An explosive mix of record-breaking energy prices and geopolitical tensions have kept analysts and policy-makers in Europe in a constant state of adrenaline rush in the second half of 2021. Natural gas prices are breaking fresh records and power prices across Europe are surging. Unlike a literal roller-coaster, however, the energy crisis does not have a safety handle and decisions are more a product of the panic than of sound reasoning. While consumers are footing the bill despite all sorts of extraordinary and often eyebrow-raising measures including price caps, profit freezes for energy companies and a Robin-Hood-style helicopter money, there is one clear winner from the crisis – Russia.

Widespread disinformation campaigns, many originating in Russia, have put the blame for the spike in energy prices on the European Green Deal. However, market assessments have clearly shown that natural gas is the key driver of the surge of power prices in Europe. A lower than usual renewable energy-based generation has led to higher reliance on gas and coal. And, as coal and gas supply shortages deepened in late summer, prices have skyrocketed in the fall. As in a perfect storm, the availability of nuclear power capacity in France has fallen considerably due to maintenance sapping the air out of Europe’s baseload. In a vicious cycle, this has exacerbated the reliance on natural gas, and producers have called in even fuel oil to meet high winter demand. Russia has taken advantage by gradually tightening gas supply since June, thus fuelling the crisis even further and reaping the profits of record prices. In this way, Russia kills two birds with one stone – pressuring Europe to approve Nord Stream 2 and giving a clear signal that unless the West accepts a solution of the Ukrainian conflict in the Kremlin’s interest, Russia will keep gas taps only half open.

Just a year ago, global energy markets were facing acute oversupply, with cheap natural gas, electricity and oil prices even turning negative in April 2020. So what happened? Fossil fuel markets are highly cyclical, with periods of low prices leading to underinvestment in additional supply amid an increase in demand. This in turn pushes prices up. The latest price cycle is exceptional due to the unusual surge of the demand from the post-COVID recovery. Meanwhile, low prices in 2019-2020 reduced the incentive for buyers to hedge against the risk of price spikes, hence the panic in 2021. When gas companies struggled to build storage ahead of the heating season due to the unusually high consumption levels earlier this year, when gas withdrawals began, a panic ensued on the market. And the worst may be yet to come as further withdrawals, low temperatures and a new tightening in Russian gas deliveries via Ukraine and Poland has already led to a fresh price spike that may cause a chain reaction of power shortages and heating plant outages.

This is the most important prerequisite for high prices. More storage draws are to be expected in line with typical seasonal trends. If colder-than-usual weather hits Europe, demand spikes will lead to even higher draws, as illustrated by the storage outlook based on the 2017/2018 winter withdrawal rate when the Beast from East invaded Europe. Lower supplies from Russia are set to maintain the supply tightness and a general market unease. Russia’s strategy to use short term pipeline capacity booking, keeping the market on its toes, and the mounting risk premium linked to geopolitical tensions over Ukraine could lead to a non-food related post-Christmas nausea among market players. Considering all this, it is likely that prices will stay close to recent record levels or even go higher in January. A market respite is not to be expected before the tail-end of the heating season in April 2022.

The current crisis could cause demand destruction in the industry and the power sector as companies shut down or there is an extra push for decarbonisation. At the same time, the high prices are likely to accelerate the recovery of US gas production. The latest Short-Term Energy Outlook of the US Energy Information Administration projects a recovery of US gas production to above pre-COVID-19 levels by December 2022. This is 7% higher than the projection in January 2021, pointing to the strong positive impact of higher prices on supply. Higher production from the US would contribute to easing prices. Russia will continue to be a wild card. If geopolitical tensions with the EU and NATO do not subside and there is a sharp reduction in exports to Europe, there will be little to stop a repetition of the crisis next winter. A worrying clue for this negative scenario is the forward price of the Dutch virtual trading hub benchmark for January 2023, which has increased strongly in the last weeks of December 2021, suggesting that market players are pricing in a deterioration of Russia-EU gas relations.

The 2021 energy crisis has clearly demonstrated that the energy transition is not the problem but the solution. The efforts to promote the role of natural gas as a cheap and reliable bridge fuel for a low-carbon transition are failing. The need to promote accelerated fossil fuel phase out and a shift to renewables-based electrification is clearer than ever. The longer gas prices remain high, the faster the shift to alternative energy sources will be. Decarbonizing energy markets will also deliver a blow to Russia’s ambition to increase its economic and political influence in Europe. Hence, there is an urgent need to simultaneously strengthen gas supply diversification efforts, the completion of European gas markets’ integration and the decarbonisation of electricity supply making Europe more energy secure and resilient to future market volatility. To overcome the political fallout from the current energy crisis and the spectre of energy outages in the winter would require strong political will to power through necessary reforms that will switch the gears of the green energy transition in Europe.