European Union economies seem headed for a recession as Russian gas supply cuts push up prices and limit availability, exposing the bloc's industrial sector.

Gazprom's decision to reduce capacity at the Nord Stream 1 pipeline to 20% has severely reduced the supply of Russian gas to the continent. EU countries, dependent on Russia for 41.1% of their gas requirements in 2020, responded by agreeing to reduce gas consumption by 15% between August and March 2023.

With governments likely to prioritize households in the distribution of available gas supplies, energy-intensive industries such as chemicals, cement and metals will likely face the brunt of the rationing, reducing industrial output in economies already bruised by the impact of inflation on consumer spending power.

"We're looking at a situation where the European economy has lost significant momentum, mainly due to record high inflation, and the [energy] shock is worse in a worsening economy," said Diego Iscaro, senior Europe economist at S&P Global Market Intelligence. "We think recession is very likely late this year or early 2023. Even the third quarter of this year is looking quite weak."

Contraction ahead

The economic damage will be much more severe if Russia decides to turn off the taps completely.

"A complete end to Russian gas exports would cut eurozone GDP by around 2% whilst rationing was in place in addition to the one percentage point cut due to higher inflation," Andrew Kenningham, chief European economist at Capital Economics, wrote in an August 9 research note.

Swiss bank UBS forecasts a recession with three consecutive quarters of economic contraction if Russia cuts off the gas supply to Europe.

Gas prices have rocketed as European countries seek supplies to fill their stocks ahead of winter. Plans have been made to build new LNG terminals to increase capacity for gas imports, while investments in nuclear power and renewables are also receiving more support. However, these projects will take time to bear fruit.

The Biden administration has pledged to increase exports of LNG to the EU and established a task force to design measures to reduce European reliance on Russian energy. The supply commitment has been likened to the Marshall Plan in 1948, which helped European economies reconstruct following World War II.

"The plunge in Russian gas flows to Europe will continue to support European gas price levels for at least the next few years," said Ornela Figurinaite, gas analyst at S&P Global Commodity Insights. Figurinaite noted that current constraints in capacity to regasify liquified natural gas back to atmospheric temperature will keep prices high enough to reduce demand in the industrial and heating sectors.

The eurozone economy is already feeling the strain. The S&P Global Market Intelligence Eurozone composite purchasing managers index, or PMI, survey fell into contractionary territory in July for the first time since February 2021, with the manufacturing sectors in the region's major economies — Germany, France, Italy and Spain — all registering declining PMIs.

Germany at risk

The German economy is particularly vulnerable to gas rationing, according to Iscaro. "The industrial sector is quite large compared to GDP and they have quite a strong reliance on Russian gas," he said.

At 18% of GDP accounted for by manufacturing in 2021, Germany is more dependent on the sector than many other leading Western economies. In the U.S., manufacturing accounts for 11% of GDP, while in the U.K. it is just 9%.

Capital Economics calculates that a 50% reduction in output in energy-intensive industries would directly reduce German GDP by 2%, while ripples through the supply chain would double that cost to 4%.

Germany, which lacks large LNG terminals, is particularly exposed to Russian gas, having decided to decommission its nuclear fleet in the wake of the Fukushima disaster in 2011. Reduced output from France's nuclear fleet has limited another important source of power for the continent.

Russian gas supplies to the EU were 30% below the average for the past five years according to the EU Commission, and the struggle to find replacement supply has left German gas stocks 29.1% below the level of a year earlier, according to Commodity Insights.

Interconnection brings vulnerability

The interconnectedness of the eurozone economy means there will be knock-on effects from a downturn in German manufacturing. Emerging European countries such as the Czech Republic and Slovakia have significant roles in the supply chain of Germany's industrial powerhouse.

Energy rationing and high prices could persist beyond the next year even as the eurozone develops the infrastructure to import more LNG and reduce its reliance on Russia.

"Even after the necessary regasification capacity becomes available in Europe, we still need growth in global liquefaction capacity for prices to stabilize," said Commodities Insights' Figurinaite.

Shielding consumers

Consumer spending has also taken a hit as energy costs soar. Consumer price inflation in the eurozone rose to a record high 8.9% in July, limiting household purchasing power. Retail sales in the eurozone fell 1.2% month over month in June with the sharpest declines seen in Germany and the Netherlands.

European countries are likely to enact fiscal policies designed to shield citizens from the worst effects of scarce gas.

"Governments are likely to react the same way they reacted to the pandemic," Iscaro said. "In France, subsidies are being used to limit the increase in energy prices, but also other countries, like Greece, have put in place measures worth 3% of GDP."

Oncoming colder weather will add another dimension to the grim economic outlook.

"If we have a particularly cold winter things can go pretty bad quite quickly," Iscaro said.