Putin’s Gamble Shakes Up Energy Trade – And China May Gain



Stewart Paterson | Hinrich Foundation

As the EU and Russia reorientate their energy trade patterns to break their mutual dependency, Russia is likely to look east to the energy-hungry economies of Asia, and China in particular. If China commands a price discount while retaining alternative sources of energy supply, this dynamic would improve its export advantage and reward Beijing with considerable leverage over Moscow.

Russia’s invasion of Ukraine has caused a significant hiatus in global energy markets. At the root of this disruption is the threat to Russian supplies of energy. Russia accounts for about 10% of global energy supply and its economy is heavily dependent on both the foreign exchange and the tax revenues provided by the energy sector. In 2020, for example, US$142 billion of Russia’s total exports of US$ 337 billion came from mineral fuels, which includes oil, gas, and coal. In 2021, more than 36% of Russia’s government revenue came from the energy sector.

Given Russia’s dependency on the energy sector, sanctioning its energy exports is regarded as a quick way to debilitate the country’s ability and willingness to prosecute its war in Ukraine. There’s a catch, however: trade benefits both the seller and buyer. In this case, the buyer of most significance is the European Union and specifically Germany, whose political alignment with Ukraine is compromised by its economic dependency on Russian energy.

EU energy dependency

The gamble that Putin has taken is to believe that EU energy dependency on Russia will impede western nations from acting decisively and coherently to punish and frustrate his military aggression. Indeed, although the raft of sanctions announced so far are hard hitting, a potentially crippling EU embargo on Russian energy has not been forthcoming. Instead, the EU has made clear its intention to wean itself off Russian energy over the medium term. The gamble the EU has taken is to believe that, in the face of other economic sanctions, Russia will not cut off its energy supply, which accounts for one-third of the EU’s energy imports. This has produced a short-term stand-off along the lines that game theory might suggest: an economic version of the Mutually Assured Destruction paradigm.

In the coming year, expect both the EU and Russia to reorientate their energy trade patterns to break their mutual dependency, thus giving each party more freedom of action. The party that breaks the dependency first will have the potential to impose a heavy cost on the other. The trade diversion in a global industry that accounts for US$ 1.5 trillion of global exports- the total energy sector represents 9% of total merchandized exports – will be highly disruptive to global trade.

In 2020, the EU’s total energy import dependency was 57%. While this is a decline from over 60% in 2019, it remains very significant. This dependency for energy imports is perhaps the EUs biggest vulnerability for its potential influence through economic policies. Renewable resources and nuclear energy account for most of its domestic resources, but 85% of the bloc’s natural gas and 97% of its oil supply is imported.

And despite strides in its energy transition, oil still accounts for about 34% of fuel usage throughout the bloc, while gas accounts for 24% of energy use. While the EU accounts for 11% of global energy consumption, bilateral EU-Russian energy trade accounts for only 2 to 2.5% of energy consumption worldwide.

The raw numbers suggest that an energy divorce between Russia and the EU may be manageable to engineer. In practical terms, however, several complications arise. For example, switching from Russian piped gas to liquified natural gas (LNG) requires additional infrastructure. Electricity generation capacity cannot necessarily simply switch from one source of primary energy to another.

Furthermore, the LNG market is a contact market rather than a spot market. While non-Russian sources of piped gas could fill part of the void left by Russia, the EU will have to engage in contracting long term supplies of LNG from the Middle East and elsewhere to make up the gas shortfall.

In addition, given the EU’s significant import dependency, the expansion of renewables capacity will take years. The prospects at the global level are more feasible, Renewable energy account for about 30% of energy capacity and is charting 10% growth per annum. Hence, given the relatively small size of EU-Russia energy trade as part of global consumption, an acceleration of investment could have immediate effect.

Finding alternative buyers for Russia’s energy exports is also not simple. That said, the oil market is liquid and, although not perfectly fungible, Russian oil will likely find a home somewhere in whatever quantities Russia chooses to produce. The issue is the price. Given the sanctions and embargos, Russian oil is currently trading at a 25% discount compared to market prices.

Advantage: China

Russia is likely to look east to the energy-hungry economies of Asia, and China in particular. There are two important observations here. First, it is not in China’s interests to become dependent on Russian energy. Second, China is likely to maintain a diversified basket of suppliers in order not to face the same quandary as the EU.

China’s mineral fuel imports in 2020 totalled US$ 267 billion, of which US$ 33 billion – 12% – came from Russia, its largest single supplier by value. Other major suppliers include Saudi Arabia, which supplies US$ 28 billion of fuel, followed by Australia’ with US$ 19 billion of imports, Iraq with US$ 19 billion, and Angola with US$ 14 billion. Hence, there is scope for China to increase this share to as high as 20 to 25%. This would account for about 60% of the exports that Russia currently sends to the EU, valued at US$ 60 billion at 2020 prices.

For Beijing, becoming a monopsony buyer of Russian energy would enable China to command a price discount. If China retains alternative sources of energy supply, this dynamic rewards Beijing with considerable leverage over Moscow.

If China increases the proportion of its hydrocarbon imports from Russia, it will displace supply from other sources. Geopolitics will then play a role. Will China then de-emphasise supply from countries with which it is less closely aligned? Among China’s top energy suppliers, only Australia and Saudi Arabia voted in the United Nations to condemn the Russian invasion of Ukraine. Angola and Iraq aligned with China by abstaining.

Oman, Malaysia, and Brazil – also suppliers of China’s hydrocarbons – all voted against Russia. They can potentially divert their energy exports towards the EU to replace Russian supply.

Hence, three major ramifications may result from the displacement in energy trade caused by Russia’s invasion of Ukraine. First, China may find itself importing Russia’s hydrocarbons at below market prices. This will improve China’s terms of trade and give it considerable economic leverage over Russia going forward. Beijing would become the senior partner in its ‘no limits’ strategic relationship with Moscow.

Second, China’s export competitiveness will benefit from its access to lower-cost energy. So, while the rest of the world’s energy input costs are rising, China’s costs are likely to fall.

Third, we may see a closer alignment of energy trade with political ideology. In a future of unpredictable aggression, like-minded nations may have to form commercial relationships with each other to the exclusion of geopolitical opponents. While such a dynamic may improve resilience, it may also come at the expense of welfare losses and is another example of the increasing prioritization of resilience over efficiency.

Stewart Paterson is a Research Fellow at the Hinrich Foundation who spent 25 years in capital markets as an equity researcher, strategist and fund manager, working for Credit Suisse, CLSA and most recently, as a Partner and Portfolio Manager of Tiburon Partners LLP.

To read the full commentary from the Hinrich Foundation, please click here.