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What does the European natural gas crisis mean for inflation?

By Angela Barnes

15:21, 20 October 2021

A file photo of natural gas tanks
The two biggest sources of natural gas, Norway and Russia, have both seen output reduced this year – Photo: Shutterstock.

The European wholesale price of natural gas has risen by 380% since the start of the year – and the high costs have raised concerns among many over the potential impact it will have on inflation.

Azad Zangana, a senior european economist and strategist at Schroders, said that given households have little choice but to pay the increase in price, it could have a negative impact on demand for other goods and services – and also raises the risk of indirect inflation, or even second-round wage inflation.

Household winter challenge

He highlighted in a press release sent to on Wednesday that households have faced tremendous uncertainty over the past two years due to the coronavirus pandemic. And while the outlook for the economic recovery looks good, the spike in natural gas prices this winter adds another layer of uncertainty.

“This is unfortunate, as it has the potential to dent consumer confidence and temper the expected recovery in spending. Many economists and indeed investors had failed to spot the divergence in gas and oil prices, which started in May. The rise in gas prices gained momentum in July, before grabbing the headlines in September,” Zangana explained.

He also highlighted that the divergence between European gas prices and the price of Brent Crude oil was very unusual, as most natural gas is extracted as a bi-product of crude oil. 

“Winter 2005 was the last time this happened, which was also the first year the price of European gas started to be traded independently, and not simply indexed to oil prices,” he said.

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Why the price of natural gas is so high?

Zangana also gave his take on this and said there are a number of both demand and supply factors that have contributed to the surge in prices, but the demand side seems to be dominating.

“According to the European Commission, a colder than usual winter over 2020 led to higher demand for home energy, which was then followed by a much warmer than normal summer, causing demand for electricity and air conditioning to spike,” he said.

“A push for more environmentally-friendly behaviour appears to have also contributed. There has been a gradual shift away from using heavy-polluting fuels, such as oil and coal, in the generation of electricity. And while renewables are expected to play a very important role in Europe’s energy transition, natural gas is filling the gap for now as the cleaner alternative, raising demand again,” he added.

Zangana explained that the necessary shift to increased working from home caused by the pandemic was also likely to have contributed to higher energy use. 

“Finally and to a lesser extent, rising sales and usage of electric vehicles has been a factor, raising demand for electricity usage. According to a report by the European Commission, 350,000 new electric vehicles were registered in the first quarter of 2021, reaching 14% of market share sold. This is only expected to rise further as the sale of new combustion engine vehicles are phased out. By our estimate, the typical electric vehicle adds between a third and a half to a typical European households’ electricity usage per year,” he said.

Higher demand over the past year has led to reserves being greatly reduced heading into this winter, just as supply was also hit, it was also noted.

Zangana said it was also worth noting that natural gas is not a “typical commodity”.

“Once extracted, its physical properties make it difficult to store and transfer. It is still mostly piped, meaning that markets and pricing become regional rather than global. Though the process to liquify natural gas to aid with transportation exists, it remains about 12.5% of global production, due to the complications and expense of the additional process. In short, Europe cannot simply buy more gas from elsewhere,” he explained.

Biggest suppliers of natural gas

The two biggest sources of natural gas are Norway and Russia – and both have seen output reduced this year.

Norway’s production fell by 3% in the year to July 2021, with exports down 7.2%. The UK’s production also fell by 28% over the same period, with exports down by 59.2%. However, it is worth noting that supply from the UK has been diminishing for some time as the continental shelf matures, and it becomes more costly to extract from it, Zangana added.

“Higher demand from Asia, in particular China, has meant that some of the supply may have been diverted there from Russia. China and many emerging markets are facing their own energy crisis due to a spike up in coal prices.

“There are also accusations that Russia is limiting supply in order to gain political approval for the Nord Stream 2 pipeline. This is a newly-constructed pipeline between Russia and Germany, built to bypass Ukraine, which is accused of syphoning supply as it passes through. Nord Stream 2 has many opponents, including the US, as the increased dependence on Russian supply is seen as risky from a geopolitical perspective,” he said.

