As it all kicks off in Ukraine and amid a fast-moving backdrop (Kiev is already in the process of being surrounded by Russian armoured forces), it is pointless speculating on President Putin’s next moves, whether partition or full occupation, what he will and will not do, how far he is prepared to go (only he knows that, certainly none of the rest of us). Events will surely render any commentary out of date as soon as it has left the keyboard.

Nord Stream 2: Germany in focus

The focus of this week’s article is on Germany. Of the West’s fairly predictable and so far limited reactions with sanctions against Putin, much the most important with long-term ramifications is that of Berlin. Having presented itself as a significant pain in the neck to its fellow NATO members and eastern European EU countries with its dovish, appeasing attitude towards Russia, at last Germany has done The Right Thing. Or, at least, nearly The Right Thing. If it has not completely killed off the Nord Stream 2 (NS2) gas pipeline, at least it has put the project on ice for the time being.

 

It is a big step for the new Chancellor, Olaf Scholz. It goes some way towards rehabilitating Germany with its allies, though doubts remain about its flakiness with other sanction programmes, in particular the proposals to freeze Russia out of global capital and trade markets (Germany and other EU countries are still buying buckets of Russian oil and gas, for example), and expelling it from SWIFT, the international settlements system.

 

Within Scholz’s own coalition, the ending of NS2 plays wholly to the Greens’ agenda (who always opposed it vocally on principle); it discombobulates the rightwards-leaning FDP who strongly support the project; as for Scholz himself and his own SPD party, as junior members in Merkel’s previous coalition governments, those administrations which negotiated and signed the contracts, they now have to explain why, if NS2 were indispensable to Germany’s strategic energy needs at the time, it is now perfectly fine without the pipeline.

Is Germany’s energy policy unravelling in front of our eyes?

Economically, announcing NS2’s suspension, Germany’s medium-term energy policy is in danger of unravelling. It appears less a case of the emperor’s new clothes as the emperor’s garb is distinctly threadbare. The sub-sea pipeline running under the Baltic from Russia to Germany, sitting alongside the 10-year-old Nord Stream 1 and with more than double its capacity, was supposed to be the secure, cheaper and more reliable means by which the bulk of Germany’s gas requirements would be delivered directly. NS2 would enable bypassing the existing principal overland lines: the first transits through Belarus and Poland (the Yamal Pipeline); the second (the ironically named Brotherhood Pipeline; some ‘brotherhood’!) passes through Ukraine and into Hungary.

 

Before Christmas, the new coalition government in Germany declared publicly that all coal usage will be gone by 2030 (and nuclear even sooner, all remaining installations are due to be decommissioned by the end of this year), by which time it expects 80% of all German energy to be derived from renewable sources. As coal and nuclear are phased out and reliance on oil is reduced, so ‘clean’ natural gas would logically become even more important in the transition to a renewables-based economy and society. In context, in terms of Germany’s total energy generation, a third (34%) comes from oil, over a quarter (28%) from natural gas, 15% is derived from solid fossil fuels (coal and lignite), 17% from renewables and 6% from nuclear. Of its natural gas requirement, 95% is imported and about 40% of that volume originates from Russian gas fields. Germany has limited port infrastructure to handle large-scale shipments of liquid natural gas from, say, Qatar, as an alternative to the pipelines from eastern Europe.

 

Virtually 100% of the oil is used in transport with only a fraction being burned for electricity production; estimates vary but somewhere between a half and two thirds of all Germany’s domestic dwellings are powered by gas for heating, cooking and hot water. What the new government is intimating, spurred on heavily under the influence of the Green Party members of the coalition, is that in no more than 7.5 years, it will have completely restructured the country’s energy generating capacity and the means by which that energy is delivered and consumed. Ambitious? Certainly. Pie in the sky? Probably.

Ukraine crystallises the problem

If there were questions over the plausibility of these plans before the Ukrainian crisis, they now look increasingly improbable. Germany is the fourth-largest economy in the world, albeit a relative minnow at a fifth of the size of the US and a quarter the size of China. However, it is substantially the biggest in the EU, nearly half (40%) as big again as the economies of France and Italy respectively. It is a heavily industrialised, energy-intensive nation; it runs up significant trade surpluses from its exports of cars and automotive parts, pharmaceuticals, capital equipment and aerospace products. In the aftermath of incurring the costs of reunification compounded by the effects of the Global Financial Crisis when Germany’s national accounts were in a frightful mess, it was enshrined in law (Germany’s Basic Law) that Germany should incur a ‘debt brake’ under which the federal budget is limited to a deficit not exceeding 0.35% of GDP, and in line with the limits set by the Maastricht Treaty, the ratio of national debt to GDP should not exceed 60%.

 

To maintain economic stability, let alone growth, it needs reliable and constant sources of energy: among renewables, wind and solar, the two principal sources, are neither reliable nor constant. Although not a cliff-edge event in 2030 when the sale of new combustion-engine vehicles will be prohibited, largely to be replaced by electric vehicles, and coinciding with the need to convert domestic consumption away from gas, demand for electricity is going to accelerate sharply in the 2030s. In the absence of solid hydrocarbons to fuel power stations and an outright refusal to entertain any new nuclear generation, among the current technologies available to deliver a constant and reliable fuel for electricity generation in scale only natural gas is the most viable option. And here, as has been only too obviously demonstrated, Russia has Germany in a vice.

Could Putin turn off the gas tap?

The most immediate question is what if Putin decides to retaliate against Germany’s decision to freeze NS2 by closing off all gas supplies, not only to Germany but to the rest of the EU too? President Biden has been clear that the western allies, already facing significant inflation pressures many of which arise from energy prices that were escalating even before Putin invaded Ukraine, have no intention so far of placing sanctions on Russian oil and gas exports in order to maintain ‘orderly’ global energy markets.

 

However, as has been demonstrated, Putin has no such scruples about wider global responsibilities. Every decision he takes is purely through the Russian lens (more accurately, it is purely though his lens). With only a couple of months’ worth of gas storage capacity in Europe, he knows that he would leave many countries in the EU with significant headaches about how literally to keep the lights on and their industrial wheels turning (much as the problem faced by China in the second half of last year when it ran out of coal leading to swathes of industrial capacity having to be taken off-line in rotation to preserve fuel stocks); at what point would European popular opinion say, “enough! Give him what he wants!”. For Putin, his is purely a strategic decision based on how long he can incur the economic pain from the loss of income from gas and oil sales to Europe while finding alternative markets for his products.

 

As for Germany’s long-term future, there are some hard choices to be made now as it is confronted by the reality of its strategic reliance on imported energy, and what energy it produces domestically in a post-fossil fuel paradigm being neither reliable nor constant. If the strategy struggled to stack up before, in the light of current events it stacks up even less. It simply does not seem a realistic target to be trying to run a large, modern, industrialised economy, particularly one such as Germany’s which has the additional burden of being the lynchpin of the eurozone’s economic and financial system, based largely on sunshine and windmills.

 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

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