here is an energy crisis in Europe, and it’s getting dangerous. Finnish Economic Affairs Minister Mika Lintila believes it will be the “Lehman Brothers of the energy industry”, and Norway’s Equinor says energy companies need more than €1.5T ($1.51T) to avert a potential meltdown.

These statements come on a backdrop of a disproportionate amount of short interest on European energy, and potentially trillions of Euros in margin calls waiting to happen. European energy companies have confirmed Equinor’s thesis, stating they may need billions in bailouts, which comes as a surprise given the record margins European utilities have generated over the last year.

Just recently, Germany’s Uniper warned its “on the brink of insolvency” as Russia shut off more gas flows to Europe. Of course, Germany is the most likely to withstand the winter shortages after completely filling its natural gas reserves over the last few months.

german natural gas storage levels
source: bundesnetzagentur

Meanwhile, the Austrian government had to bail out the city of Vienna over energy trading losses. It is unclear which other countries will face similar problems, but after the emergency meeting of European Energy Ministers on September 9th, observers should assume every country in favour of price caps on natural gas is in trouble.

Energy companies sell futures contracts to “lock in” deliverables prices and manage their balance sheets. But as energy prices increase, the cost of maintaining those positions increases as well. Even if energy prices decrease in the short or long term, the price of a contract will remain elevated. If gas prices continue to increase across Europe, energy sellers may be forced to liquidate positions in order to fund fewer deliverables while energy buyers can afford fewer contracts, further constraining supply..

This is a crisis for both buyers and sellers. Sellers have to put up a significant margin as collateral for a contract. Margins are a static rate, so they rise with the price of futures. Most energy companies model their exposure to a fairly static volatility in energy prices. After all, natural gas and oil are cyclical and mean reverting. A situation in which energy prices increase 2000% is a true tail event.

monthly price of delivered, residential natural gas (per thousand cubit feet)
source: us energy information administration

Although energy companies guarantee the margins, banks underwrite the loans which provide them. So if energy companies are unable to meet their margin requirements, banks ultimately lose out.

So far, governments have provided energy companies with liquidity support. But on Friday, Lagarde insisted that the ECB only provides liquidity to banks and not to energy companies. Otherwise, it would be meddling in fiscal policy.

Although Germany and Austria are liquid enough to deal with the crisis, other countries, such as Italy, are not in good shape. Italian banks were already on thin ice before the crisis; now Intesa, Sanpaolo, and Akros Bank are facing pitfalls in Tier 1 capital availability.

To make matters worse, European banks have been lowering their provisions following the recent economic slowdown, and have a smaller capital buffer to deal with emergencies. Shockingly, bank management teams have said they view provisions as unnecessary , because the government would bail them out.

total capital ratios and components by country (1q2022)
source: ecb

Financing costs also changed relative to EURIBOR, the ECB rate scheme which replaced LIBOR earlier this year. If the ECB continues to raise rates through next year, the financing costs of forward contracts could increase substantially. They have already done so for many companies after the ECB made rates positive for the first time in years and hiked to 125 basis points.

Even the most dovish ECB members are discussing a neutral rate of 225 basis points. In other words, at least another 125bps of rate hikes could more than double Euribor through the rest of the year.

euribor overnight rate (january 2020 to present)
source: euribor

There is a trade based on each possible outcome. The first assumes Europe recovers on its own and avoids a bank-catalysed energy crisis. European energy companies are near-monopolies in their respective countries, meaning there isn’t much chance for competitors to make inroads should the system be disrupted. These companies are “too big to fail,” which provides more incentive for them to be bailed out.

The second outcome assumes Europe plunges into a full-scale energy crisis and deep recession led by a collapse of the banking industry in a fashion not-dissimilar to 2008. The Eurozone would adopt an “every man for himself” attitude, meaning the most prepared countries like Germany would refuse to help troubled nations like France or Portugal.

The reality is probably somewhere in the middle. Europe will likely face an energy crisis through next year, regardless of the outcome of the war in Ukraine. Russia has little-to-no incentive to trade with Europe after the BRICS nations filled in trade gaps, and Putin accelerated a joint-initiative with China to bring natural gas to every corner of his country. If (or when) Russia cuts off gas flows entirely, the US is likely to fill in the gaps. Of course, US midstream companies won’t give their gas away for free, so the government will step in with subsidies to “donate” gas to the EU through the winter. And as we'll discuss later this week, this could bring windfalls to natural gas producers and transporters in the US.

So far, the best trade might be one that buys the crisis.

Sep 13, 2022
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