The Heat Is On – Can Europe Avoid an Energy Crisis?

 KEY TAKEAWAYS:

• European consumers have done a good job cutting demand through various conservation measures; however, there is a potential need to draw from more expensive global LNG later in the year. 
• Industrial production order books look healthy despite the sensitivity to energy prices.
• In the short term, energy prices will continue to trend higher as European industrial production picks up, and China reenters as another buyer in the LNG markets.
• We see a lot of unique opportunities to attach to high-quality energy and utilities businesses.

    

 

Kyle Helton:

Hello and welcome to the latest episode of the QPD podcast. I’m your host, Kyle Helton, Senior Vice President and Western Regional Director at Cambiar Investors. On today’s show, we shift our focus across the pond and a deeper dive into Europe and the impacts of rising energy costs in the region. To help break down the situation and provide some insight, we have Robbie Steiner, co-portfolio manager of the Cambiar Europe Select Strategy. Robbie, thanks for being here.

Robbie Steiner:

Thanks, Kyle. Thanks for having me.

Kyle Helton:

To set the stage for our listeners, can you briefly describe what the impacts from the Ukrainian War has on energy supply and prices in the rest of Europe?

Robbie Steiner:

Yeah, so if we go backwards to pre-pandemic, Europe had a gas market that roughly consumes about 550 billion cubic meters annually, and this was comprised of about 35% of supply that came from Europe, but 30 to 40% of the market was coming from Russia via several pipelines. The Nord Stream 1, the Yamal pipeline system, and then a series of pipelines that go through Ukraine and Eastern Europe. And this was the primary and cheapest source of gas supply for Europe. And then there was an additional 15 to 20% of the market that was coming from LNG. And if we think about this in terms of market structure, the cost curve for European gas looks like 80% of it was flowing from low cost sources, and 20% of the market was coming from high cost LNG that was setting the price that Europeans were paying in the market. So if you could sell gas in Europe cheaper than the LNG price, you were making money.

From 2019 to 2021, Russia was slowly reducing the amount of gas that it was sending through its various pipelines. I think they were doing this for few reasons. One was to raise the price and improve their margins. Two was to arm twist the Europeans into eventually approving the Nord Stream 2 pipeline that was very controversial in the news. And the third motive was to reduce the taxes that they had to pay to the Ukrainian government through the pipelines that flowed through those territories. And the combination of all of these led the Europeans to buy more and more spot LNG from the open market. That mix went from about 15 to 20%. And you were seeing LNG prices actually increase even prior to the invasion of Ukraine.

Then in February of 2022, Russia did invade Ukraine, and there was initially a huge spike in gas prices as buyers were rushing to secure supply. But given that there was really no physical disruption in gas flows into the spring and the restock season, the prices started to work their way back to normal. However, Europe did come out in support of Ukraine, sending weapons and support, and Russia in response started to throttle back the amount of available gas that was being sold to Europe in preparation for the winter restock. So gas flows into Europe began to dissipate into the summer, and then in the fall of 2022, the Nord Stream pipelines were destroyed and Russian gas flows into Europe started to approach zero.

So given that most of the restock cycle occurs into the summer and the fall, Europe had to pivot very quickly to repair for the winter. They did this in 2022 through a variety of sources. The first was demand response. Demand in 2022 was about 10% lower than it otherwise would’ve been, and local production, the other pipelines that they have access to, were mostly flat. The Norwegians did try to send a little bit more gas, redirect some of their oil operations gas into Europe, but it’s really not enough to move the needle. And Russian gas throughout 2022 was about 15% of supply, given that most of the turbulence didn’t occur until the second half of the year, which led the Europeans to increase their natural gas purchases via LNG through 10% of the total mix.

So looking forward into 2023, the Europeans have quite a different problem to deal with. They’ve had 10% of their demand come offline from various conservation measures. Consumers have done a heroic job of cutting their demand, but aided by the third warmest winter in the last 50 years. And industrial customers have reduced demand by around 20%, meaning business is not getting done because the lack of available natural gas. So they have another 10% that they’ll need to look to global LNG markets. It could be more than that if the demand response is higher. And when we remake that cost curve that was originally 80% of cheap, low-priced, source-able gas, this is now something like 50 to 60% of what they normally need that is going to be needed to be drawn from global LNG markets. So that’s the situation, then, and what it looks like going forward.

Kyle Helton:

So you mentioned a shifting of the energy cost curve. How, if at all, has this impacted Euro manufacturing? I know for a while that gas prices were very high, some plants shut down due to poor economics. Has this trend reversed, that prices have receded?

