Drought Is Driving European Energy Markets Toward Disaster

By Irina Slav of OilPrice.com

Energy markets and nature seem to have it in for Europe. Record-breaking gas prices, rising coal prices, and droughts that interfere with electricity generation in some key markets have combined to push electricity contracts in the EU to record highs as uncertainty about the coming winter deepens.

Reuters reported earlier this week that a number of power forward contracts traded in the EU hit highs because of what increasingly looks like a perfect energy storm, affecting every energy source in one way or another.

“A number of factors are adding up: The market is uncertain about whether (French utility) EDF will increase nuclear availability enough for winter, which explains the price differences between the two countries [France and Germany],” Rystad Energy analyst Fabian Ronningen told Reuters.

EDF has had to significantly reduce the capacity utilization rate of its nuclear power plants because droughts in France have reduced water availability for cooling the reactors. But the drought came on top of earlier problems: reactor corrosion that prompted the utility to close some of them earlier this year, effectively reducing the supply of electricity available for sale on the domestic or regional market.

Meanwhile, in Germany, wind output is low, and so is the water level of the Rhine—a key transport route for things like coal, for example. Germany’s economy is quite dependent on this crucial shipping corridor, but when the water level is critically low, shippers simply cannot load the usual volume of cargo, meaning that coal and other commodities are reaching their destinations in smaller mounts and more slowly.

The drought is also affecting hydropower output, adding to worries about future supply. Because of the drought, Norway, which generates more than two-thirds of its electricity from hydropower, announced it would curb electricity exports, threatening supply for other European countries at the worst possible time. In the UK, there’s talk about blackouts.

Meanwhile, Gazprom’s gas flows to Europe remain much lower than usual, with the Russian state major warning this week that gas prices on the spot European market could top $4,000 per 1,000 cubic meters. Recently, spot prices broke the $2,500 barrier.

“European spot gas prices have reached $2,500 (per 1,000 cubic meters). According to conservative estimates, if such a tendency persists, prices will exceed $4,000 per 1,000 cubic meters this winter,” Gazprom said.

The European Union has been quick in switching from Russian gas to U.S. LNG amid the Ukraine crisis, but speed has not been enough: U.S. LNG export capacity is not limitless, and producers also have other clients, in Asia. As the winter season approaches, Asian buyers have become more willing to pay hefty premiums for any LNG, which has intensified competition for a limited number of LNG tankers.

No wonder, then, that electricity prices in some parts of Europe have hit records. Even less wonder that industries are beginning to buckle, per a recent Bloomberg report. The report noted that Germany’s year-ahead electricity contract rose to more than 530 euros per MWh earlier this week, which constituted a 500-percent increase over the past 12 months. No industry can absorb such a price shock unscathed, and German industry didn’t.

Germany had to pay the equivalent of more than $15 billion to bail out one of its biggest gas utilities, Uniper, earlier this year. Chemicals giant BASF warned that a gas shortage could wreak havoc on the industry. Aluminum and zinc smelters are closing, and so are fertilizer plants, all because of record gas and electricity prices.

Relief is not in sight unless one considers the filling up of gas storage caverns in Europe a form of relief. The EC had set a target of 80 percent for storage fill rates by October 1. Member-states are on track to hit this target ahead of schedule, but this has come at a cost: the EU’s gas bill this year is ten times higher than it normally is, at over $51 billion.

What’s more, storage alone will not be enough to keep European economies going through the winter months. The EU will need more gas as regular supply. Besides the U.S., there are few other places it can get it. It could be why the head of the German energy regulator warned the EU’s biggest economy would need to reduce gas consumption by a fifth to avoid shortages and rationing in the winter.

“The longer these price rises go up, the more this will be felt across the economy,” Daniel Kral, senior economist at Oxford Economics, told Bloomberg this week. “The magnitude of the increase and magnitude of the crisis isn’t comparable to anything in the past few decades.”

It is unfortunate that Europe is experiencing one unprecedented crisis after another. And it could yet get worse as the oil embargo against Russia kicks in at the end of the year.

Analysts have warned that this could lead to higher prices for oil. This will, in turn, add to upward electricity price pressure due to the switch from gas to oil some utilities in Europe have implemented to shield themselves from prohibitive gas prices.