Casual observers can be excused for not comprehending topsy-turvey events in energy. As September turned to October 2022, the gap between European and U.S. natural gas prices stood at 10X – $60 million British Thermal Units (MBTUs) vs. $6 MBTUs.  True, Russia has drastically cut gas supplies into Europe.  That still doesn’t explain the unprecedented premium being paid by Europe’s customers. Meanwhile, crude oil prices, which retreated from $100/barrel in August, are back above $90/B on the news that OPEC+ has cut production by 2 million barrels per day (MB/D).  The EU is adopting price caps on Russian oil purchases. Putin, for his part, threatens to remove even more supplies from the market.

What is going on here? What accounts for natural gas prices that threaten to bankrupt European manufacturers and utilities? Why did crude prices decline in the first place and why has OPEC surprised the markets with a larger than expected cut? Are price caps any kind of answer? We will try to answer these questions, touching briefly on the “known knowns” and spending more time on lesser known but more explanatory factors.

We start with some data. Russia has deliberately removed a large amount of natural gas from the European market. In 2021 it supplied about 150 billion cubic meters (BCM) of gas or about 12.5 BCM per month. That figure is now down to between 1-2 BCM. As for crude oil, EU countries have partially stopped buying Russian oil and plan a more focused embargo by year end. The EU + Great Britain bought 2.6 MB/D of Russian crude in 2021 plus another 1+ MB/D of refined products.  Those figures are now down to about 1 MB/D of combined crude oil and product, most of it crude. Russia has been forced to sell the difference to distant markets like India and China, absorbing substantial logistics and marketing discounts.  Perhaps 1 MB/D of pre-war Russian oil supplies are no longer being sold.

Next, we add some context. The oil market was tight before the Ukraine conflict broke out. Global investment in oil exploration and production fell sharply after 2014. Some of this was in response to prices, which declined from $90+/B to around $50/B. Some of it reflected Wall Street firms’ disillusionment with the performance of America’s fracking companies. These firms funded a dramatic expansion in U.S. production by tapping copious amounts of private equity. Much of that capital was destroyed when production surged, bringing about collapsing prices. PE investors then switched to demanding investment returns and capital distributions; these demands were reinforced by pressures to apply ESG criteria to capital allocation, i.e., to stop funding fossil fuel investments. Collectively all these pressures brought about sustained underinvestment in new oil/gas exploration and production. Capital budgets and firms like Chevron and Shell fell by 50% or more. When Covid hit, driving crude prices below $30/B, exploration/production budgets went to rock bottom levels.

As for European natural gas, it now is widely appreciated that allowing Russia to supply 40% of the continent’s consumption was a policy mistake. Unlike oil, natural gas is not easily replaced logistically when a major source dries up.  Liquified Natural Gas (LNG) is the flexible source of supply, but that requires available export supplies, specialized ships, regasification facilities and pipelines connecting importing sites to consumers. Europe, in general, and Germany, in particular, lack this infrastructure.

Click here to read more from UNC Kenan-Flagler Energy Center’s Stephen Arbogast on recent events in oil and gas markets, the creation of energy security canons, and how caps on Russian oil interact with existing market dynamics.

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