War in Europe and energy markets

Energy markets have adjusted to the removal of most of the direct sales of Russian and oil gas to Western nations.

| 11 min read

Like many in the markets we have taken the view that the nasty wars in Ukraine and Gaza will continue to cause death and destruction in those places but will not escalate into a war between the big powers that causes wider spread damage. So far, that has been right – with the proviso that Houthi attacks on shipping in the Red Sea have pushed up freight rates and insurance costs, diverting considerable trade to longer sea routes to avoid the violence. US and Nato naval vessels have been drawn into direct conflict with the terrorists.

Recent days have brought news of an intensification of hostilities in Europe. Ukraine has increased its drone attacks on Russian shipping and on oil refineries within Russia. Russia has stepped up attacks on Ukrainian energy supplies. We need to ask if this makes any difference to the outlook?

There are now three main possible outcomes in this dangerous conflict. There could be a widening of the war leading to more death and damage and the possibility of more Western involvement. There could be a continued stalemate. There could in due course be attempts to negotiate ceasefire and settlement.

Will the West continue to provide large sums of financial support and the necessary weapons? Ukraine is frustrated at the lack of supplies of ammunition and modern weapons from its Western allies in the European Union (EU) and US. The US has sent $75bn to date, the EU $93bn, Germany $24bn and UK $16.5bn (US Council on Foreign Relations February 23, 2024). There are now more difficulties in securing agreement in the US and EU to sustaining large flows of cash, and problems over the quantities and types of weapons the West will supply.

US President Joe Biden has wanted to send another $60bn worth of support but this has been delayed by Republican resistance in the House.

The EU has agreed a new package of €50bn, but this is to run to 2027 implying a sharp slowdown on past levels of financing. Of this sum, €33bn of it is to take the form of loans, raised on the markets as EU borrowing, with only €17bn as grants from within the EU budget. The EU has said it will allow more flexibility for member states borrowings if they are increasing spending on defence, but we must see how far this flexibility might go and whether it can and will be used by individual countries to step up military supplies for Ukraine. So far, the EU has provided more money and the US more weapons. The EU has been unable to fulfil its promise of providing one million shells owing to a shortage of production capacity.

US President Joe Biden has wanted to send another $60bn worth of support but this has been delayed by Republican resistance in the House. There is talk of the Republican leadership allying with Democrats to get through the Biden financial and weapons package when the House returns from recess. The Speaker could only do this at the risk of precipitating a stronger move to get rid of him from Freedom Caucus and pro Trump members.

The emergency $300 million of weapons Biden did authorise will not last long in the intense battles along the extended Russian/Ukraine front in the south east of the country. Some Republicans are considering amending the Biden proposal to turn it into a loan rather than a grant, and also looking into use of the immobilised Russian assets in the banking system. Candidate Trump detects a cooling of support for the Ukraine war amongst his followers and has called for a negotiated settlement.

Nato remains determined to avoid direct involvement in the war. As a result, Ukraine has developed its own weapons for attacking targets inside Russia, and has complained about the reluctance of Nato friends to send some of the more sophisticated and powerful weapons that it thinks could help its battles on Ukraine soil. It looks as if the deteriorating climate on both sides of the Atlantic to providing more aid will limit Ukraine’s capabilities to wage the war. Nato wills the end of a Ukrainian victory but does not provide all the means to bring it about. Meanwhile, Russian President Vladimir Putin steps up the anti-Nato rhetoric and draws attention to the help Nato is giving to Ukraine.

Ukraine’s needs

Ukraine’s President Volodymyr Zelenskyy is crying out for more air defence protection as the country seeks to protect electricity installations from attack. It has faced some periods of blackout as some Russian munitions get through and bring down power cables or disable power stations. He also wants more artillery ammunition as the trench warfare is brutal and involves heavy bombardment of the opposing army’s positions. Ukraine has developed more of her own drones and is launching more drone attacks on Russia.

