On Europe and the UK’s Energy Pain

Europe’s energy crisis has dominated headlines for nearly a year, with many fearing shortages will lead to recession. 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 the pond reveals how dour moods are—a sign of the low bar reality must clear to positively surprise.

Of course, moods are dour for a reason. Natural gas prices are surging in Europe, with hot weather boosting demand and Russia throttling supply in response to EU sanctions. 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 while filling storage for the winter.^[i] 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 August 26, and some anticipate the new cap will double today’s record levels—worsening UK households’ burden.

Politicians have responded in myriad ways. 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. Pols have also sought to provide relief. Italy approved a €17 billion aid package while the Netherlands cut energy taxes for 8 million households. The contenders in the UK Conservative Party leadership contest are each reportedly preparing household assistance packages to introduce once they take office next month. France plans to re-nationalize power operator EDF—in which it already owns an 84% stake—in order to sell electricity below cost without getting pushback from minority shareholders. 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.

Many treat each development in European energy as a new negative set to roil markets. But 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. 

Go back to September 2021. Energy demand was surging globally as economies eased COVID restrictions. But 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. 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. Later, tensions over Ukraine sent prices even higher. These shortfalls drove demand for alternate energy sources, including coal and oil—which, in turn, caused spiking prices for those commodities.

In the UK, 25 suppliers went under between summer 2021 – January 2022. The price cap prevented them from passing rising costs onto consumers, and forced losses drove them out of business.^[ii] 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%.^[iii] The ONS noted the distribution of gas fell due to adverse weather conditions, which boosted energy demand.^[iv] 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.^[v]

To that backdrop, this year has obviously added more pressure. Economic sanctions have disrupted energy markets, and supply lines have been changing accordingly. More UK suppliers have gone out of business, which adds another variable stoking shortage fears. But markets are efficient discounters of widely known information, and they aren’t overlooking any of this. Consider: Eurozone stocks are down -20.0% year to date, well behind global stocks’ -11.1%—a sign markets were pre-pricing weaker growth on the Continent, which a spate of recent survey-based and output data have implied.^[vi] But since their year-to-date low in July, eurozone stocks have risen 13.3%, a tick higher than global stocks’ 13.0% over the same stretch.^[vii] Maybe this is a head fake, as so many claim. But it also resembles how new bull markets begin: Deep in pessimism, well before major “improvement” is tangible to most investors.

We think energy fears’ dominance helps inform sentiment, so a critical question for investors to ask: Is reality as bad as so many think? While experts have reduced economic forecasts and brace for recession—see the IMF’s latest projection—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.^[viii] 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. 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. UK June fuel exports to the Netherlands were up 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.^[ix]

These adjustments don’t mean Europe or the UK will get through this stretch unscathed, nor are they immediate salves. But consider: Many analysts are projecting a return to 1970s economic stagnation this winter. Some even argue the UK is becoming an Emerging Market because of its political instability, high inflation and labor strikes. In our view, these fears show just how low the bar is for reality to clear. When expectations are this tepid, avoiding blackouts and energy rationing could be enough to positively surprise investors.