Six months ago, Cornwall Insight, a consultancy that nobody had previously heard of, was forecasting that the energy price cap would reach £6,616 per year.
Mainstream media accepted that without question. In fact, the price cap was set at £2,500 and although the government has said that it will be lifted to £3,000 in April, gas prices have fallen so far that the same firm is now forecasting that the cap will be only £2,200. Gavin Law from the McInroy & Wood division of leading energy consultants Wood MacKenzie remains cautious.
“It is too simplistic and too short term to think that the energy crisis is over,” he says. Oil prices fell back below those prevailing when Russia invaded Ukraine, after more supply came on- stream and Russian oil was rerouted.
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Prices were moving higher before the Ukraine war
Gas prices in the UK and Europe were rising before the invasion, but the spike in prices, fear of a shortage and the closure of nuclear plants in the summer led to a panic. They have since fallen 80%, as a result of several factors – the panic premium disappearing; lockdown in China; mild weather over the new year; a 20% fall in use due to high prices; and new sources of supply.
Most significantly, gas from Russia was replaced by liquefied natural gas (LNG), which has risen from 12% to 35% of the European market. LNG is liquefied at low temperatures at atmospheric pressure to a density 600 times that of gas. It is then transported by ship and regasified at the destination.
This involves a great deal of upfront cost – typically $10bn-$20bn, but $60bn for the giant Gorgon facility in Australia. However, LNG is economical over long distances, and more flexible as ships can be rerouted. Before the advent of LNG, gas was often a waste by-product of oil production and vented or burnt. The cost of pipelines meant that gas had a lower value than oil for its thermal content.
The costs of producing energy are prohibitive
Much has changed, but gas is still inflexible compared with oil. High upfront costs require long-term contracts, usually for 20 years, to justify the investment. That puts LNG out of the reach of all but the largest companies. These are “utility- like, but plants throw off a lot of cash”, says Law.
“Optimisation is the key to the process – you can’t afford spare capacity or inefficiency.” Start this year, deliver in 2026 European demand for gas starts to fall in spring, so the crisis appears to be over. However, Chinese demand is likely to recover, 2023-2024 could be a cold winter and supply disruptions other than from Russia are possible, says Law. Russia doesn’t have the infrastructure to export gas from western Siberia to China and new LNG projects will take three years to come on-stream.
Decisions made in 2023 won’t increase flows until 2026. This means that “higher prices could be with us for a few more years”. It could be longer if governments disrupt the oil and gas majors through tax, regulation, or obstruction. At some point, gas will flow from Russia again, but LNG developers will tie buyers into long-term contracts. Eventually, there will be a glut “if markets work properly” and prices will revert to $8-$9 per million cubic feet, where they now are in North America.
The pick of the global energy funds
Oil and gas companies don’t make money from high prices, as governments will always intervene to extract the windfall gain through taxation. They make money, like any business, from investing well, operating efficiently and managing their finances conservatively.
Still, firm prices reduce the risk of new investment, enabling producers to increase revenues and profits. The risk is that high prices encourage commodity producers to overinvest, resulting in excess supply, lower prices and poor returns on capital.
John Bennett, manager of the Henderson European Focus Trust, raised his exposure to the energy sector significantly in mid-2022 due to favourable valuations, companies becoming more fiscally responsible and the aversion of many investors leading to an attractive outlook being ignored.
“One of the unintended consequences of the ESG (environmental, social and corporate governance) movement is that it enforced capital discipline on an industry that has historically – like mining– been ill-disciplined when it comes to capital investment,” he says. “These companies are in long-term run- off, but not as quickly as the market thinks.”
The European energy crisis creates additional opportunities
Higher demand for LNG should favour big companies with the financial resources to invest the huge sums of capital required. There has been a glut of gas in North America, keeping prices down, but additional LNG exports should sustain gas prices and encourage an expansion of output. Equipment and services providers should also benefit.
Some firms have moved heavily into renewable energy, outside their core area of expertise and so, perhaps, misallocating capital.
In jurisdictions such as the UK, the popular and political environment is so hostile to conventional energy companies that it adds the additional risks that they will ignore investment opportunities for public-relations reasons; that they will be subject to global windfall taxes; that they will be unable to attract the skilled staff they need and that their operations will be obstructed by legislation and protestors.
This makes a global energy fund far more attractive than the stalwarts of the FTSE 100, BP and Shell. John Bennett is being proved right, but it’s not too late to buy into the sector.
There are several funds to choose from, but the Guinness Global Energy Fund, managed by the highly experienced team of Jonathan Waghorn, Will Riley and Tim Guinness, is my pick.
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