Russia, Nord Stream 1 and the bond market

With no end to the war in Ukraine in sight, risks are mounting that Russia may resort to escalatory measures in an attempt to force concessions from the West.

One of the major levers that Russia has available is the Nord Stream 1 natural gas pipeline (NS1) connecting  with Germany. If the gas supply were to be shut down, Russia would in effect be using a key part of Europe’s energy infrastructure as an enormous bargaining chip against the West.  

With energy costs already soaring across the continent, such a move could wreak severe damage on European output and growth. We must take this risk seriously when managing European credit portfolios.

If Putin does turn the gas off over the next few months, it is easy to imagine euro-denominated credit spreads shooting wider. However, this outcome could be very challenging to monetise in the summer period if any selloff proves to be short-lived, if a political solution is found, or if a less hawkish European Central Bank utilises its new anti-fragmentation tool to act as a buffer for spreads.

Winter worries

The picture becomes more threatening for winter, when for obvious reasons the continent becomes more vulnerable to disruptions in its energy supply.

Gas inventories are already below what we could expect for this time of year, and there are a limited range of alternatives available. Any shut-off would come at a time when Europe has already had its energy security called dramatically into question.

The EU imports 40% of its natural gas from Russia, of which 40% arrives via the NS1 pipeline[1]. Russia has curbed 60% of this supply since the beginning of June, and the pipeline was closed for planned maintenance between 11-21 July . This action was routine but did serve to focus European minds on the vulnerability of their gas supply.

Risks and mitigation

As indicated earlier, any cut-off scenario poses material operational and financial risks for European industry.

The most exposed businesses are in energy-intensive sectors such as utilities, energy, chemicals and autos, particularly in Germany and Italy as their energy mixes are especially reliant on Russian gas supply.

Examples of companies that are heavily impacted include the Finnish utility Fortum and its Russian gas-exposed German subsidiary Uniper. The latter has already been forced to procure gas from other sources at higher cost given the reduced gas flow. The German government has said it will step in to bail out Uniper by acquiring a 30% stake from Fortum and allow the utility to pass on some costs to consumers, leading to bond spreads retracing most of the widening since the end of June.

Another impacted company is German gas transporter Vier Gas on concerns around reduced volumes flowing through its networks. However, the company could be benefitting from additional capacity bookings bringing gas from Norway.

Overall, the full consequences of any NS1 suspension or shutdown are unclear, but across Europe authorities have developed mitigation strategies to avoid major disruptions to energy supplies. EU member states agreed to reduce gas demand by 15% compared to their average consumptions in the past five years, with measures of their own choice.

It remains to be seen how successful they will be, however, and we can be even less certain of the unpredictable second-order effects of any true energy shock. We can be certain, however, that any imposition of a de facto energy embargo is one of the most significant risks facing Euro credit as we head into winter – and one for which we are preparing.

[1] https://www.nord-stream.info/