Robbie Steiner:

Yeah, I think when we look at European industrial activity, orders were actually surprisingly strong in the second half of the year. Most European industrials responded much earlier in the year and economic activity was subdued. A lot of companies were going through destocking cycles. But when we look at cap goods orders, for example, order books look incredibly healthy. There are, however, a few places that are sensitive that are more gas dependent. I think ammonia production is a very important one in that it’s one of the most gas-dependent chemicals in it’s entirely necessary for the production of fertilizers, which eventually goes into food production. European ammonia production was very uncompetitive, and names like BASF and Yara had to shut down a lot of production. So there were some particularly sensitive touch points.

On demand on the consumer side, going into 2022, consumer wallets were extremely full, much like they were in the US. People had generated a lot of savings. Savings rates were 25%. They’re normally something like 10%. And generally, Europeans have lower amounts of consumer debt, although it is a bit more interest rate sensitive. So when we look forward on the consumer side, there is a reason to believe that this could be problematic. Higher interest costs could be a significant portion of consumer wallets. The inflation and the higher energy costs are leading central banks to keep rates higher, and that is affecting homeowners’ interest costs.

Mortgages reprice much more quickly in Europe than they do in the US. For example, in the UK, average mortgage life is something like two to three years. So if you reprice a 250,000 pound mortgage and add an additional four points of interest expense, that’s 10,000 pounds a year of additional interest expense on average consumer discretionary income of something like 30 to 40,000 pounds. Energy bills are higher, too. In many cases, they’re regulated and protected by the government. In the UK, energy bills are going from a maximum of something like one and a half thousand a year to 3000 a year. So the impact is a little bit more manageable.

Kyle Helton:

So how does all of this impact Europe’s desire and potentially need to go green?

Robbie Steiner:

They really haven’t flinched from a policy standpoint. Europe has had the longest-standing emissions trading scheme and cap and trade through the European ETS. They’ve only gotten more stringent. They did a review under their Fit for 55 plan, I believe as late as December of last year, in the thick of the energy crisis, and there’s really been no appetite to increase the amount of available carbon credits for European production, despite that the price of these credits has gone up quite a lot as they’ve had to burn more coal to support power generation with lower gas availability.

Europe’s never really been a friendly place for drilling for the exploration and production companies. You’re not allowed to frack there. There’s a field called Groningen in the Netherlands that’s a significant producer of natural gas that is being shut down due to earthquake risk. There’s really nothing about this crisis that has led people to go back on the desire to move away from fossil fuels. As a result of the crisis, they introduced the EU, the REPower plan, which is two to 300 billion euros of subsidies for investment in various infrastructures. That includes renewables and distribution and transmission equipment, that interconnects those renewables, as well as providing for pooled purchases of natural gas and trying to streamline some of the regulatory issues around permitting.

But the REPowerEU is much more focused on green energy capacity, not traditional fossil fuels. And even in their latest iteration of the Green deal industrial plan, which is meant to be the answer for European competitiveness against the Inflation Reduction Act in the United States, all of the subsidies are directed towards energy efficiency, carbon capture, green hydrogen. So no, I think trying to produce more fossil fuels as the response to this crisis is not something that they’re interested in. I think it would be antithetical to their general attitude towards carbon emissions, and they really don’t have much of a competitive advantage in fossil fuel production in the first place. So they’ve committed to going this route.

Kyle Helton:

So with that large investment mostly in green and renewable technologies, what kind of impact is this going to have on European energy prices?

Robbie Steiner:

Yeah, I think in the short term, European energy prices are going to move back higher because of the cost curve issues and the immediate amount of gas that needs to be resupplied in this restock season. There’s somewhere between 50 to a hundred BCM short that they’ll have to draw on the global LNG market for under most scenarios, and in order to restart their economy from an industrial standpoint, they’re going to really need to increase gas demand. The other element that’s been a tailwind in 2022 that will not repeat in 23 is that China, given its COVID lockdowns, was more or less out or less in the global LNG market. LNG trades at a global price, so Europe is competing with Asian buyers for LNG, and they reduced their consumption of something about 20% during the pandemic.

In China, most of the gas demand is industrial and commercial related, something like two-thirds of their gas demand, whereas it’s two-thirds utility and heating in Europe. And China does not have a historical pattern of worrying too much about what it pays for commodity prices to fund its growth. I’ve seen that in oil, and iron ore, and other commodities over the years. And their normal course of action would be, when they’re in the mode of resuming growth, would be to get back in the LNG market and increase demand there, as well.

Kyle Helton:

And when you think about short-term versus long-term when evaluating these businesses and the energy complex in Europe, can you quantify what you mean?

Robbie Steiner:

I think for this specific situation, the short term is going to be about two years. There’s an increase in global LNG capacity that will be available to serve the European market by 2025, maybe 2026, that will help rebalance global LNG. Over the long term, we think global energy demand will grow something like two to 3% over the next 20 years. While OECD countries are able to keep energy demand fairly flat or potentially down in fossil fuels, non-OECD countries are experiencing still high population growth, as well as the need to consume more energy as quality of life improves.

