Europe's crucial manufacturing sector faces a crisis as companies scramble to adapt to the loss of cheap Russian gas as fallout from the war in Ukraine.

Companies including BASF SE and ArcelorMittal SA have pulled back or stopped production after Russia turned off the taps to the Nord Stream 1 pipeline. European Union countries counted on Russia for more than 40% of their gas supply, and the loss has more than halved imports of Russian gas this year compared to the same level in 2021.

That is pressuring the EU's manufacturing sector, which accounts for nearly 15% of the region's GDP, compared to just over 11% in the U.S., and is a key link in global supply chains. Energy prices have fallen from their summertime highs, though forecasts call for another rise and elevated costs that will last for years. Even as companies contemplate a longer-term shift to a new energy network centered on liquefied natural gas and renewables, the energy crisis and labor shortages could devastate manufacturing in the region.

"We are potentially looking at a massive shock in European industry," said Diego Iscaro, senior Europe economist at S&P Global Market Intelligence.

Manufacturing pain

Month-ahead gas prices on Europe's key benchmark, the Dutch Title Transfer Facility, hit €114.83/MWh on Nov. 14, down from the Aug. 26 peak of €319.98/MWh as efforts to fill gas storages and source LNG cargoes, including floating terminals, have eased price pressures, according to S&P Global Commodity Insights. Still, the Nov. 14 price is nearly 700% higher than the price two years ago before the crisis.

Since access to supply from the Nord Stream 1 pipeline was cut off in late August, Russian gas imports to the EU and U.K. have fallen to about 62 billion cubic meters for the year so far, compared with nearly 125 Bcm at the same point a year ago.

As a result, the EU's manufacturing and export operations are contracting, with S&P Global Purchasing Manager's Index readings in October of 46.4 and 39.4, respectively. The new export orders reading is the lowest level since May 2020 when COVID-19 was battering the world’s economy. The index measures monthly changes in activity, with a reading above 50 indicating an increase.

The EU is the world's second-largest manufacturer behind China and the largest net exporter of manufactured goods, with an annual trade surplus in goods of €215.8 billion in 2020, from €148 billion in 2013. The bloc's carmakers, steelmakers and chemical plants form the backbone of international supply chains, and the loss of Russian gas threatens operations across the region.

BASF has announced it would "permanently" downsize its European operations, while fellow steelmakers ArcerlorMittal, Salzgitter AG and Acciaierie d’Italia have all stopped production.

"The challenging framework conditions in Europe endanger the international competitiveness of European producers and force us to adapt our cost structures as quickly as possible and also permanently. ... We, as a company, must act now," BASF's CEO Martin Brudermüller said during the company’s third-quarter earnings call.

The energy crisis "erodes the competitiveness of European production," according to Frederico Carita, senior manager of developer services at LevelTen Energy Inc., which operates a marketplace for green power purchasing.

Strategy shifts

Power prices have risen in tandem with gas. Year-ahead prices in Germany peaked at €985/MWh on Aug. 26, compared with just under €42/MWh two years earlier.

This increase may force a shift in corporate power procurement strategies, Carita said. Increasingly, heavy industry buyers are seeking longer-term electricity contracts "because [they] are just afraid that prices will go even higher."

Norsk Hydro ASA, which has production sites across Europe, uses a mix of its own hydropower production with long-term electricity contracts to run its power-hungry aluminum smelters.

Smelters across Europe have been shuttering production due to the high electricity costs, with lobby group European Aluminium anticipating a 50% decrease in production capacity by the end of 2022. The losses would be replaced by increased production in China, the group said.

Norsk Hydro was forced to halt production at its majority-owned Slovalco smelter in Slovakia in August, pointing to "substantial financial losses" if operations continued beyond 2022.

"Very few, if any, [aluminum] producers would be able to run at spot prices today because of the significantly higher costs," Halvor Molland, senior vice president for group communication at Norsk Hydro, said in an interview.

Complicating factors

The value of the euro has slumped during the Russian gas crisis as investors bet against the region, dropping to parity with the dollar from $1.14 at the start of 2022. The weak euro makes it easier for exporters to compete in global markets priced in dollars, but the more energy-intensive European companies are suffering from having to pay in dollars to import energy.

Labor shortages in Germany, which houses large industrial players BASF, automaker Volkswagen AG and engineering company Siemens AG, are driving up wages at a faster rate than other EU countries, compounding problems with higher energy costs, according to Stefan Schilbe, chief economist at HSBC Germany.

"The erosion of competitiveness, amplified by relatively higher energy costs in Germany, could force some companies to move production plants abroad in the future," Schilbe said. "These headwinds will only partly be alleviated by [German] government measures like the proposed gas price cap."

Future energy mix

At the industry level, steelmakers across the region are devising different plans to decarbonize, from replacing coking coal in the blast furnace process with hydrogen, to the complete removal of blast furnaces and the development of electric arc furnaces that use electricity to melt scrap steel. The scale of the costs involved means the process will be impossible without government help.

Government support should be given on the condition that companies make investments that ensure they are resilient to future energy shocks including changing their production processes to use less fossil fuels, said Michele Rimini, who leads think tank E3G's program on industry transition and trade. This will allow companies to address the gas crisis while making sure they are on track to hit net-zero emissions.

"The direction of travel is there," Rimini said. "There's no going back from the decarbonization pathway that countries have agreed to."

In Germany, Europe's biggest consumer of gas and electricity, the government unveiled a €200 billion debt package to cap energy bills for industry and households. The French government also plans an "electricity guarantee" for 2023 to cover a part of companies' bills.

Gas demand reduction is a key pillar of the European Commission's strategy, with a goal of voluntarily reducing consumption across the region by 15% already met.

In the longer term, the European Commission plans an accelerated roll out of renewables and higher LNG inflows to revolutionize the EU's energy supply and end its reliance on Russian gas.

LNG imports from the U.S. have more than doubled from 22 Bcm in 2021 to 48 Bcm this year so far, and gas storage capacity across the trading bloc is at 95%. But the market vulnerability extends beyond the upcoming winter as the development of alternative energy infrastructure will take years to realize.

"It's how we get to 2025-2026," Iscaro with Market Intelligence said. "We know there is LNG coming to the global market, European governments have been successful so far in investing in regasification and new terminals and interconnections to landlocked countries. … The question is how to minimize the industrial loss from now until 2025."