In recent exchanges Russia, has shown itself capable of penetrating Ukraine’s air defences. Ukraine has been able to hit naval vessels off Crimea, Crimean command and communications headquarters and to damage refineries in Russia. President Putin has been stung by US published intelligence of a forthcoming terrorist attack from Islamic State sources just before the brutal assault on the Crocus concert venue. He now alleges that Ukraine played a role in this, which it categorically denies.

Mr Putin appears to be seeking more reasons to intensify actions against Ukraine and to provide a cover story for the failure of Russian intelligence to reveal a likely plot at a time when the US was trying to warn them of its imminence. This too may intensify the war, which Russia has upgraded to war status from “a special military operation”. If the widening and intensification of the war continues there could be further disruption to oil and energy markets beyond the combatants.

Russia will take comfort from the way the main allies, the EU and US, are going slow on financial support. With his renewed mandate from his orchestrated election, President Putin is in a stronger position to hang tough on the war than President Biden or European Commission President Ursula von der Leyen. Russia can sustain a war economy footing for a bit, whilst the West argues over how to afford the money needed to maintain a Ukraine at war. Ukraine has lost a substantial part of its population who have moved elsewhere and lost a portion of its territory. As a result, tax revenues are well down when spending must be greatly increased to pay for a large army.

The US is ambiguous over the Ukraine war

From the very beginning the US and its Nato allies have been ambiguous about the war. There has been a clear wish to see Ukraine resist Russian invasion. There have been plenty of statements supporting Ukraine and condemning Russian aggression. There has also been a clear imperative to keep Nato out of the war, with frequent reassurances that no Nato personnel will be in the fight, and that no Western weapons sent to Ukraine will be used outside Ukraine.

There has been some escalation of the range and types of weapons offered to Ukraine since the fighting began, and considerable training assistance given. Today the ambiguity is chafing with Ukraine. They say as Russia attacks their energy installations why shouldn’t they attack Russian ones.? As Russia attacks some non-military targets in Ukraine and often harms civilians why should Ukraine not do that in Russia?

The West sternly warns none of its weapons can be used in this way. Recently it is reported President Biden has told Ukraine not to attack Russian refiners for fear of putting up world oil product prices. Whilst the Russian oil trade is heavily sanctioned by the West, the EU is complicit in getting round or even breaking sanctions. The EU has increased its imports of oil products from India, Turkey and Bulgaria, knowing these countries have increased their imports of Russian crude to run through their refineries. The EU banned sea imports of Russian crude and gas but not all pipeline imports. With an election to win President Biden is very sensitive to any forces that may increase gasoline prices. He is also well aware that the US public does not want a war with Russia. His opponent, Mr Trump, has said he wants to help negotiate a peace between Ukraine and Russia.

Fortified by his well-orchestrated election win Mr Putin seems to want to increase pressure on Ukraine, sensing weakness by Ukraine’s allies. Ukraine has to listen to the US as it relies on US and EU financial and military assistance. The West is going to have to get more of the money and arms to Ukraine that the leading governments have promised but are finding difficult to deliver. Ukraine needs more support to recreate some momentum against Russian positions.

It is very unlikely the US and Nato will want to get more involved in the conflict or will want to intensify the war. This makes it more likely there will in due course be peace feelers put out, as Trump’s influence rises and as Biden worries about the impact of the war on the election. Our base case still assumes a largely ugly and frozen conflict between Russia and Ukraine, with containment of its impact on the wider world. We also look at ways there could be some exploration of a settlement, as the continuing death and destruction with neither side able to win is taking its toll on both Ukraine and Russia.

Despite the obvious deterioration in the Ukraine war, with more damage on both sides, we keep as our base case no widening of this war to include the US and Nato. There are early signs that the US is moving more towards a position of considering negotiated solutions, recognising the limits to what can be achieved by military means. There is clearly no wish to use Nato’s power to defeat Russia in Ukraine by using Nato’s full might. The less money and weapons the EU and US supplies, the more they will be forced to consider other options.

Meanwhile, energy markets have adjusted to the removal of most of the direct sales of Russian and oil gas to Western markets, with tacit acceptance that Russia can sell its oil and gas elsewhere with some Western countries importing product that does come from Russian oil.

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War in Europe and energy markets

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