Europe’s problems in sourcing oil and gas this winter after a dispute with Russia may be exacerbated by a new crisis in the market where prices are already red-hot: a liquidity crunch that could send them spiralling higher still.

But European governments have only belatedly rallied to offer financial support to power providers on the brink of collapse, in an effort to ease pressure on a market whose smooth operation is vital to keep people warm.

“We have a dysfunctional futures market, which then creates problems for the physical market and leads to higher prices, higher inflation,” a senior trading source told Reuters.

The problem first came to light in March when an association of top traders, utilities, oil majors and bankers sent a letter to regulators calling for contingency plans.

This was triggered by market players rushing to cover their financial exposure to soaring gas prices through derivatives, hedging against future price spikes in the physical market, where a product is delivered, by taking a ‘short’ position.

Market players typically borrow to build short positions in the futures market, with 85-90% coming from banks. Some 10-15% of the value of the short, known as minimum margin, is covered by the traders’ own funds and deposited with a broker’s account.

But if funds in the account fall below the minimum margin requirement, in this case 10-15%, it triggers a ‘margin call’.

As prices for power, gas and coal have risen over the past year, so have the price of shorts, with the resulting margin calls forcing oil and gas majors, trading firms and power utilities to tie up more capital.

Some, particularly smaller firms, have been hurt so badly they have been forced to exit trading altogether as energy prices soared after Russia’s invasion of Ukraine in February, which made a general global shortage worse.

Any such drop in the number of players reduces market liquidity, which can in turn lead to even more volatility and sharper spikes in prices that can hurt even major players.

Since late August, European Union governments have stepped in to help utilities such as Germany’s Uniper.

However, with winter price spikes lying ahead, there is no indication of whether or how quickly governments and the EU can back banks or other utilities that need to hedge their trades.

Exchanges, clearing houses and brokers have raised initial margin requirements to 100%-150% of contract value from 10-15%, senior bankers and traders said, making hedging too costly for many.

The ICE exchange is, for example, charging margin rates of up to 79% on Dutch TTF gas futures.

Futures/margin-rates: Although market participants say that fast disappearing liquidity could severely reduce trading in fuels such as oil, gas and coal and lead to supply disruptions and bankruptcies, regulators still say the risk is small.

Norwegian state-owned firm Equinor, Europe’s top gas trader, said this month that European energy companies, excluding in Britain, need at least 1.5 trillion euros ($1.5 trillion) to cover the cost of exposure to soaring gas prices.

That compares with the $1.3 trillion value of US subprime mortgages in 2007, which triggered a global financial meltdown.

However, one European Central Bank (ECB) policymaker told Reuters that worst case scenario losses would amount to 25-30 billion euros ($25-30 billion), adding the risk lay with speculators rather than the actual market.—Reuters