While the global recession has remained the most commented topic by investment managers since mid-Aug, the European energy crisis is again a hot topic as winter approaches. This month, we gathered the investors' latest views on this crisis's short-term and long-term impacts and explored the resulting areas where you can elaborate on your equity narrative.
Briefly on the origin of the crisis, while Europe sources 40% of its gas needs from Russia, the problem started before the war. The primary cause was a rebound in energy demand from the economic slowdown during the pandemic, with delays in power generator ramp-up and higher than pre-covid energy demand being the major factors. Domestic energy consumption increased as more people shifted to hybrid work, while office space energy consumption returned to normal to cater to back-to-office workers. Lord Abbett published a detailed timeline of how the crisis built up if you are interested in digging more.
The risks around Europe
A recession in Europe looks inevitable. Amundi, the largest European investment manager, believes it is likely that the continent will continue to experience frequent reduced gas flows and partial disruptions as Russia will gain the most bargaining power from such a scenario. This winter, they expect a European recession driven by higher energy and food prices. BlackRock, JPM Asset Management, Russell Investments, and many others have the same view, albeit with slight differences in timing.
According to the ECB, natural gas is the most important source of energy in the manufacturing sector and a leading fuel source for home heating in Western Europe. 38% of the homes in continental Europe use gas for heating, 75% in the UK. However, more than 90% of the gas consumed in the euro area is imported. Northern Trust highlighted that natural gas markets are regional due to high transport costs. For example, gas prices were ~USD 13.6 per MWh in the US last year, ~USD 31 in Germany, and ~USD 61 in China. Now it is over EUR 200 in Europe or ten times the 10-year-average.
Energy rationing for industries is now on the table. European Policy Centre thinks that supply-side alternatives have been largely exhausted. The EU's next logical move is to act on demand. The European Council approved an EU-wide gas demand reduction proposal in August. But countries need to carefully balance supplies between households and firms. High utility bills will damage consumption, while reduced factory operations will limit industrial output. The shortages will take a toll on growth, and the ECB is unlikely to help as it focuses on controlling inflation and supporting the euro.
The situation may worsen if there is no concerted effort to support European utility companies. Uniper, Germany's biggest importer of Russian gas, was nationalized last week for EUR 29 bn. It is one of the largest bailouts in the country's history, but it is only the tip of the iceberg. Europe has a liberalized power and gas market where utility companies trade their production on exchanges. Producers can sell their power in advance against security deposits. These deposits, aka margin calls, have risen sharply in line with energy prices. As a result, several companies were exposed to insolvency. Governments and regulators are now forced to step in to prevent bankruptcy. Equinor, Fortum, Axpo, Centrica are the few big names that appeared in the headlines, but thousands of energy firms across Europe face similar issues.
A long-term solution will take time. Premier Miton, Schroders, Goldman Sachs, all highlight that replacing Russian gas supplies is a lengthy project. Securing LNG supply contracts will take years, while building LNG storage facilities will take roughly 3-5 years, with nuclear power plants requiring more. Until electricity storage is solved, renewables are not a viable primary energy source. Their construction will also require large amounts of imported steel, metallurgical coal, and minerals from Russia, China, and elsewhere, which will lead to further geopolitical considerations.
The geopolitical landscape is likely to reshape in the long run. The race to re-direct energy supply will pressure Europe into more complicated relations with energy-exporting countries like Algeria, Egypt, Angola, Azerbaijan, and renewable energy equipment-exporting countries like China. Finally, if the energy crisis is not solved smoothly, political leadership change can happen in Europe, which will further complicate the problem.
What's your exposure to Europe?
• The typical question investors would ask is, what steps have you taken to assess the potential direct and indirect impacts of the European energy crisis on your business?
• Are your sales heavily reliant on European corporates or consumers? Do you foresee near-term protectionist measures from the EU that could further dampen your sales?
• Is part of your supply chain heavily dependent on Europe? Do you have significant European production capacities that will make your operations vulnerable to energy rationing? How sensitive, directly or indirectly, is your margin to gas price?
• If gas / LNG is part of your company's lower-carbon transition roadmap, how will higher prices in the medium-term impact your transition execution?
• How much of your financing stack relies on European banks? Do you have significant refinancing needs in the next 12 months that will depend on European banks?
Where are the opportunities?
• At first glance, the clearest opportunities are along other fossil fuels and renewable energy value chains. While LNG demand has surged in Europe, a new report by the IEEFA estimates that LNG demand in Asia has fallen by about 6% for the first seven months of 2022. As Aegon Asset Management explains, European buyers are out-competing Asian buyers in the global LNG market. Schroders does not see this trend fading until new supply comes on stream in 2024/25. For many Asian players, the supply shortfall from LNG will need to be replaced by other fossil or clean energy sources. The energy crisis also accelerates the shift to renewables. For example, European industries are actively considering captive renewable power plants.
• However, a less talked about investment area is the electrification of production processes that will reduce the need for gas. Energy efficiency and energy conservation will also capture the mid to long-term focus. Columbian Threadneedle mentioned that the RePowerEU plan aims to at least double the current installation of electric heat pumps to ~40m by 2030. Besides heating and cooling, energy efficiency improvements in buildings and industry will also propel the demand for energy-saving construction materials, lighting systems, appliances, etc. The incentive to invest is stronger for both corporates and consumers. While those energy efficiency projects may have appeared costly 12-18 months ago, the current energy price has shorten the payback period and will accelerate adoption.
• Can you benefit from the European industry shutdowns? Do you have significant competitors that operate mainly out of Europe? Do you see them losing competitive advantage in the long term? How can your company benefit from it? For example, the European chemical industry is one of the hardest hit by the gas shortage. 70% of European fertilizer capacity is offline. The increasing cost of synthetic materials pressures the personal care product industry. Pulp and paper products, basic metals, food and beverage, etc., are all directly or indirectly reliant on gas. The ECB published a full assessment of industries impacted by the rise in gas price and supply shortage earlier this year.
• The cost of living crisis pushes consumers to down trade. Are your products and distribution channels positioned to grow sales? The latest McKinsey survey highlights that rising prices are the biggest concern for low-income and Millennials European consumers, over 1/3 of European consumers are switching to cheaper brands.
• The economic downturn in Europe creates opportunities for acquisitions. Do you have active targets under watch? Will those targets meet the upcoming sustainability requirements from the European Commission? Are you financially strong to carry out the post-acquisition integration? Can you benefit from domestic and regional banks' looser financing conditions than other bidders?
• Finally, maybe your business has no exposure to Europe at all; in this case, it is worth highlighting your immunity compared to competitors.
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Amundi Lord Abbett BlackRock JPM Asset Management Russell Investments Northern Trust Premier Miton Schroders Goldman Sachs Aegon Asset Management Columbian Threadneedle
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