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Europe’s current energy supply crisis has precipitated a boom in demand for energy infrastructure that we think has the potential to provide a significant tailwind for the European utility sector. What’s behind our positive view on the sector and where are the investment opportunities?
Today’s energy crisis has two components: an availability crisis and an affordability crisis.
Availability crisis: Prior to Russia’s invasion of Ukraine in February, Russia supplied around 40% of Europe’s natural gas requirements. Today, that number is close to zero. Against a backdrop of a drought-induced drop in hydroelectric power output and maintenance issues with France’s nuclear power plants, Europe is now facing a severe shortage of both natural gas and electricity. Finding alternative energy sources has become critical, encompassing options such as importing more liquefied natural gas (LNG), increasing domestic gas production, extending the life of nuclear plants, enhancing the use of coal plants and building more renewable energy plants. While some of these potential solutions like extending nuclear and burning coal are more immediate, the longer-term solutions such as expanding renewables and LNG infrastructure can take several years.
In our view, Europe’s stores of natural gas are sufficiently high to cover this winter, provided we do not experience exceptionally cold weather conditions. However, supplies are likely to be considerably depleted by the winter of 2023/2024 (Figure 1).
Affordability crisis: The price of European natural gas has skyrocketed during the last year because of the supply shortage and relatively inelastic demand, causing massive increases in gas and electricity bills across Europe. As a result, energy consumers across Europe face significant increases in their utility bills, even with the cushioning provided by the various national support packages and the European Union’s (EU’s) proposals to put caps on power prices and apply windfall taxes to the oil and gas sector.
We think significant investment in domestic energy infrastructure is critical if Europe is to resolve the energy crisis. We anticipate the building of new wind and solar farms and more electric networks to connect renewables to the grid, the construction of more LNG import terminals and natural gas networks to accommodate the increased LNG and the development of more electricity and gas interconnections across the region. This transition towards greater self-sufficiency is also supported by ambitious decarbonisation goals, most notably, the REPowerEU Plan, which targets a 150% increase in Europe’s renewable energy capacity between now and 2030.
Europe’s energy crisis has highlighted the US’s relative advantage in terms of energy supply. While Europe relies heavily on imported energy, the US is largely self-sufficient, so the increase in US natural gas prices has been much less dramatic than in Europe and Asia (Figure 2). As of 30 September, European natural gas prices were a staggering seven times higher than the price of US natural gas.
Data is rolling front month futures for TTF, Henry HUB and JKM priced in euros/megawatt hours (MWh), as of 30 September 2022. | Sources: Bloomberg and Wellington estimates.
However, just as in Europe, the need to decarbonise the US energy production is now driving significant investment into renewable energy and the electricity network across the country, with the US Inflation Reduction Act serving as a meaningful catalyst.
While spot LNG prices in Asia have followed the upward rise in European LNG prices, Asia is in a far better position than Europe as the region's long-term oil-linked contracts currently imply prices far below those experienced in Europe. In addition, the muted pace of the Chinese economy has helped offset any supply shortages.
In our view, this transition to a more reliable and renewable energy framework creates a number of potentially compelling investment opportunities within the global utilities sector.
Stock selection and geographical diversification are, however, more essential than ever in this environment to create a balanced portfolio: for instance, by combining exposure to select opportunities in Europe with more stable US utility allocations. We also think it is important to focus on businesses that have significant growth potential in the areas of renewable energy and electricity networks and that have a low likelihood of negative regulatory intervention. In contrast, we believe investors should avoid companies with valuations that may be vulnerable to negative future regulatory intervention.
We think that Europe’s energy crisis has highlighted the urgent need for significantly improved and enhanced domestic energy infrastructure. Implementing these changes won’t happen overnight, which, we believe creates a likely long runway for growth to the benefit of patient investors.
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