The energy transition is anything but smooth. This week, two energy suppliers went bankrupt in the United Kingdom and more are to follow. All this as a result of the record prices for natural gas. In continental Europe, too, the prices for natural gas are going up vertically.
As a result of the energy transition, companies have become more reluctant to invest in new capacity. Also the relationship with Russia is not what it used to be and in the the Benelux, people even want to get rid of the gas. The gas tap in Groningen, in the Netherlands, remains closed. Yet the causes of the shortage of natural gas lie largely outside Europe. The fact is that hardly any LNG (liquefied natural gas) is transported to Europe anymore.
Cause of shortage: China
Prices for LNG have increased from 7 dollars per mmbtu (equivalent to about 30 m3 gas) to 20 dollars mmbtu, which is also a new record. The cause of the shortage of gas lies in China. In China, more than half of the electricity comes from coal-fired power stations, but there is a shortage of coal in China. As a result, coal prices in China have risen to their highest level ever. Internationally, coal prices are at their highest level in 13 years and the 2008 peak is in sight. There are several reasons for this.
First of all, China is no longer importing coal from Australia. The reason is that Australia is demanding an investigation into the origin of Covid-19. Due to heavy rain and a shortage of personnel, there is also less coal coming from Indonesia. In Russia, there are problems on the railways, which means that less coal can be transported, and the unrest in the South African coal mines is not really helping either. Another important source of electricity in China is hydropower, but due to the extreme drought this summer in large parts of China, there is also less production there.
China is trying to cope with the shortage of electricity by, for example, switching off the lights on the motorways at night. Steel factories are also being shut down, which has led to a short-term fall in iron ore prices. At the same time, China is also buying a lot of LNG to produce electricity from natural gas. China is not alone in this; Brazil is also facing a shortage of hydropower due to drought and is also buying LNG on the world market. Many of these LNG terminals are located on the south coast of the United States, but the hurricane season means they are regularly closed. And the world is not even fully open yet due to the delta variant of the Covid-19 virus.
Investors underweight energy
In the coming quarters, the demand for energy will only increase. What is striking is that the energy sector is underweight almost everywhere. The main reason is that there are big question marks about the future. At the previous peak in the oil price, Peak Oil meant that there might not be enough oil left, a repeat of the Club of Rome’s “Limits to Growth” report. Now we know better. Proven reserves are higher than ever, thanks to shale rock fracturing and horizontal drilling. Now Peak Oil means that some oil will stay in the ground.
On Tuesday, it was reported that Royal Dutch Shell had sold the American shale branch in the Permian Basin for 9.5 billion dollars. The reason is probably that earlier this year, the company was told by the courts to reduce its CO2 emissions by 45%. The climate is not helped, as ConocoPhilips continues production in what is probably the largest oil field in the world.
This oil field with the appealing name Wolfcamp has been producing since the end of the First World War and thanks to modern extraction techniques the field is getting bigger and bigger. There is probably more oil in the ground than in the Ghawar field in Saudi Arabia. The proceeds of the sale go to the shareholders. The moment oil prices rise further, while investments decline, the cash flow of many oil companies will rise sharply. Then concerns about the distant future will give way to short-term returns.
Supply does not keep up with demand
The peculiarity of this energy cycle is that higher prices do not sufficiently increase supply. There is unprecedented capital discipline among oil producers, an indirect consequence of the energy transition. Competitors in the field of alternative energy are heavily subsidised. Furthermore, more and more shareholders of energy companies are encouraging them not to grow further in fossil fuels, but to switch to alternative energy. And if they don’t want to listen, they have to feel it. Some institutional investors are selling their positions in oil companies (albeit around the low point).
Sustainable investors also push up the valuation of the renewable energy producers and, from the point of view of personnel options, this is also a thorn in the side of the oil companies’ managements. Otherwise, there is always the judge and/or the government who will give the final push. The result is that the weight of the energy sector in the world index has not been this low in a long time.
Many investors are underweight this sector, but falling costs and rising returns mean that nowhere are profits rising so fast as in this sector. A strange combination. Moreover, investors also run the risk that when oil companies actually switch to alternative energy, this alone can cause the valuation to rise sharply. Now we just have to hope that the productivity of alternative energy rises sharply, because I see solar panels and wind turbines everywhere, except in the statistics, and the demand for oil is almost back at the pre-Covid peak.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear on Tuesdays and Thursdays on Fondsnieuws.nl, Investment Officer Luxembourg’s sister publication.