Fund Strategy - The power of energy
Although it may seem that the only things that matter in markets are macro-political, real economy trends are also affecting outcomes. Energy prices impact companies, individuals and governments through costs and margins, utility prices and taxes.
A series of unforeseen events have had a substantial impact on energy markets in 2011. The so-called ‘Arab Spring’ highlighted energy security concerns with potential disruption to supplies from affected gas and oil-producing countries in the Middle East, especially Libya, and the potential for contagion in other major producers. Japan’s nuclear crisis has resulted in a loss in capacity that is likely to be met by increased oil and liquid natural gas (LNG) consumption for some time.
In the last two decades global energy consumption has risen 45%, far outpacing any gains in energy efficiency. Fossil fuels will continue to meet the bulk of demand and the proportion may even increase, despite ambitious targets for alternative energy sources. The International Energy Authority recently estimated that global gas use could account for a quarter of energy use by 2035, a 50% increase from current levels. Energy markets are regional, even national and far less global than many investors realise, and are a key determinant of competitiveness. Natural gas supply conditions have varied regionally with the US experiencing a glut and Asia a shortage. Hence, the US benchmark Henry Hub price declined by 36% between 2007 and 2010, while UK and German benchmark prices were flat to slightly higher and Japanese prices increased by 40% in dollar terms. Asian liquified natural gas (LNG) prices in 2010 were 30% higher than the Japanese benchmark average in 2010, and three times higher than the US Nymex future.
While oil and gas prices in Europe have been closely linked, the relationship in the US has been more tenuous. Substantial additions to LNG refining capacity in the US mean that oil and gas prices there are likely to converge. Regional differences between gas prices will also be smaller going forward. The refinement of technologies relating to shale gas extraction provides a new hydrocarbon source, which is abundant and accessible in the US. Other desirable technological breakthroughs, for example in carbon capture and storage, are more elusive.
Disparate factors are shaping the future of energy provision. Climate change concerns relating to emissions from fossil fuels have grown in importance, leading to tighter regulation in developed economies. Post-crisis, cash-strapped governments have imposed new taxes and reallocated subsidies for alternatives. Given that growth in energy use in the emerging markets is much faster than that in developed markets, investors should pay careful attention to emerging market energy policies. Here administered prices add to the complexity of analysis.
The assumptions priced in to equity and corporate bond markets and to energy prices vary considerably: European energy utility equities have been treated as high yielding (5%) cash machines. Our view is that the cash flow is vulnerable. The pricing environment throughout Europe, though varying between countries, has been weak and is subject to a great deal of government intervention. Gas prices overall are still below marginal costs of production. The UK stands out as slightly more open to price increases but still vulnerable to political backlash.
In the US, gas prices have risen on the back of improving prospects for LNG exports from North America. However, access to prolific natural gas shales should mitigate any price impact as producers can increase production. In oil markets, uncertainty over spare capacity will keep a floor on the market, and demand destruction will kick in at the high end. Equipment deficits could abate by early 2012 but persistent labour shortages will underpin high service costs.
Energy was formerly viewed by corporate bond investors as an attractive regulated sector offering low growth and a solid income stream. However, regulation is now seen more as a source of uncertainty rather than promoting a stable environment. Carbon-related costs will increase again from 2013 when carbon credits are removed, although the extent of the rise will vary from country to country. Political involvement is rising. German decisions, to make the grid more incentive-based and to abandon nuclear power completely are forcing asset disposals by E.ON and RWE. Further windfall taxes, such as one-off taxes in Belgium, Germany and the ‘Robin Hood’ tax in Italy cannot be ruled out. Utility companies in the European periphery are facing weak demand and have seen their spreads and borrowing costs rise with sovereign debt yields.
Investors can benefit by focusing on three areas relating to energy which are undergoing significant changes:
The Japanese nuclear incident has already led to policy change in Germany and Italy, where public opinion on nuclear power had never been particularly favourable. German nuclear power is due to be phased out by 2022. However, in the short-term, energy requirements will be met either by importing from France, which relies heavily on nuclear generation, or using more (dirty) coal in Germany. Whether or not other countries, including the UK and Switzerland, reassess or postpone plans to expand or update nuclear capacity remains to be seen. Japan will be using less nuclear power until its generating capacity can be restored and, given its geographic vulnerability to future earthquakes probably should review its long-term policy. In contrast India is increasing its commitment to nuclear.
For the emerging markets which are still in the process of building power generating capacity, pragmatic considerations, such as cost, will play a large part. For instance, coal is relatively abundant in China while drought is a factor which will affect the viability of both hydro and nuclear generation. For the United States, water may also be a limiting factor in the exploitation of shale gas and oil in drought-affected areas because the hydraulic fracturing or ‘fracking’ extraction process uses substantial amounts of water. Environmental risk and the cost of complying with regulations are rising.
The release of strategic reserves by the International Energy Agency suggested a developed economy recovery too fragile to withstand the demand destruction that would result from prolonged high energy prices. The future cohesion of OPEC bears watching. Two of its members, Qatar and the United Arab Emirates are involved in the NATO-led military action against Libya, and Libyan capacity is unlikely to be back on stream anytime soon. Voting tends to be political posturing rather than heralding binding decisions. Quotas historically have not been stringently observed. The balance within OPEC may be shifting as Venezuela on some measures has overtaken Saudi Arabia as the producer with the largest proven crude reserves.
Frances Hudson, Global Thematic Strategist, Standard Life Investments