I think it would surprise a lot of people to see how little the global energy mix has changed in the past 20 years. We consume globally primary energy including transport, industrial, power generation, all types of fuel, 50% more energy than we did 20 years ago. Yet, coal has roughly maintained its share of that total energy mix at 27 to 30% over that time. Gas has grown in share as countries have realized the flexibility of the fuel and some have reduced their carbon emissions, and renewables have only gone from 1% of the total mix to 8% of the total mix, which is a remarkable accomplishment. Oil has actually lost share and the world is doing its job in terms of reducing oil consumption, yet total volumes of oil have continued to grow because of the end market growth there.

When we think about coal being two and a half times as carbon-intensive as natural gas and commitments from Asia in particular, where 50 to 60% of all power generation comes from coal, the primary driver of gas demand and LNG pricing over the long term are those commitments around reducing coal consumption and reducing carbon emissions. From Europe’s perspective, that affordable energy in Europe is available due to China burning less gas and more coal is also antithetical to their policy goals. Carbon is, of course, a global problem in that consumers are able to achieve lower prices by outsourcing their carbon emissions doesn’t really make sense over the long term.

I think it’s important that we talk about, with some of the risk factors to this hypothesis, in the short term, demand is clearly a constant risk factor in the energy space. I think top of mind for investors right now are around central bank tightening policies, and even more so just issues that are currently happening within the banking system. I think what mitigates this a bit in Europe’s situation is that industrial and residential demand, as we’ve talked about, are already off of 10 to 20% lower than normal levels, and from a physical standpoint, it’s difficult to go much lower than that, at least sustainably over the next few years.

Secondly, a resolution in Ukraine that allows for Russia to send gas back to Europe through its remaining pipelines would be a downside risk to energy prices, but for obvious reasons is clearly a result that we’re rooting for in Europe. Over the long term., Any sort of hesitation from coal-fired economies to delay or prevent an energy transition away from coal and towards gas would clearly be a long-run risk, as well. Unknown unknowns are inherent to the analysis of the energy space, and we try to constantly reassess every thesis with an open mind for new information constantly.

Kyle Helton:

The energy complex as a whole has traditionally been rife with poor capital discipline. Have you seen changes in capital investment over the past year or two? And if so, do you expect that these decisions will continue?

Robbie Steiner:

Yeah, absolutely. I think most companies in the oil and gas production space have very much reduced their capital budgets and have improved their cost structures, have right sized their dividends, and have in general improved capital allocation. Shell is an example of a company that reduced its cost to high teens, lifting costs per barrel, making their dividend very well-supported, and has recently improved their capital allocation, not only by not investing in pie in the sky, long-dated offshore oil projects, but more so by owning down their investment in renewable energy that we’re offering lower returns and being more disciplined about the pricing that they charge for those assets.

Kyle Helton:

How is your Europe select portfolio finding opportunities within both the energy and utilities space currently?

Robbie Steiner:

Europe Select portfolio sees a lot of opportunity in both energy and utilities. Our healthy allocation in energy via Integrated Oil, Shell, and TotalEnergies and utilities exposure via Centrica, SSE, and Iberdrola, all of whom should benefit from current pricing of energy, as well as a transition to renewables. What we’re trying to focus on is identifying the big structural changes that make the sector investible over long periods of time. For example, in the 1970s, if you had seen that West Texas production was peaking, giving a lot more power to OPEC, or in the early 2010s, if you had seen that the increase in shale production was going to be dilutive to pricing over the next 10 years, you could have made a lot of money going long or short the space over long periods of time.

Our focus here is whether or not the change in the European energy environment creates a long-term dynamic that becomes investible beyond the 2025 period, and we believe that it likely does. Capital allocation has been more disciplined in terms of controlling supply of both oil and gas, and the increase in volatility and the need for different energy flows around the world provides an opportunity for these businesses to match supply and demand across different regions. Both Shell and Total have trading businesses that draw from their upstream production or from their vast global relationships in order to supply Europe and other areas that are short energy. Iberdrola and SSE are two utilities businesses that benefit from European investment in both renewables and transmission and distribution, and we believe have mid to high single-digit growth rates into the back half of the decade.

Kyle Helton:

Thanks for your insights today, Robbie. Hopefully, our listeners can agree that there should be greater optimism regarding Europe as an investible area despite the energy concerns. I look forward to having you back soon for a deeper dive into Europe and where you and the team are finding opportunities. Thank you to all of our listeners for tuning in, and please hit the subscribe button to stay updated on our show. To learn more about the Europe select strategy, please visit Cambiar.com. Thank you, and until next time, take care.

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