Energy storm rising
Markets and AlphaValue have been wrong-footed by the sudden twists of energy markets, for the worse. It has the potential to be an accident in progress as the mechanisms are the same whether in Brazil, the UK or China, all converging towards a big slowdown on energy scarcity.
The awareness is recent as gas prices in Europe shot through the roof only recently (see UK spot price chart below). It immediately became political and hotly ahead of the northern hemisphere’s winter. Before July, the energy talk in the western part of the world was, as usual, focused on crude and the OPEC+ convolutions with nobody really paying attention to gas. As it happens, gas spot prices are merely a loud and clear signal to wider disruptions.
A UK gas story, spot on
It is hard to unravel all the mechanisms at work that help create price spikes. There are two root ones though. The first is cheap money swamping the real economies and, as a result, a faster recovery than expected, with the world essentially in sync. The second is the drive for emission cuts sending confused price signals but, above all, triggering a sense of urgency about energy arbitrage, hedging and pre-positioning.
What seemed to be very European centric (carbon rights/ETS) suddenly became a more global drive with China having its own carbon market (up and running but deployed in steps) and Biden’s America being more open-minded to greenery. Energies are more interconnected than ever, whatever the geography, with very complex strategies hinging on carbon expectations. The result is that an efficient carbon rights market in China has an impact on gas prices in Europe.
Out of those two root causes, one is about to stop, i.e. excess financing, the other is here to stay and will be increasingly impacted by political interference: carbon rights. The mess may last.
Two geographic areas are worth extra observations: China and the UK. They tell stories found elsewhere.
The first is China. Central authorities seem to be surprised by the sudden disruptions in energy markets as manufacturing demand is strong and the pressure against burning more coal is rising. Capacity is short. Authorities are torn between cutting on pollution and keeping the lights on. Lights on mean cheap and capped retail power prices that will never pay the suppliers’ expenses on higher coal prices (courtesy of demand) and newly-imposed Chinese-type ETS.
Chinese consumers will not change their ways, failing a price signal. On top, the Chinese phenomenal hydro power has been run dry by excess draw over last summer. The mess is a mighty one, in a conflict between local authorities and central ones. Manufacturers are idling plants in rising numbers; exports are at risk and the domino effect on the rest of the planet with no damper in the form of inventories can be nasty.
The big Chinese demand for LNG to offset coal emissions while keeping the burner on is having repercussion on prices over the world. Brace?
The second is the UK. The unfolding energy crisis appears to be another poorly-designed attempt at using the market to get lower prices in what are natural monopolies. There were historically 6 big suppliers, of which Centrica, Iberdrola, EDF, E.ON and SSE are under AlphaValue coverage.
Starting from 2014, the number of electricity suppliers surged following a change in regulation by Ofgem (the energy regulator) to promote competition. It also implemented a price cap, preventing suppliers from selling electricity to retail clients above a certain level, no matter the wholesale price ones. The number of suppliers rapidly grew above 25, with players making a punt on accessing forever low supply prices and gaining market share by charging wafer-thin margins, i.e. too low to buy hedges anyway.
The current sharp increase in wholesale gas and electricity prices has already led to a dozen bankruptcies, which means that retail customers will share the collective burden of such a poorly-conceived competition, i.e. the tiny savings on their power bill will be wiped out many times over by the mutualisation of industry losses in individual bills. In this respect, it is a political catastrophe as it amounted to give for free an option for new entrants to mint money with no capital.
As it happens that ‘capital’ was to be ultimately provided by retail power buyers through mutualisation of the sector losses. While traditional suppliers are managing the collapse of the new players, they may emerge stronger, but the opportunity cost will have been a monstrous one. The near-term outlook is not great either as UK offshore wind seems to be on strike and a major power interconnector with the continent has suffered from a fire.
For doomsayers, one can add that essential hydro resources are essentially dry in Brazil and weakening fast in India. For such big countries that means relying on external resources at higher world market prices.
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