Richard Cockburn is Senior Vice President of Commodities and Risk Management at Flow & Ebb our specialist energy partner firm
Now is not the time for inaction
It is difficult not to notice that energy prices have been rising inexorably of late. The UK energy market is in the middle of a systemic supply squeeze, caused by various factors including an inability to fill up gas storage during the Summer. This is creating serious concerns over whether we will have enough gas this Winter to meet both UK heating demand and higher electricity demand through gas fired generators.
A Europe-wide issue of being unable to attract Liquified Natural Gas (LNG) from the Middle East and the US (mainly driven by high Asian LNG prices driving what spare LNG there is to the East) has seen dwindling opportunities to flow gas throughout the Summer. This has combined with extremely low Russian gas flows and a high maintenance season in Norway – meaning that we have simply failed to secure enough supply of gas for this Winter.
Is the market broken?
High prices are not necessarily a sign that markets are not working, but a lack of supply response after the price rises, is. More worrying is that some consumers will have hedged or bought forward and so to some extent are immune from high prices, but face other issues associated with supply chain logistics.
Ofgem has been summoned by the Government to set out their plans. The Business Secretary, Kwasi Kwarteng, has been informed that at least four small scale suppliers are on the brink of collapse. Energy tariffs are being removed from the marketplace. However, whilst 70 different suppliers is one measure of competition success, price competition is fast disappearing. Consumers are finding that they cannot switch supplier to a cheaper rate because no suppliers can sell energy at a profit. The current tariff caps (around 18 – 20p/kWh) bear no resemblance to wholesale prices (45p/kWh for day ahead and 15p/kWh for this Winter), and when you add in the costs of delivery and taxes, the delivered cost of energy (around 8p/kWh) means that we face significant systemic issues.
So what could happen?
The Government will be well aware that if the system needs more gas, we cannot magically produce it overnight. Similarly, they will be wary of intervention in a global market, Government intervention can be dangerous – Conservative politicians have long memories from Black Wednesday on 16 September 1992, when the Exchange Rate Mechanism collapsed and Government intervention could not stop the market collapse. Spain and Italy have already put in place regulatory steps to protect domestic customers but this can be an open ended cheque, which the Government has hinted they do not want to pursue.
In our opinion three things are likely to happen which could lead to lower prices:
- High prices cause consumers to reduce consumption: The fertiliser industry has already stated that it will close for the Winter. This has had a huge impact on CO2 – one of its by- products, which is used in frozen food production and abattoirs for stunning animals. According to meat producer Cranswick, they only have ten days of supply left. To avoid similar supply chain disruption, a concerted campaign targeted at businesses and consumers could be launched to look at reducing waste and ultimately bringing demand down across Europe and the UK.
- Government led demand intervention: Although this is harder to implement, a form of quiet rationing may be considered . This could see reductions in military exercises, rail services and non-essential energy usage.
- Supply changes through politics: The low flows of Russian gas are in part driven by sanctions, which were imposed by the US and Europe in 2015. These were largely imposed due to the breach of the Minsk protocols, which recognise and protect Ukraine as an independent state. The EU recently agreed to uphold economic sanctions until 2022. But this game of chess is not playing well for Europe when the Russians have completed Nordstream 2 – a new gas pipeline. As a result, by the end of this year they can start flowing gas direct to Europe, through to Germany at Greifswald on the edge of the Baltic.
Difficult choices – what can be done
It is not an unreasonable assumption to make that eventually energy prices will become cheaper as supply and demand dynamics stabilise. If the EU strikes a deal with Russia, it is probable that prices will fall substantially and quickly. All buying decisions are fraught with increased risk. What is certain, however, is that sitting on your hands and hoping that a systemic change will be implemented is very high risk.
This Winter is likely to throw up some extreme price moves due to events outside of anyone’s control. Our advice to large corporates in this time of extreme volatility is to assess and measure your true risk and to calculate what you as a business can bear. Once you have controlled your price, then start aggressively looking at demand reduction options. If supply chains falter, businesses may be faced with difficult decisions when balancing energy costs with reduced productivity or sales. In some instances it may even be that temporary shut downs or closures are the most economically viable option. Selling back existing hedges could be more profitable than producing products. The market challenges are very real, and unlikely to go away quickly.