Winter is Coming
Recently a number of clients have asked for our thoughts on the ongoing crisis in the UK energy sector, so we thought it was worth expanding on those thoughts more broadly here.
The brunt of the energy shock in the UK has been felt by those energy suppliers that have commodity price exposure, but are unable to pass rising prices on to consumers due to price caps. The energy supply sector has been largely loss-making for several years as a result of fierce competition (encouraged by the regulator), mostly from small private equity funded start-ups. In many cases, these small suppliers are totally unhedged (and only profitable when prices are low) so it’s not surprising we are seeing a number of them collapse following the adverse price moves we have seen over the past couple of weeks. On the other hand, the larger energy suppliers such as Centrica (British Gas), EDF and E.on have the scale and risk management systems in place to ensure they are as well hedged as they can be, and longer term they may well benefit from this shake-up.
At TwentyFour we tend to prefer the cash flow stability of generation and grids businesses such as National Grid and SSE over energy suppliers. Grid businesses are immune to commodity price moves, while generation companies are able to pass price increases on to suppliers (and are typically well hedged). We have long been cautious of the supply sector due to the strict regulatory backdrop and competitive landscape, but the bond issuers in this space do have the capacity to weather any financial impacts from the recent moves in energy prices; these are strong investment grade rated companies and in our view any potential defaults here are off the cards.
How has the market reacted? We believe the recent move wider in spreads has been largely due to contagion concerns surrounding Evergrande rather than the energy shock. The market has stabilised somewhat over the past 48 hours, with IG corporates only 1-2bp wider this week and hybrids around 0.25-0.5 points lower. Some of the supplier names such as Centrica and E.on have widened a touch further, but we believe this is down to cautious sellers rather than any fundamental idiosyncratic concerns around those firms.
Everyone loves a cheap deal and free Amazon vouchers for clicking a few buttons to change their energy supplier, but it looks like those days are over. It will take time for this sector to recover and we are likely to see more suppliers collapse in the coming weeks and months.
The more pressing issue for bond investors here though is how the crisis might impact inflation.
Prior to the current energy crisis, UK household energy bills were already set to increase by around 12% on average as Ofgem (the UK energy regulator) increased the price cap to its highest level since it was introduced in 2019. The next price cap review is set to take place in February 2022, when we can expect a further increase in prices both from the heightened wholesale energy prices and also as suppliers start to recover some of the losses they are currently experiencing. These price caps are reviewed twice a year, and we can expect this upward trend to persist as the shock in the wholesale market is gradually fed back to the consumer.
While household energy bills represent a relatively small portion of the UK consumer price inflation (CPI) basket, the compound effect of higher energy prices in the manufacturing and industrial sectors will also be felt in the CPI number, so the October and November prints will be interesting to watch.