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He also noted that Russian politicians have not hidden away from using the situation to attempt to gain favour, while Russian president Vladimir Putin has denied limiting gas supplies to Europe to drive up prices.

Countries most impacted

Zangana said it is very much a European energy crisis. However, he said countries will feel very different degrees of pain. “Data taken for 2018 from the International Energy Agency shows that of the largest economies, the Netherlands is most reliant on natural gas, with 43% as a share of its total energy use. Italy is next, with 41%, followed by the UK at 39%,” he said.

Moreover, at the other end of the spectrum, he continued, Sweden only uses 2%, as it has invested heavily in renewables for many years (38%). France is also low with 15% gas share, as it relies far more on nuclear power (43%).

Impact on eurozone inflation

Schroders said its last forecast update had eurozone inflation using the harmonised index of consumer prices (HICP) at 2.1% in 2021, falling to 1.7% in 2022. Its analysis suggested that the rise in wholesale gas prices should add about 0.5 to 0.6 percentage points to inflation in 2022, meaning that inflation should now rise further next year, before falling back in 2023, the company said.

“Inflation is currently rising due to a more general recovery in energy inflation, which began last year, but also due to core inflation (headline excluding energy, food, alcohol and tobacco), which had been depressed by various tax cuts in 2020, and is now being distorted to the upside by the reversal of those cuts,” Zangana said.

“The main impact is likely to be seen in household’s gas inflation, which tends to follow the wholesale market in euros with about a six-month lag. Although some electricity is generated using natural gas, we found the relationship with wholesale gas to be very weak. That may be due to the alternative sources on offer, and the strong connectivity of the European transmission grid. European electricity price inflation is rising, but not by as much as suggested by gas prices,” he added.

Impact on UK inflation

The press release also said that the UK is more exposed than the average eurozone economy to the spike in gas prices. 

The Schroders’ economist set out how the energy price cap is shielding many UK households (but not firms) from the full extent of the rise in energy prices, “at least until the next adjustment in the cap, which will be applied in April” added Zangana.

Schroders said its analysis was a first attempt to estimate the impact of the surge in gas prices. However, it was noted that there are additional factors and risks that need to be considered for its next full forecast update in November.

It was also noted that central banks across Europe will be keeping a close eye on developments and preparing the narrative of higher inflation in the next year.

“Everything at this stage suggests that the energy price shock will be temporary by nature, but there is a risk that we could see additional ripples given there are significant supply constraints in most economies at present,” Zangana said.

Higher bills, higher inflation

In conclusion, Zangana said the spike in European gas prices will predominantly feed through to higher home energy bills in coming months, which is likely to lead to higher inflation in 2022.

“We expect the rise in inflation to be temporary; however, households are likely to also face additional indirect inflation through higher production costs, feeding through to higher goods and services prices. Demand in the economy is likely to be lower, as the purchasing power of households is reduced,” he said.

“Whether workers can negotiate higher wages will depend on how tight those labour markets are. And judging the degree of slack is difficult at present due to the use of government furlough schemes. But, unemployment rates remain elevated in most of Europe, with a significant number still relying on government support due to the pandemic.”

The European Central Bank (ECB) was likely to look through this period of higher inflation, he continued but said the Bank of England (BoE) appears more split on the matter. “If markets are correct, then the UK should expect a rate hike imminently, with more to follow in 2022. This could prove to be the BoE’s ‘Trichet moment’ – in reference to ECB president Jean-Claude Trichet who oversaw the first of two rate rises in 2011 after the global financial crisis – a move widely regarded as a policy error, which may have triggered the subsequent European Sovereign Debt Crisis,” he said.

He also said Schroders does not believe the BoE will follow through, as raising interest rates to hurt demand at a critical point in the post-pandemic recovery would be self-defeating, especially if supply in the economy is only temporarily constrained.

“Central banks have been desperately trying to raise inflation since the global financial crisis, but not this type of inflation,” he concluded.

Read more: UK inflation dips unexpectedly in September

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