How the Natga Crisis Mimics the Northern Rock Crisis

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Britain’s natural gas shortage and fears of a possible winter of discontent with ’70s-style blackouts have been in the headlines all week. But one fact largely missing from coverage is how much the structural situation resembles that which led to the collapse of Northern Rock in 2007, and which then catalyzed the broader financial crisis of 2008.

Before explaining how, however, it should be pointed out that the natgas shortage is not just a British phenomenon. Europe is also suffering. Significantly.

The shortages themselves are the product of a perfect storm of global problems. These include, in particular, under-storage during the summer period in Europe due to increased competition for supplies of LNG (national liquid gas) from Asia; uncertainty related to delays at the launch of the the Nord Stream 2 gas pipeline from Russia; and colder than expected weather in many parts of mainland Europe, including Russia itself.

While it may appear that the rise in natgas prices is particularly acute in the UK compared to Europe, where prices have at times been considerably lower, it is not outside the norm. Because the UK is a net importer, it often has to source from Europe through its interconnection system at a premium. Apart from a few transient spikes from time to time, however, the two markets tend to trade very closely.

Another underestimated point is that the natgas market as a whole – similar to its close cousin the electricity market – has a historic sensitivity to extreme price movements and volatility. This is because there is little piping and long-term storage in the system, and a market incentive never to pay for expensive storage or excess reserves if it can be avoided. . In recent years, the boom in the LNG spot market and the ability to ship ad hoc volumes beyond the main pipeline network have tempered some of this volatility. As a result, prices in the UK have been remarkably stable throughout 2015-2019.

But much of this crisis is linked to the unexpected removal of this LNG buffer due to additional demand from Asia. Prices are therefore returning to their historically high standards.

But even then, proponents of market-based solutions would not call it a problem. There is no better remedy for high prices than high prices in their eyes. They see the market’s ability to alleviate unexpected shortages through sudden but short-lived price increases as a feature of the system, not a bug. Indeed, a finely balanced market needs very strong incentives to divert supplies to Britain when they are needed most, as well as extremely costly penalties for oversupply in the event of a sudden collapse in demand. .

Britain’s vulnerability

While it is true that the crisis is not uniquely British and that price volatility is common to all natgas markets, there are nonetheless specific local factors which amplify the risk for Great Britain compared to other markets. Europeans.

One important factor is that Britain was until recently an energy independent nation, which made it very complacent about market risks.

The other represents more than a decade of efforts to liberalize the UK natgas market and make it increasingly dependent on real-time wholesale supply.

By 2017, these efforts had succeeded in bringing down consumer prices by increasing competition in the UK market from incumbent Big Six players to no less than 70 organizations. Many of these new providers were happy to gain market share by downsizing their competition and providing consumers with lower-cost offers. Many were also light companies that did not have their own infrastructure, which gave them another big advantage. Others were less inclined to hedge their market-based exposures than more experienced traders.

But competition also had a downside. This has made investing in critical infrastructure incredibly unattractive for any player who still manages legacy assets.

It was under such market conditions that one of the UK’s largest natgas suppliers, Centrica, decided to shut down its Rough natural gas storage facility – the largest in the country – in 2017. The installation was coming to the natural end of its life. anyway, and would have needed a significant investment to modernize and revive it. But also, the chances of getting a return on that investment were becoming increasingly negligible, especially in the context of ESG trends which risked locking up the underlying asset in the long run as well.

As a result, a vital reserve mechanism that had helped the UK store gas in the summer to release it during the winter months for many decades – smoothing out supply and demand price shocks in the process – was definitely lost.

While many feared this would expose the UK to severe systemic shortages in colder-than-expected weather, supporters of the decision argued that the UK could still look to wholesale markets in the UK. LNG and mainland spot markets to ship additional supplies when needed.

No one, however, expected the natgas wholesale markets themselves to be squeezed to the present extent.

Flexibility as a factor of fragility

For the most part, price spikes in the natgas market work much like the upward price dynamics you see balancing the taxi market on the Uber app.

How sharply these prices rise, however, is directly correlated with how prone service providers are to hold expensive reserve reserves (which might never be needed) directly on their own, or to engage in longer term supply contracts. Just like with Uber, which benefits from not being tied to long-term employment contracts with its drivers, most of the time, the market has an incentive to run a natgas operation as lean as possible. This means avoiding costly blankets, contracts or storage facilities as much as possible – and taking market-based risks – so the savings can flow directly to consumers.

It is for this reason that commodity producers like British Gas have seen fit to separate their retail activities from their production activities.

But while reducing retail activity to its bare minimum is great for maximizing utility and reducing costs, it introduces the same type of risks that apply to undercapitalized banks, or those that are excessively dependent on bank financing. short term to finance their long term lending operations. . If and when the wholesale market crashes, these operators have no reserves or own production to fall back on and need bailouts to keep their business going.

This risk is especially high in wholesale markets which are exposed to structural bottlenecks on the supply side – something that differs greatly from the taxi driver market, which has much lower barriers to entry. and can easily cultivate a new supply.

In 2007, when the wholesale markets unexpectedly frozen Due to the credit crunch, Northern Rock’s over-reliance on short-term funding markets meant there were no reserves in the bank to fall back on. After failing to secure a third-party investment or government bailout, the bank was forced into bankruptcy.

This situation is analogous to that which the UK natgas system is currently facing. Except, unlike what has happened with the funding markets, this is not something that can be fixed by simply throwing money from the central bank on the problem.

The bottlenecks are a function of the actual supply problems. Since bailouts cannot magically make more natural gas, the only thing they can do is shift the high cost of supplying natural gas for the critical industry to the government’s balance sheet instead of the balance sheet. private.

Such a transfer, however, inevitably comes at the expense of other domestic spending commitments. The rescue plans under discussion for industrial CO2 suppliers in Great Britain, thus, is more tantamount to nationalizing a giant short naked natgas position than anything that looks like a resolution. If the crisis were to worsen due to a particularly cold wind, the UK nation state would risk being exposed like any other player caught off guard in a rising market.

The unfortunate observation of the situation is that the low prices that consumers have suffered as a result of market liberalization may have been largely illusory. They will have come at the cost of investments capable of making the system more resilient which, it turns out, was worth paying for when times are good.

What the situation further reflects is that we, as a society, seem to have learned very little from historical crises with similar fundamentals, including the 2008 global financial crisis, the 2001 Enron crisis and, yes, even the great Egyptian famine of the scriptures. More worryingly, this indicates that while we focused on improving the resilience of the financial system, we were inadvertently inducing fragility elsewhere. Notably, in the world of physical goods and services, through increased reliance on just-in-time supply chains, wholesale markets and competition.

Related links:
Explain Merchandise Warehouse Trade with Paperwork – FT Alphaville
Britain’s energy woes take vulnerable sector in perfect storm – FT
Why some see Russia’s hand in the gas price crisis in Europe – FT
Why the real economy also needs a prudential authority – FT Alphaville


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