On Europe and the UK's Energy Pain

Europe’s energy crisis has dominated headlines of financial publications we follow for nearly a year, with many arguing shortages will lead to recession (a broad decline in economic activity). The Continent’s hot and dry summer has further stoked energy supply concerns, as droughts impact increasingly in-demand electricity. We don’t dismiss the economic pain for households and businesses, but our focus is on the market impact. In our view, the widespread discussion of an energy-driven recession across Europe reveals how weak sentiment is—a sign of the low bar reality must clear to positively surprise, in our view.

It is easy to see why sentiment has sunk so far, in our opinion. Natural gas prices are surging in Europe, with hot weather boosting demand and Russia throttling supply in response to EU sanctions.^[i] Russian gas flows through the Nord Stream 1 pipeline have been around 20% of contracted volumes since late July, straining Europe’s ability to generate power whilst filling storage for the winter.^[ii] There have been repeat warnings amongst financial publications we follow that even this flow will cease fully, particularly during periods when Russia claims to be performing maintenance, including today’s announcement in which Russia’s state energy giant imposed a three-day shutdown order on the Nord Stream 1 pipeline for gas compressor repairs.^[iii] Beyond this, the summer heat has impacted other energy sources: In France, high river water temperatures are interfering with nuclear reactor cooling. In the UK, energy regulator Ofgem will announce October’s energy price cap (which resets semiannually) on 26 August, and we have read some observers estimate the new cap will double today’s record levels—worsening UK households’ burden.^[iv]

Politicians have responded in myriad ways, based on our review of the latest reports. The EU has asked member states to reduce gas demand voluntarily. Some governments have imposed new taxes, from the UK’s windfall tax on energy firms, which passed last month, to Germany’s levy on households to help utilities. Elected officials have also sought to provide relief. Italy approved a €17 billion aid package whilst the Netherlands cut energy taxes for 8 million households.^[v] The contenders in the UK Conservative Party leadership contest are each reportedly preparing household assistance packages to introduce once they take office next month.^[vi] France plans to re-nationalise power operator EDF—in which it already owns an 84% stake—in order to sell electricity below cost without getting pushback from minority shareholders.^[vii] An example of that resistance: The government ordered EDF to sell nuclear power to its rivals at below-market prices, and EDF is now suing for having to take a loss.^[viii]

Many commentators we follow portray each development in European energy as a new negative set to roil markets. But our research shows stocks don’t move on whether things are good or bad in an objective sense. Rather, we think it is important to consider whether there is negative surprise potential. In this case, it is worth considering how the last year in energy has unfolded in Europe, in our view. 

Go back to September 2021. Our research showed energy demand was surging globally as economies eased COVID restrictions. But energy supply didn’t keep pace due to several factors. Wind-driven electricity production in Europe slowed because the winds calmed in the North Sea—driving demand (and higher prices) for natural gas as a replacement.^[ix] Yet Europe’s natural gas supply was also under pressure, as pipeline flows from Russia slowed—tied to political pressure from Moscow over German resistance to opening the Nord Stream 2 pipeline.^[x] Later, tensions over Ukraine sent prices even higher.[xi] These shortfalls drove demand for alternate energy sources, including coal and oil—which, in turn, caused spiking prices for those commodities.^[xii]

In the UK, 25 suppliers went under between summer 2021 and January 2022 as the price cap prevented them from passing rising costs onto consumers—and forced losses drove them out of business.^[xiii] Energy developments also registered in economic data. The October 2021 UK monthly GDP report showed heavy industry contracted -0.6% m/m, with electricity, gas, steam and air conditioning supply down -2.9%.^[xiv] The Office for National Statistics (ONS) noted the distribution of gas fell due to adverse weather conditions, which boosted energy demand.^[xv] On the Continent, eurozone consumer prices accelerated from 3.4% y/y in September to 4.1% in October, with over half the rise due to energy prices’ 23.7% surge.^[xvi]

To that backdrop, this year has added more pressure to energy prices. Economic sanctions have disrupted energy markets, and supply lines have been changing accordingly.^[xvii] More UK suppliers have gone out of business, which adds another variable stoking shortage chatter.^[xviii] But in our view, markets are efficient discounters of widely known information, and they aren’t overlooking any of this. Consider: Eurozone stocks are down -11.3% year to date, well behind global stocks’ -0.7%—a sign markets were pre-pricing economic weakness on the Continent, which a spate of recent survey-based and output data have implied.^[xix] But after a sharp early-year downturn and year-to-date low in March, eurozone stocks have risen 10.4%, just slightly behind global stocks’ 10.8% over the same stretch.^[xx] Whilst more negativity is always possible, we think market conditions suggest stocks are more likely to rise than enter an extended downturn.

In our view, the widespread discussion of energy developments helps inform sentiment, so a critical question for investors to ask: Is reality as bad as so many think? Whilst we have seen many experts reduce their economic forecasts and brace for recession, we think some underappreciated energy developments have gone overlooked. In Germany, gas storage facilities were more than 75% full as of last week, several weeks ahead of target.^[xxi] The government also reached an agreement with the country’s top gas importers to ensure liquefied natural gas (LNG) supply for two import terminals and plans to postpone the closure of Germany’s last three nuclear power plants to meet power needs for the near future.^[xxii] In France, EDF received a temporary waiver to keep nuclear power plant operations ongoing despite the discharge of hot water into rivers, which would otherwise run afoul of environmental standards.^[xxiii] UK June fuel exports to the Netherlands rose 67% y/y—pointing to Europe’s ability to find non-Russian sources of energy—and Britain’s biggest gas storage facility just received permission to reopen, which should boost its reserve capacity.^[xxiv]

These adjustments don’t mean Europe or the UK will get through this stretch unscathed economically, nor are they immediate salves, in our view. But consider: We have observed analysts claim a return to 1970s economic stagnation looms this winter, and some have argued the UK is resembling a developing economy with fragile political institutions because of its perceived political instability, high inflation and labour strikes. In our opinion, these views show just how low the bar is for reality to clear. When expectations are this tepid, simply avoiding blackouts and energy rationing could be enough to positively surprise investors, in our view.