of 2021. The depreciation effect of the lira will also affect the price to be paid in new contracts. Therefore, in terms of the effects of the global gas crisis on our economy, it is necessary to consider both the foreign import prices and the exchange rate effects in their conversion to the lira.

 

Distribution of Natural Gas Import Quantities in July 2021 by Countries from which Natural Gas is Imported (%)… (Source: EMRA)

 

If we consider the domestic consumption of natural gas and the use of inputs in production together; the price effects of the energy crisis are also direct and indirect; or can be differentiated into primary and secondary. We can highlight the industry and energy sector in terms of corporate use and demand. The role of natural gas in electricity generation also highlights the cost increase in terms of natural gas and electricity bills, which are the subject of consumer use. Therefore; An increase in production costs increases the price of goods and services sold. We also directly see the effect of increase in housing consumption. Since the lack of energy input may also slow down industrial production, there may be a decrease in the supply of final goods and the difficulty in finding goods in the market may cause prices to increase.

 

Comparison of Turkey CPI inflation (white), Brent oil (blue), natural gas (orange) and USDTRY exchange rate (purple)… (Source: Bloomberg, TurkStat)

 

Turkey is not a rich country in terms of base metals and energy resources. Therefore, many companies engaged in production in the industry need imported inputs. The bindingness of exchange rate volatility also emerges at this point. Since the depreciation of the local currency will increase the prices of imported inputs; One of the main problems we will encounter is the upward movement in inflation through the exchange rate pass-through effect. In addition; Due to the increase in imported input prices, the deficit in the foreign trade balance and balance of payments grows.

 

Managing risk… It is possible to reduce the risk arising from global pricing fluctuations by hedging by using derivative instruments. In other words, the risk can be managed by taking a position that is proportional to the price risk carried (such as a long position against the risk of rising costs). The use of derivative instruments is important for the management of financing costs, especially against the protection of enterprises from input prices and the effects of exchange rates. The management of this risk is forward, futures transactions, etc. possible with. By effectively hedging the currency risk of raw material prices and costs, the company can limit and balance the contraction in operating and net profit margins.

 

Conclusion? If we consider the institutional and individual areas of energy use, the result is that the initial effects and aftereffects occur multidimensionally at different times and coefficients. Risks related to insufficient or slow supply in response to high usage demand will be reflected in prices over costs. Reflecting the increasing costs of the companies to the product and service prices in the lagged periods will mean an increase in prices in many expenditure groups, and reflecting the cost of the energy supplied directly to the housing consumption will have a direct consumer inflation effect.

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