What are the different crude oil and natural gas prices for the EU and the US?

When Russia invaded Ukraine in late February, forecasters were quick to revise their forecasts of sharply higher energy prices, citing shortages in oil and natural gas supplies. Europe was widely believed to be vulnerable to cuts in natural gas supplies from Russia, which supplies about 40 percent of its energy needs.

At the same time, some forecasters have seen the price of West Texas Intermediate (WTI) double to $125-$150 per barrel in response to the sanctions imposed on Russia.

Developments since then suggest that the European Union (EU) may face the worst-case scenario. But the fall in the U.S. has exceeded expectations, with WTI prices falling below $90 a barrel. According to a Wall Street Journal report, liquefied natural gas (LNG) prices in Europe have nearly quadrupled from a year ago and are eight times higher than in the US (Henry Hub).

While the long-term correlation between crude oil and natural gas prices is low at around 0.25, today’s price differential is unusually high. As a result, many people are wondering why it is happening and what it means for the respective economies and financial markets.

In a previous commentary, I examined Russia’s squeeze on natural gas exports to Europe and the European policy response. The problem is that even if the EU agreed on plans in May to reduce its dependence on Russian oil, it will take years to implement.

Meanwhile, European policymakers are scrambling to reduce the burden on consumers if the squeeze is delayed until winter. The most urgent need is to stop the price increase for electricity and heating fuel. A New York Times article reports that manufacturers are furloughing workers, shutting down production and facing energy bills as contracts expire in October.

Last week, the European Commission announced plans to distribute $140 billion in wind power profits from energy companies to consumers and businesses to soften the blow. The plan calls for low-cost non-gas electricity producers to be covered by revenues of €180 per megawatt. It requires coordination with EU member states that are implementing their own plans. As such, it is unclear how effective these measures will be and whether they will reduce inflation, which is currently at 9 percent.

By comparison, the energy picture in the U.S. has improved significantly over the past three months: Gasoline prices at the pump have fallen for 13 weeks in a row, from more than $5 a gallon in June to a recent high of $3.70. This, in turn, contributed to a decline in headline inflation and an increase in consumer confidence.

So, what is behind these price cuts and can they continue or be reversed?

It was linked to a decision by Russia and 30 other IEA member states to release 60 million barrels of strategic petroleum reserves (SPR) in March to address supply disruptions caused by Russia’s invasion of Ukraine.

While there is ongoing debate about the effectiveness of using the SPR in an emergency, a 2019 report by the Federal Reserve Bank of Dallas concluded that such measures could temporarily lower oil prices. The biggest unknown, however, is whether the price drop will occur if no action is taken, as higher prices lead to faster stockpiling. Additionally, prices may increase again after the sale ends.

Furthermore, a recent report by analysts at Morgan Stanley (MS) titled “Finding a Floor” helps shed light on the structural and cyclical forces at play in the global oil market. The main conclusion is that the decline in Brent and WTI prices is mainly the result of reduced demand for oil related to the weakness of the global economy. “Spot prices have fallen, forward curves have disappeared, physical differences have crept in, and refining margins have weakened,” the analysts wrote. The demand slowdown occurred among all major economic groups, with the report citing China as a particularly important contributor, with crude oil imports down nearly 2 mb/d from two years ago.

As for gasoline prices, the MSS report notes that the crack (refined) spread has dropped from a high of $45/bbl in early summer to zero recently, which is highly unusual. Another strange thing is that crude oil has fallen below the price of coal, which raises the question of whether it will fall further.

Morgan Stanley’s assessment of the structural outlook for the oil market is firm, but is currently being eroded by cyclical weakness. The bottom line is that oil prices will remain at current levels until mid-2023. With WTI prices down about $40/bbl from a high of $130, the downside is limited. But until the global economic recovery, the increase in prices is impossible.

With these in mind, my guess is that the direct impact of Russia’s invasion of Ukraine is not as bad for America as first believed. One reason is that the fall in Europe is worse than expected and could lead to a European recession, so the ECB will be forced to tighten monetary policy to curb inflation. Another reason is that China’s economy has shrunk more than expected due to weakness in the property sector and the government’s strict COVID-19 policy.

The main implication for financial markets is that the US dollar is likely to remain strong. First, while core inflation remains high, the Federal Reserve has signaled that it will continue to raise interest rates at a higher rate for some time. Second, the US benefits from being energy independent, while the EU and China are heavily dependent on energy imports. Thus, the US may experience a positive change in the trade (relative value of exports) compared to the EU and China. In this regard, the US has been protected from some of the negative effects of Russian aggression.

Nicholas Sargen, PhD, is an economic consultant at Fort Washington Investment Advisors and is affiliated with the Virginia Darden School of Business. He has written three books including “Global Shocks: An Investment Guide to Turbulent Markets.

Leave a Comment