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Hoping for some winter sun…

UK: Suitable for professional clients only.

Date: 30 September 2021

Wholesale gas prices have hit the headlines as prices have rocketed to levels never before seen. The question is whether this is a short-term issue that’s likely to subside or if it reflects a more structural, long-term problem. Unfortunately, the answer is: both.

Noble intentions

The push towards a cleaner, more stable climate should be enjoyed by all of us, especially those in our densely-populated cities. But this transition to a lower-carbon environment requires more than simply swapping out our old diesel burners for a shiny new electric vehicle. Notably, the financial costs of achieving this goal are likely to be far reaching.

Keep in mind that this blog isn’t intended to be a debate on the cost of cleaner air. However, we need to acknowledge the consequences, and the potential risks, for some businesses presented by the path we’re now on.

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Blowing hot and cold

The recent sharp rise in wholesale gas prices is a good example of the ‘perfect storm’ created by the accelerated push towards fossil-fuel alternatives.

In recent years, investment in the UK has migrated away from coal and the North Sea in favour of renewables such as wind.

Encouragingly, the UK garnered nearly a quarter of its entire electricity supply from wind in 2020.

However, the milder weather conditions we’ve seen this year mean that, at times, wind’s contribution to the UK’s power grid has dropped to just 7%. Unfortunately, with natural gas as the ‘least bad’ option for power production to fill the gap, energy producers have scrambled to secure supply and reserves; this has resulted in stratospheric price increases.

 

Why did no-one see this coming?

Although, in principle, some aspects of the current crisis perhaps should have been predicted (winter, after all, still comes every year), this time around, there are numerous exceptional factors including the huge disruptions caused by policy changes within individual European countries that reverberate right across the region.

At ground level, lockdown has wreaked havoc on the maintenance schedules for storage facilities meaning that many are offline for the very “peak season” for which they were intended.

Meanwhile, a fire in Kent at the ‘IFA1’ interconnector site has reduced the UK’s ability to pipe in nuclear power from France.

Even more critical, for us in the UK at least, is our historic reliance on Europe for our energy security.

This state of relations is now not so much ‘transitioning’ as undergoing a complete volte-face. For example, a giant Dutch natural-gas field, that once pumped enough fuel to provide for all of Germany’s needs, is shutting down next year due to environmental concerns.

Such concerns are nothing new, of course; what’s new is the unprecedented policy push into such areas and their global repercussions.

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What this means for consumers

In the long term, our migration away from fossil fuels should provide for a cleaner environment for generations to come. However, in the short term, it’s the current generation of consumers and businesses that will have to foot the bill for the transition.

Consumers in the UK are already seeing this in the form of higher gas bills and disruption to industries that rely on by-products such as the carbon dioxide sector, which is a vital cog in our food supply chains. Unfortunately, higher bills and volatile prices are likely to be the norm until efficient alternatives are made widely available.

For businesses, the impact of such rising costs could range from reducing margins to complete obsoletion, as we’ve already seen with many of the UK’s flotilla of poorly capitalised (and poorly hedged) small energy providers. They were quick to move into the UK’s relatively liberal energy markets and were the first to be dragged under when the tide suddenly changed direction.

Higher bills and volatile prices are likely to be the norm until efficient alternatives are made widely available.

What this means for investors

For now, market pricing suggests that energy prices will remain elevated for the next sixth months but that they should ease thereafter. The UK government’s nuclear industrial strategy, while bold, can’t come fast enough to impact the current outlook.

In the meantime, it’s extremely difficult to predict with any great degree of certainty the impact that rising wholesale gas prices will have on corporate profit margins.

Ironically for an island nation famously obsessed with its own weather, the weather, over which we have no influence at all, is likely to play the deciding role in the demand for gas and its subsequent price moves from here.

We also need to remember the other variables that are causing concern for both small and large companies right now, including supply constraints across the production chain, rising transportation costs and labour shortages. All of which will impact the bottom line.

We also need to stay alert to the changing demand picture in Asia, which continues to coin hungry new middle-class consumers faster than any other region, not to mention the dark geopolitics that will likely attend any attempts to employ Russia’s huge gas fields to keep the rest of Europe warm this winter.

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Wrap up warm

At times like these, when problems seem to be coming faster than solutions, investors should seek solace in diversification and active management with a focus on quality companies, regardless of investment style.

With so many unknowns currently in the system, investors need to allocate to those companies with the strongest balance sheets, the best cashflows, the fattest margins and the most pricing power so they can pass along cost increases to the end customer.

The companies in this enviable position, which might also have real assets that can benefit from asset price inflation such as real estate, utility and infrastructure assets, are also likely to be those that are best able to manage their operating costs and, possibly, supply chain disruptions.

In the meantime, it wouldn’t hurt at all if we all crossed our fingers and hoped for a mild winter!

* For further insight into the looming European energy crisis, click on the sister piece to this blog entitled It’s an ill wind…. It’s a recording of our recent meeting with Rob Sorrentino of Eckhardt Trading Company (ETC) and Alex Rau of Environmental Commodity Partners, both of whom are experts on the dynamics of the energy sector.

The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rates may cause the value of overseas investments to rise or fall.

This communication is issued by Quilter Investors Limited (“Quilter Investors”), Senator House, 85 Queen Victoria Street, London, England, EC4V 4AB. Quilter Investors is registered in England and Wales (number: 04227837) and is authorised and regulated by the Financial Conduct Authority (FRN: 208543) but is not licenced or regulated by the Monetary Authority of Singapore (“MAS”).

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Paul Craig

Portfolio Manager