Energy companies over a barrel

It isn’t often that Conservative chancellor of the exchequer George Osborne and Labour party leader Ed Miliband see eye to eye. But both men have issued stark warnings to the UK’s energy companies to pass on recent dramatic falls in the cost of energy to consumers, or face regulatory intervention.

Osborne said it was “vital” that historic lows on the global oil markets were passed through to customers, saying the Treasury would launch an investigation into whether action should be taken, while Miliband called for Ofgem to enforce the cuts directly.

With just months to go before the May general election, energy companies are back in the stocks. But are the cross-party calls to pass on lower costs to consumers unreasonable?

Following the decision of the world’s major oil producers last year to allow the price of oil to plummet, Brent crude prices have more than halved from levels above $100 per barrel in July 2014 to dip below $49/bbl in the second week of January. The bearish super-commodity hastened the descent of already weak gas and power prices, which have since fallen to four-year lows – raising the political pressure on suppliers to offer lower bills to customers.

But energy experts have warned that dramatic wholesale losses cannot result in a similar impact on consumer bills.

Whereas in 2007 the cost of oil would have been used to secure the price of more than 70 per cent of Europe’s gas, supply contract terms are now far more likely to be based on the wholesale gas price itself. Now, only around 30 per cent of the gas in northwest Europe is bought based on the price of oil, a figure likely to be even less for the UK.

Even weaker gas and power market prices will have a muted impact on utilities’ costs.

Energy analyst at market reporter Platts, Alex Froley, says: “A utility company will have a mixed procurement strategy. It could have some production of its own (North Sea gas fields or power plants) and some long-term import contracts and then top these up with spot market purchases.

“The companies argue that even if the daily price falls, this may not mean their own costs have fallen by the same degree if they bought their supplies in the forward market a year or two earlier,” Froley adds.

In addition, wholesale costs make up less than half of the average consumer bill, according to Ofgem, with upward pressure coming from rising distribution and policy costs.

Despite this, analysts agree that some reduction in bills should be possible. But how far bills fall, and how soon, is a complex decision, they warn.

“The reduction in wholesale gas and power prices over the past 12 months should give some headroom for retail price reductions, but energy companies face tough decisions,” says Deutsche Bank’s utilities analyst, Martin Brough.

“Warm weather since the start of 2014 has reduced retail profitability, while forward hedging of purchases is likely to delay any reduction in purchase costs in the wholesale market,” Brough adds.

The typical purchasing strategy of energy companies, which can be years ahead of delivery, means the heavy losses across oil, gas and power markets late last year may only be felt by the companies at the end of this quarter, Citigroup analysts say.

“It is important to remember, though, that the 2013/14 winter was extremely mild, with gas demand down 10-20 per cent in most European countries, meaning that overall customer bills might actually still end up flat or even up year-on-year just on weather normalisation of demand even if unit prices end up being lower,” Citigroup adds.

With the general election scheduled just weeks into the second quarter, and with the threat of a Labour price freeze still in mind, it might make sense to wait.

“Rising social and environmental costs for 2016 and 2017 also make it dangerous to cut prices now and potentially have them frozen at a lower level,” Brough adds.

But companies in Northern Ireland and France are already recalibrating the price consumers should be asked to pay. French newspaper Le Figaro reports that the monthly French gas tariff revision will yield a bit more than a 1 per cent cut in February, to reflect falling oil prices. And the Northern Ireland regulator says its February study into costs could result in cuts from April.

Within the UK, business energy suppliers and smaller independent companies have made moves to cut consumers’ costs. But the larger the customer base, the larger the risk, meaning the big six will need to act with greater caution.

“Every 1 per cent off retail prices cuts around 8 per cent off Centrica’s earnings per share [EPS] and 5 per cent off SSE’s if procurement costs are flat,” Brough said.

“The [approximate] 25 per cent drop in forward gas and power wholesale prices in the past 12 months could in theory drive a 10 per cent reduction in retail prices once hedges unwind. However an early price cut of more than a few per cent could be extremely damaging for 2015 EPS for both companies,” he adds.

Both have already faced heavy declines in share prices as mild weather has sapped earnings and the Competition and Markets Authority investigation threatens greater political risk. Whatever their next moves prove to be, they are unlikely to be rushed.

Shifting economics

The UK’s push towards low-carbon technologies is supported by the belief that rising fossil fuel costs will drive bills higher. But as falling oil prices weigh on gas and power markets, the economics could shift.

EY’s head of power and utilities, Tony Ward, says the falling price of oil and gas will “shift the relative attractiveness of different types of assets (gas, coal, renewables), making longer-term investment and planning decisions less clear cut”.

Centrica and SSE both have exposure to upstream oil and gas assets, which sill come under pressure with lower market prices.
Already, Centrica has seen its target price per share fall from 290 pence to 270p because of oil price exposure and political risk.

In its latest results, SSE’s wholesale business reported operating profit 83.4 per cent lower as its gas production operating profit fell by 80.7 per cent because of low summer prices.

In addition, the nascent shale industry might prove uneconomic if the ­market price for the gas produced is too low.

Early shale projects include Cuadrilla’s licence area in Lancashire, in which Centrica holds a 25 per cent stake, and the Dart Energy-operated licence near ­Stirling in Scotland, which has already secured a five-year gas supply deal with SSE Energy.

The economic case made for EDF’s Hinkley Point C new nuclear project, already criticised by many as being too expensive, could also become less palatable as prevailing market prices sink.

However, Bloomberg New Energy Finance analysts say the collapse in world oil prices will have a “moderate impact” on the development of low-­carbon technologies generally and may reduce the use of coal-fired power: “Renewable energy rollout in Europe is generally driven by specific targets and policy initiatives, so cheaper gas, combined with a carbon price that has increased 44 per cent so far in 2014, is likely to reverse the recent surge in coal-fired generation. In the UK, for instance, the Department of Energy and Climate Change’s Energy Trends, published last week, shows coal-fired production down by 11.5TWh in Q3 2014 over the same quarter in 2013, a reduction of 43 per cent, with gas gaining 8.0TWh and renewables 2.6TWh.”

Dramatic improvements to the cost competitiveness of wind and solar technologies as well as by the removal of barriers such as grid bottlenecks should help renewables costs to fall further in the future, the analysts add.