The Latest Update on the EU and Russian Energy

Global energy markets got a big dose of seemingly bad news on Monday and Tuesday, with the EU announcing sweeping sanctions on Russian oil and Russia cutting off natural gas shipments to the Netherlands and some suppliers in Denmark and Germany. And in response, oil and natural gas markets … didn’t freak out. Brent crude oil prices and Dutch TTF natural gas prices (the European benchmark) inched higher but remain below their recent peaks, which they set shortly after Russian troops invaded Ukraine and the US and UK unveiled their bans on Russian energy. Notwithstanding the potential for further volatility from here, the relatively muted reaction doesn’t totally shock us. As we will discuss, while the latest developments aren’t great from an economic standpoint, they don’t appear likely to result in outcomes worse than the widespread fears markets have already priced in. Moreover, both moves should help put an end to questions over what will happen, which likely reduces uncertainty and helps markets move on.

The EU’s measures, announced Monday, were both worse and milder than many feared. Milder because while the EU announced it will ban all seaborne imports of Russian crude oil, the sanctions exempted shipments via pipeline in order to avoid handicapping landlocked nations, like Hungary, that don’t have the infrastructure to replace Russian crude. That gives the most Russia-reliant nations—and the bloc overall—some needed flexibility. But the measures are also heavier than expected, as they will ban all EU insurers from covering seaborne shipments of Russian oil—a provision that wasn’t a part of the initial public debate. Given European insurance companies presently insure the vast majority of tankers carrying Russian oil, this restriction aims to prevent Russia from continuing to sell discounted crude to China, India and other Asian nations. As many observers note, this is likely the more important of the measures. If it worked exactly as intended and stranded Russia’s oil, it would probably have a material impact on global oil supply.

But that is sort of a big if. For one, these actions don’t take effect immediately, giving room for the global oil trade to readjust. The insurance ban doesn’t come into force for six months. Two, it is unclear to us that banning EU insurers from covering tankers ferrying Russian crude will really stop up the drain. European insurers may cover the majority of shipments for now, but they aren’t the only game in town. Insurers from nations that aren’t participating in sanctions, including India and China, could fill the void. Some observers suggest the Russian government could write its own insurance.^[i] Then too, Russia could simply ship more oil and gas to these nations via pipelines and rail, as these links are already established (and the former are expanding).^[ii] Heck, black and gray markets could even flourish. Maybe Russian crude makes its way to refiners and ports in other nations and takes to the sea in disguise. It isn’t even clear Russian oil products are sanctioned, providing the refining or blending takes place in a third-party country like India.

As for markets, while the insurance provisions make the sanctions tougher than expected on paper, even if they prove more easily enforceable than we suspect they will, the broader outcome shouldn’t be worse than what markets already expect. For months, people have feared Russian crude leaving the global market entirely, causing a severe supply shortage. If markets are at all efficient, that fear is largely baked into prices by now. The insurance ban mechanism may be a different route to this endgame than people anticipated, but if it works as intended, the outcome would theoretically match expectations. The tactics may surprise, but the outcome wouldn’t be a shock. Rather, it would be a classic case of the thing everyone fears actually happening. Perversely, far from being a massive negative for markets, that tends to enable the world to move on.

The same goes for the latest Russian retaliation. On Tuesday morning, Moscow cut off natural gas shipments to the Netherlands’ state energy supplier, effectively canceling a contract to continue delivering gas until October. Later in the day, it severed links with key suppliers to Denmark and Germany. In all cases, the rationale matched the rationale for severing shipments to Poland and Bulgaria—Russia announced the entities in question had refused to abide by its requirements to open forex accounts at Gazprombank and pay for gas in rubles.

Here, too, this isn’t great news for the affected nations, which will now have to scramble to fill natural gas shortfalls. So far, all three say there is minimal risk of shortages. The Netherlands says it has already contracted replacement supply, and the Danish and German suppliers anticipate they can easily find what they need on European wholesale markets. At the same time, a supply interruption is a supply interruption, and we think it is important to look modest headwinds in the eye.

Yet from a market standpoint, this, too, isn’t unexpected. Headlines have warned of a sudden cessation of Russian gas flows—and associated economic trauma—for months. Markets deal efficiently with this sort of thing, pricing expected events well in advance, without waiting for confirmation. As a result, the uncertainty in the run-up to a widely feared disruption is often the main source of market negativity. Once the widely feared thing happens, it ends that uncertainty. People no longer have to fear something might happen. Instead, they can quickly see the impact and move on. This can clear the way for markets to improve when everyone least expects it.

Mind you, we aren’t dismissing the risk of energy shortages causing recession in some EU nations or even the bloc overall. That remains possible, and we are watching closely. Yet even that outcome doesn’t ensure a global recession. The regional recession in 2011 – 2013, tied to the eurozone’s sovereign debt crisis, didn’t go global. Nor did the European double-dip recession that erupted from the end of the European Exchange Rate Mechanism in the early 1990s. On both occasions, the world eventually pulled Europe along. Same goes for high oil prices, which tested investors’ sanity from 2011 – 2014 but didn’t bring a global recession or bear market. No two time periods are exactly alike, but these precedents show you disaster isn’t assured, even if Europe’s economy broadly contracts (and that is still an “if”).

Markets have swallowed a lot this year, and energy market disruptions are a major contributor to the uncertainty that has roiled returns to date. But markets look forward, not backward. From here, we think it would take something much worse than what stocks have already priced to cause deeper, longer declines. For now, we don’t see a high likelihood of this happening. Instead, we see policymakers gradually crossing questions off global investors’ list of uncertainty, which should help eventually clear the way for sentiment to improve.