Weekly Wisdom – August 31, 2022

By Hightower Great Lakes on August 31, 2022

Energy Sector Performance

The S&P 500 energy sector has returned +50% year-to-date, compared to the S&P 500 down -15%.

And while recession fears and a market shift to growth drove underperformance from the end of June through the beginning of August, the sector has since roared back and is again outperforming in the third quarter.

Broad market tightness and security concerns have led to record corporate profits and secular demand trends. The aggregate S&P 500 energy sector grew earnings per share +308% y/y in Q2, compared to +8% y/y growth for the broader index.

While the energy sector tends to be cyclical and has historically underperformed in periods of economic slowdown, energy security and tight capacity problems – created by a decade of underinvestment and Russian reliance – make this period unique due to the volume of inelastic (not excess) demand.

It’s the inelastic demand – powering homes, buildings, industries – that is supporting high energy prices.

Energy Commodity Prices¹

Europe’s Energy Crisis

Europe is currently experiencing unprecedented energy costs, with natural gas costing 10x more than it did a year ago.

Europe’s natural gas benchmark, TTF, hit record highs last week, mainly due to Russia announcing that they will be shutting down the key Nord Stream 1 pipeline beginning on Wednesday, August 31 due to “maintenance.”

Even prior to this announcement, the Nord Stream 1 pipeline has been operating at 20% capacity since July 27 due to “technical problems,” but it is generally assumed that Russia is simply throttling the pipeline to raise energy prices and leverage energy as a weapon against Europe.

For context, it’s important to recognize the depth of Europe’s energy dependence on Russia. Prior to the ongoing conflict in Ukraine, Russia supplied 40% of Europe’s natural gas.

The 2020 energy mix in Europe was 35% petroleum products (including crude), 24% natural gas, 17% renewable energy, 13% nuclear and 12% solid fossil fuels – so natural gas represented nearly a quarter of all European energy consumption.²

Natural gas generates lower-carbon electricity compared to other fossil fuel-alternatives; thus, a short supply of natural gas is expected to result in higher carbon-emitting fossil fuels being burned to produce electricity.

Natural gas is also used to make ammonia – a key ingredient in plant fertilizer. Due to soaring natural gas costs, the European fertilizer industry is only operating at around 33% capacity.

For example, Yara international, a Norwegian fertilizer producer, became at least the third major ammonia producer recently to significantly cut production; the company is now operating at 35% capacity.³

A shortage of fertilizer could have adverse costs toward agriculture-related industries and consumers. Other energy-intensive industries are also scaling back to save power and lower costs.

This crisis may be further amplified by OPEC potentially cutting their oil output due to the disconnect between the paper and physical oil markets.

Oil has fallen to ~$97 per barrel from its June highs of around ~$115 per barrel, despite the tight physical market for oil.

Prince Abdulaziz, the Minister of Energy for Saudi Arabia, has said that the price has fallen from these highs due to the futures market falling into “a self-perpetuating vicious circle of very thin liquidity and extreme volatility.”

The prince also stated that false information surrounding demand destruction and general misunderstanding of sanctions on Russian oil are contributing to the price decline.⁴

This potential production cut is even more significant coming from Prince Abdulaziz, considering Saudi Arabia and the UAE are the only OPEC countries believed to have spare oil capacity.

Other countries, like the U.S., Canada and Brazil, are expanding their outputs and increasing their exports – this includes the U.S. tapping into the strategic petroleum reserves (SPR), which continues until October and has drained the SPR to its lowest level since 1985.⁵

European governments have already set aside €280 billion ($279 billion) to combat the ongoing energy insecurity and are in the process of implementing restrictive policy.

Before the war in Ukraine, Germany was the largest importer of Russian gas. Germany is also Europe’s largest economy and plans to cut gas usage within the country by 20% this fall by implementing various rules, including bans on heating private pools and lowering the minimum office temperature to 66°F.

In addition to the energy use restrictions, Germany is racing to meet their stockpile targets. The country is currently ahead of schedule for this refill process and plans to have their stockpile at 85% capacity in October and 95% in November.

Even so, 95% capacity would only cover approximately 2.5 months of industrial, heating and power demand if the Nord Stream 1 is to remain fully closed.⁶

Some other examples of EU cost-mitigating proposals include Spain mandating businesses to keep air conditioning at a minimum 81°F in the summer and heat at a maximum 66°F in the winter, and Greece plans to subsidize 94% of the increase in power bills for its citizens.

Consumer Pain

Even if countries manage to reach the stockpile levels required to meet winter power demand, the costs for businesses, governments and consumers are high.

Globally, power prices have surged, and it’s becoming a serious crisis. In the U.S., 20 million households have fallen behind on their utility bills – equivalent to about 1 in 6 homes.

And, according to the National Energy Assistance Directors Association (NEADA), that’s the worst crisis the group has ever documented.

Average consumer electricity costs were up 15% y/y in July, and the average balance owed has climbed 97% since 2019.⁷ European countries have stepped in to support household costs, and calls are growing louder for the U.S. to follow suit.

While European countries have already provided support for household energy bills, greater action is being debated. The EU has proposed price caps on energy utility costs and will be convening in Brussels on September 9 to discuss plans for emergency energy intervention measures.

Household Electricity Prices (Global Regions)⁸

Click here to read last week’s Weekly Wisdom (8/24).

SOURCES

¹ Source: FactSet (chart)
² Source: Eurostat
³ Source: Bloomberg
⁴ Source: Reuters
⁵ Source: Reuters
⁶ Source: Bloomberg
⁷ Source: Bloomberg
⁸ Source: Bloomberg (chart)

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