All eyes on oil, but prices could be about to boil over

Most coverage of the Iran conflict has focused on oil prices, but Europe's natural gas market may pose the bigger threat to the UK economy. Wholesale gas prices have climbed back close to their March peak and, unlike oil, they directly determine household energy bills and much of the UK's electricity prices. Combined with unusually low gas storage levels across Europe, the risk is that another cold winter triggers a fresh spike in prices, pushing inflation higher, squeezing household incomes and delaying the recovery well into 2027.

Why natural gas is a bigger inflation risk than oil

The focus on oil prices is largely due to their volatility and their rapid impact on petrol prices. However, natural gas matters even more for UK households. Utility bills account for around 3.1% of household spending, compared with just 2.7% for motor fuels and heating oil. That matters because the Ofgem energy price cap has already risen by 13% in July and, with wholesale gas prices rebounding to 147.6p/therm from 96.5p/therm immediately after the US-Iran ceasefire in June, another increase in October now looks likely.

As a rule of thumb, a sustained 10% increase in wholesale gas prices eventually adds around 0.15 percentage points to CPI inflation. On that basis, the roughly 75% increase in gas prices over the past year should eventually add around one percentage point to inflation. However, the total hit to household bills should be smaller because the government's decision to remove VAT and policy costs from electricity bills offsets almost half of the increase. Assuming wholesale prices remain around current levels, most of the increase in bills will already have been locked into July's price cap. However, the risks are heavily skewed towards higher prices.

What’s driving gas prices higher

The biggest reason prices remain elevated is continued disruption to liquefied natural gas (LNG) shipments from Qatar, which supplies around one-fifth of global LNG exports. The UK imported just 24.1TWh of LNG during the first two months of the conflict, compared with a ten-year average of 36.3TWh. What’s more, a scorching summer has pushed up demand to meet increased air conditioning usage, June was the hottest on record in England which prompted gas demand to surge 8.6%y/y.

The combination of constrained supply and higher demand has left European gas storage just over half full and at its ten-year minimum as our chart below shows. Stocks are even more depleted in the UK where gas storage is only around a quarter full, compared to a long-run average of 56%.

Could this be a repeat of the 2022 energy crisis?

History suggests the biggest risks may still lie ahead. Following Russia's invasion of Ukraine, wholesale gas prices did not peak until around six months later and remained elevated for much of the following year. We are unlikely to see a repeat of the extraordinary price spikes of 2022 because Qatar is a much smaller supplier than Russia was. Even so, a prolonged disruption would probably keep prices moving steadily higher.

The immediate risk is continued hot weather in Europe that further drains stocks. El Niño, officially declared last month, increases the likelihood of hotter summers that put additional strain on electricity systems. Nuclear power stations rely on cool river water for cooling, while hydroelectric output can fall as reservoirs dry up. During the latest heatwave France temporarily shut around 6% of its nuclear capacity because river temperatures became too high. In many countries that lost generation would be replaced by gas-fired power stations, further increasing gas demand.

Even if summer temperatures return to normal, with storage levels already unusually low, a spell of cold weather could rapidly deplete inventories and force European countries back into the spot market to secure additional supplies. That would intensify competition for LNG cargoes and push wholesale prices sharply higher in the autumn.

The bigger concern is not today's gas prices but how little margin for error Europe has heading into winter. Storage levels are unusually low, supplies remain constrained and demand is already elevated. That combination leaves the market highly vulnerable to any further disruption or a colder-than-average winter.

What it means for UK inflation and interest rates

If wholesale gas prices were to surge again, UK inflation could climb back above 4% and remain elevated throughout much of 2027. That would squeeze real household incomes, delay further interest rate cuts and leave Andy Burnham facing a familiar dilemma. While cutting VAT and policy costs from electricity bills has softened the blow for households, those savings could quickly be overwhelmed by rising wholesale prices, forcing the government to decide whether to provide yet more support.

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