Weighing Russia's Gas Halt to Poland and Bulgaria

After threatening for weeks to cut off natural gas flows to European countries who don’t pay in roubles, Russia has officially halted flows to Poland and Bulgaria.^[i] Several commentators we follow warn this raises the likelihood of a European recession (a broad decline in economic activity), especially if it is a prelude to stopping flows into Germany and other big Russian clients. Let us take a look and assess the likely impacts—for the affected countries, Europe and global stocks.

Russian President Vladimir Putin has jawboned for over a month about requiring his “unfriendly” customers to pay for natural gas in roubles rather than euros or dollars, signing a formal decree mandating this at March’s end.^[ii] This might sound like a strange move for a country that needs dollars and euros to continue servicing its foreign debt and can’t access most of its international reserves due to sanctions. But Putin and Central Bank of Russia (CBR) head Elvira Nabiullina are also trying to support the rouble. Those purchasing Russian gas in roubles will have to buy those roubles. Or, more specifically, it seems most are opening foreign currency accounts at Gazprombank (the state-owned financial offshoot of Russian natural gas giant Gazprom), depositing euros, converting those euros to roubles, and paying.^[iii] So instead of the CBR spending down its reserves to buy roubles, it gets to import hard currency via Gazprombank whilst forcing European clients to effectively support the rouble. Putin then gets to use those same roubles to continue funding the war effort without having to fire up the printing presses and risk hyperinflation (rapidly rising prices across the economy).

That perhaps raises the question: Is this legal under sanctions? Gazprombank is subject to British and American sanctions, but not EU sanctions.^[iv] Where the EU has sanctioned other large Russian banks, it exempted energy-related transactions—largely to keep natural gas and oil flowing. Gazprom has told customers its preferred payment mechanism doesn’t violate EU sanctions. Some EU leaders say it does, but Bloomberg reported Wednesday that 10 European energy companies had opened the required accounts and 4 had already paid in roubles.^[v] Given the huge political and business risks at stake, we have a hard time envisaging companies opening these accounts and completing these transactions without consulting EU regulators, but stranger things have happened.

At any rate, Poland and Bulgaria apparently said nyet to Gazprom and skipped payments, so their natural gas got turned off Wednesday.^[vi] For Poland, we don’t think this is a huge economic headwind, or even much of a surprise. The country’s gas contract with Russia expires at yearend, and the country had already announced its decision not to renew.^[vii] Instead, it plans to purchase gas from Norway via the soon-to-be completed Baltic Pipeline, which is scheduled to open by 3 January.^[viii] In the meantime, Poland’s gas storage reserves are 75% filled, with volumes about 130% greater than normal for this time of year, and Russian gas accounts for only about half of Poland’s consumption.^[ix] Polish officials say the impact of Russia’s decision will be minimal, and based on these stats, we agree.^[x] We think Bulgaria will likely have a harder time, though. About 90% of its total gas consumption comes from Russia, and its storage is only about 17% filled.^[xi] Officials there estimate that amounts to about one month of consumption in the warmer months, leaving them scrambling for alternatives.^[xii] The country is now in talks to import liquefied natural gas (LNG) via Turkey and Greece, but with European natural gas prices spiking again, it won’t be cheap.^[xiii] We think Bulgaria probably faces a near-term energy crunch and recession.

No financial commentator we follow is arguing tiny Bulgaria will be enough to tip Europe into recession. Its pre-pandemic gross domestic product (GDP, a government-produced measure of economic output) was just $57.4 billion (£45.7 billion), compared to nearly $14.8 trillion (£11.8 trillion) for the EU.^[xiv] What really has commentators we follow warning of broader economic trouble is the possibility that more countries will have their Russian supply shut off, possibly when the next round of payments is due in late May. In that scenario, we think it is fair to say the bloc could experience a sharp enough energy crunch to cause a recession.

But there are some potential cushions that we aren’t seeing get much notice. Whilst LNG flotillas from the US and Qatar are getting a lot of attention, the UK has quietly amassed quite the natural gas glut and has nowhere to store it.^[xv] That is a load of supply with the potential to cross the English Channel or North Sea, in our view. If Japan buys more from Russia, that theoretically frees up additional supply to journey from the Western Hemisphere to Europe. We aren’t saying this will be a perfect substitution with no collateral damage, but we think the substitution effect could help things go moderately better than commentators suggest now.

If the EU or eurozone do enter a recession anyway, there is ample reason to think it wouldn’t automatically drag the entire world down, in our view. We have three occasions in the past 30 years where a recession in a major region hasn’t gone global—or driven a bear market (typically prolonged declines exceeding -20% with fundamental causes) in world stocks. EU GDP dropped in 2012 and 2013, during the eurozone’s sovereign debt crisis, but global GDP still grew.^[xvi] Nor did the recessions that plagued the Asia/Pacific region in 1998 cause a global contraction.^[xvii] And when EU GDP contracted in 1993 as the European Exchange Rate Mechanism collapsed, global GDP didn’t.^[xviii] In all instances, growth outside the affected region was strong enough to pull the world along.

As things stand now, we think that is quite likely to be the case this time. We have detailed the US economy’s energy efficiency and ability to weather high fuel and energy prices before—and won’t belabour that here again. Consumer-focussed businesses are reporting robust demand despite high food and petrol prices eroding people’s pocketbooks.^[xix] Whilst rising living costs are a headwind, according to the Bank of England, the 5.4% year-over-year growth in the three months through February (the latest figures available) does help offset some of the consumer price increase.^[xx] Plus, the economy—not just in the UK, but also in the US, Europe, Australia and developed Asia—appears to be getting a strong tailwind from the end of COVID restrictions, based on the latest business survey data.^[xxi] Yes, China’s widespread lockdowns are probably a headwind, but we think that is a supply issue, not a demand issue—and the global economy has spent most of the last two years proving it can overcome supply constraints.^[xxii]

So we will continue watching this situation closely and updating you. But for now, we don’t view the cessation of natural gas flows as reason to be pessimistic about stocks—European or globally. We think markets are forward-looking, and several European indexes have hit or flirted with technical bear market territory during this global correction (typically a short, sharp, sentiment-driven -10% to -20% pullback).^[xxiii] We see a strong argument that they have been pricing in (or preemptively incorporating into share prices) warnings about a recession. If no recession materialises, as data currently suggest to us, we think the relief is likely to buoy markets.^[xxiv] If a European recession actually happens, we think stocks will likely rebound before the economy does. That was the case back during the aforementioned eurozone crisis.^[xxv] European stocks suffered a bear market, and the eurozone endured a recession from 2011 to early 2013.^[xxvi] Yet global stocks’ correction reached its low in August 2011, and European stocks rallied from June 2012 onward.^[xxvii] Mind you, that was a long, gruelling European recession.^[xxviii] If a recession now is sharp but fleeting, similar to what lockdowns wrought in 2020, we think European stocks have the potential to rebound even faster.^[xxix]

In general, when stocks have already digested a given outcome, we think it isn’t wise to try to reposition for it. You can’t avoid what already happened—only move forward. In our experience, resisting the temptation to act on an event stocks have likely already priced in is one of the most difficult tasks in investing, but we think it reduces the risk of getting whipsawed—selling after a sharp decline and missing the rebound. When the going gets tough, we think investors benefit from trying to remember these first principles.