Energy in crisis

Western governments have imposed punitive financial sanctions on the Russian economy in response to President Putin’s brutal assault on Ukraine. Yet Russian exports of fossil fuels are still flowing and remain a vital source of income for the Russian economy. In this article, John Barwise reviews Russia’s position on the world’s energy markets and considers the dominant role of fossil fuels that underpins economic growth.

Russia’s war in Ukraine has destabilised global energy markets, forcing commodity prices to rise and fuelling yet more inflation, at a time when businesses are still recovering from the Covid-19 crisis. Energy costs, which are already at record highs, have just risen by 54% due to the price cap being lifted and will rise even higher in the autumn, hurting businesses and consumers even more.

For the UK and other western economies, the war has exposed weaknesses in national energy security and lays bare our over-reliance on imported fossil fuels and the volatility of global energy prices over which we have little control.

The ups and downs of fossil fuel supply

Global energy supply has been on a roller coaster since the start of the Covid-19 pandemic. Demand for fossil fuels fell significantly in the early part of 2020 as governments closed businesses and restricted travel. Analysis by the International Energy Agency (IEA) showed that by mid-April, some countries in full lockdown experienced a 25% decline in energy demand, with global energy demand falling by 4% overall during 2020 — the largest decline since the Second World War and the largest ever absolute decline.

The fall in energy demand caused by Covid restrictions and Russia’s refusal to cut oil production at that time — as Saudi Arabia and other producers were proposing — led to an oversupply of fossil fuels and a sharp fall in prices — oil prices fell to their lowest levels in over two decades in 2020.

Global CO2 emissions also decreased by 17% during early lockdown, mainly driven by a fall in energy demand and fewer transport journeys. This offered some respite from growing concerns over global warming, but this was short-lived.

The easing of lockdown restrictions in late 2020 and into 2021 meant economies started to recover and energy demand began to increase, prompting oil-producing countries to go ahead with cuts in oil production to keep fossil fuel prices high and recover some of their earlier losses.

By mid-2021, energy demand was outstripping supply and energy prices rose significantly. By January this year oil prices had risen to over $90 per barrel from just $9 per barrel at the height of the pandemic’s first wave. Since then, the war in Ukraine has put further upward pressure on fossil fuel prices, with oil reaching $130 per barrel in March 2022.

The rise in fossil fuel prices and energy costs has led to an inevitable rise in commodity prices and higher than expected inflation. In May 2021, UK inflation stood at 2.1%. The Bank of England now forecasts inflation could rise above 8% in 2022.

Russia’s influence on fossil fuel markets

Russia is one of the world’s major suppliers of fossil fuels. A review of energy supplies in 2021 by the EIA shows that Russia was the largest natural gas-exporting country, the second-largest crude oil exporter after Saudi Arabia and the third-largest coal-exporting country behind Indonesia and Australia.

Fossil fuels are the heartbeat of the Russian economy with the oil and gas sectors accounting for almost 40% of Russia's federal budget revenues, and up to 60% of all its exports. A complete ban on Russian exports to western nations would certainly hurt the Russian economy, but this is unlikely to happen in the short term.

Europe is highly dependent on Russian fossil fuels, importing more than 25% of Russia’s crude oil, around 40% of its natural gas and almost 50% of its coal. Since the start of the war in Ukraine, Europe has paid Russia nearly $19 billion for fossil fuels to meet its energy needs, which some critics argue is fuelling Putin’s war machine.

The UK is itself a producer of gas, crude oil and petroleum products, and therefore less reliant on Russian fossil fuels than our European neighbours. Imports of oil from Russia account for less than 8% of UK demand and imports of natural gas make up around 4%. The US also imports a small fraction of its crude oil and petroleum products from Russia but is largely self-sufficient.

Since Russia’s invasion of Ukraine, western economies such as the US, the EU and the UK have all announced plans to significantly reduce their dependence on Russian fossil fuels. The US will impose a total ban on all imports of Russian oil, liquefied natural gas, and coal. The UK has also announced plans to phase out Russian oil imports by the end of the year and business minister Kwasi Kwarteng said he is exploring options to end British imports of Russian gas.

Germany suspended the Nord Stream 2 Baltic Sea gas pipeline project in February and, more recently, the European Commission announced plans to reduce gas imports from Russia by two-thirds by the end of this year, and to cease its reliance on Russian oil and gas altogether by 2027.

In response, Vladimir Putin has signed a decree stating European countries must pay for gas supplies in roubles through Russian bank accounts. The move has been seen as an attempt by Russia to strengthen the rouble, which has fallen in value following Western sanctions.

The EU has resisted Putin’s request and Germany and Austria have recently announced emergency plans over possible disruption of gas and oil supplies — others may follow. But it is a stark reminder of how over-reliance on fossil fuel imports can have a negative impact on economic growth.

UK vulnerability to fossil fuel markets

The decision by many western economies to reduce fossil fuel imports from Russia and impose tough financial sanctions will have a significant impact on the Russian economy, but countries still need fossil fuels from somewhere.

The reality is that, while the UK and other nations are committed to transitioning away from fossil fuels in favour of low carbon energy, over three-quarters of global energy demand is still met by fossil fuels.

The US has promised to cover some of the fossil fuel shortfall in Europe and elsewhere, but costs are likely to remain high for some time following the OPEC Plus countries’ decision not to increase production to meet growing demand.

The UK is less dependent on Russia for fossil fuels but still relies on imports from elsewhere. Norway is our main supplier of both crude oil and natural gas, followed by the US, Russia, Nigeria and Canada. Liquid nitrogen gas (LNG) is imported mainly from Qatar, with prices indexed to rising global oil prices.

In 2020, during the pandemic, the UK actually exported more primary oils than it imported. But the UK remains reliant on imports to meet refinery demand for specific crude blends and, despite plans to close down coal production here, we still rely on imports for around 3% of UK energy demand.

It’s also worth noting that the UK is part of a growing network of electricity interconnectors. In 2021, imports of electricity rose by 28%, while electricity exports fell by 7%. France, a major state-owned nuclear power producer, is the UK’s main supplier of imported electricity. A North Sea link has also been installed, linking the UK with Norway. The 720-kilometre interconnector is the longest in the world and enables both countries to share renewable energy and strengthen security of electricity supplies.

In summary

The geopolitical tensions caused by the war in Ukraine have increased volatility in fossil fuel prices and exposed the vulnerability of western economies that rely on global supplies. This poses a significant challenge for the UK and other countries that currently rely on fossil fuels for around three-quarters of their energy

The Government’s long-awaited national energy security strategy has just been published and sets out future investment plans to reduce our reliance on foreign fossil fuels and become more self-sufficient in energy terms.

Options include a mix of home-grown fossil fuels and green energy, including more oil and gas production, more nuclear power plants and more solar and wind power capacity, along with additional investment in hydrogen power, heat pumps and possibly tidal power.

The latest report from the Intergovernmental Panel on Climate Change warns that greenhouse gas emissions from fossil fuels need to peak by 2025 to avoid irreversible global warming and catastrophic climate change. The question is whether the Government has managed to get the balance right.