• Energy and fuel prices have soared in 2022, with S&P/ASX 200 energy shares jumping 22.3 per cent year-to-date. Aussie-listed oil and gas companies have performed well, offering investors a natural hedge against rising inflation. 
  • In Australia, increasing input costs due to the Ukraine war, supply shortages and strong winter consumer demand have been pushing wholesale electricity and gas prices higher, flowing through to higher retail bills. The energy shock is inflaming price pressures, heaping more pressure on Reserve Bank policymakers to rein in inflation by lifting rates.
  • Listed Aussie energy companies are also incurring higher production and utility costs, likely weighing on profit margins. The Queensland Government recently announced a lift in coal royalties, effective from July 1, and this is also likely to increase the tax burden, likely impacting company earnings.   

Background to the energy shock

Energy prices are soaring across the globe, driven higher by Russia’s moves to slash European gas supplies, increasing risks of fuel shortages and power cuts ahead of the European winter. The Russian retaliatory measures – in response to Western sanctions imposed following President Vladimir Putin’s invasion of Ukraine – could trigger a collapse in global energy markets. Already, the Nord Stream gas pipeline to Germany is operating at about 40 per cent capacity, according to Bloomberg reports after flows were cut by Russian producer Gazprom.

While fuel insecurity and supply concerns are the primary driver of rising energy prices, consumption of fuel and power have also both surged. Demand for fuel has increased due to abnormal weather patterns and greater people mobility as Covid-19 restrictions are wound back.

The US crude oil price (Nymex futures contract) has jumped almost 39 per cent so far in 2022 (to June 24, 2022). In response, US retail gasoline and Australian petrol prices have hit record highs, with crude oil prices surging and inventories falling sharply. Key drivers have been continuing OPEC supply restraint, a pickup in consumer demand during the Northern Hemisphere ‘driving season’ and political uncertainty in Libya, which is also limiting crude production.

Globally, rising energy costs are key contributors to rising inflationary pressures, with global consumer prices accelerating to annual rates of around 8-9 per cent in May, around 40-year highs.

 

Top Australian Brokers

 

Domestically, rising energy prices are also driving up “cost of living pressures” for Aussie consumers. Retail spending and household wealth have both hit record highs, bolstered by 48-year low unemployment, rising property prices and around $280 billion in excess household savings. But soaring price pressures have dampened consumer sentiment with surveys hovering around recessionary levels as inflation expectations become increasingly entrenched. 

Global central banks have begun to act aggressively, hiking interest rates, in an attempt to rein in rampant inflation. Both the US Federal Reserve and the Reserve Bank of Australia (RBA) have announced “jumbo” rate hikes, raising concerns that tightening monetary policy will slow economic growth. US Federal Reserve Chair Jerome Powell even went as far to say that a US recession is a “possibility,” as he attempts to engineer a “soft landing” for the US economy. 

 

So what’s behind the surging Aussie energy prices?

Broadly speaking, price rises happen when supply falls short of demand, or when demand outpaces supply. In the case of Australia’s current energy problem, it’s a mix of both.

Factors influencing domestic energy prices include: Russia’s invasion of Ukraine; unplanned outages at coal or gas-fired plants; extreme weather conditions; and heightened electricity and gas demand.

While external factors have been a key contributor to Australia’s recent power market issues, the domestic electricity market has been extraordinarily volatile in recent weeks amid a cold snap. Facing the prospect of insufficient supply to meet demand, Australia’s national power operator Australian Energy Market Operator (‘AEMO’) recently suspended the country’s spot electricity market.

While ultimately the “lights stayed on”, the shock comes at a ‘tipping point’ for the Australian energy sector, under pressure from the new Albanese Government and broader community following an election focused on climate change. Australia is one of the world’s largest exporters of coal and natural gas, but insufficient supplies and heightened winter demand on the East Coast have only highlighted discussions around decarbonisation, and the eventual transition to a greater mix of energy sources, such as renewable energy (i.e. wind, solar and batteries).

Further explanation of the causes of Australia’s energy shock can be found below. 

The Russian Invasion of Ukraine

Russia is the third largest exporter of coal in the world, after Australia and Indonesia. Following Russia’s invasion of Ukraine on February 24, Western nations have placed sanctions on Russian coal imports, and have sought alternative suppliers, such as Australia.

Supply disruptions have driven up coal prices. Newcastle thermal coal prices have risen by a whopping 134.1 per cent in 2022 (through to June 24, Trading Economics), hitting record highs of US$435 per tonne.  

Given this backdrop, Australia’s role as a global supplier of coal has taken on increased importance. In fact, global demand for Australia’s bulk commodities has never been stronger. The value of Australia’s coal and natural gas exports have both hit record highs, with broader resources export income up 29.2 per cent over the year to April. 

Record coal prices have powered the share prices of Aussie-listed coal miners in 2022. In fact, Whitehaven Coal (WHC) is the strongest performing stock on the S&P/ASX 200 this year, up 73.2 per cent to June 24. Also on the podium are New Hope Corporation (NHC) and Coronado Global Resources (CRN) with share price appreciation of 50.5 per cent and 45.9 per cent, respectively.

The energy sector is the strongest performer on the S&P/ASX200 index so far this year, up 22.3 per cent to June 24. Of course, oil and gas companies like Woodside Energy (WDS, up 39.6 per cent) have also been key pillars for the sector as commodity prices surge. 

While rising coal prices have boosted the incomes of listed Aussie energy producers, domestic electricity users and suppliers are ‘feeling the pinch.’ This is because electricity suppliers use coal-fired plants to generate electricity. In fact, roughly two-thirds of Australia’s electricity supply is still reliant on coal.

But the lift in demand and upstream coal supply shortages due to heightened winter demand come at a time when Australia’s capacity for coal-fired power generation is at its lowest level in over a decade. And although growing commodity prices typically boost revenue for generation industries, businesses need to keep a lid on input and production costs. Global supply chain disruptions therefore threaten fuel generators. If their local inputs are not available, they have to source them from costlier global markets, which eat into profit margins.

With profit margins under pressure, and wholesale electricity prices soaring, suppliers have been attempting to pass on higher costs to the retail market, which flow on to consumers and businesses. In response, the Australian Energy Regulator (AER) announced that from July 1, benchmark electricity prices will rise between 8.5 per cent and 18.3 per cent in New South Wales, up to 12.6 per cent in south-east Queensland, and by 9.5 per cent in South Australia.  

Unplanned outages at coal-fired plants

As mentioned above, recent power outages and maintenance at aging coal-fired plants have also contributed to rising electricity prices. Reneweconomy.com.au reported on June 13 that “one quarter of Queensland’s coal capacity remain sidelined because of maintenance and unexpected outages, and a number of gas and diesel generators were also not operating. In all, little more than half of the registered capacity in the state is being made available.”

On April 20, AGL Energy (AGL) advised that Unit 2 of its Loy Yang A power station – Victoria’s largest coal-fired thermal power station – was “taken out of service due to an electrical fault with the generator”. AGL estimated that the fault would take around three months (August) to recover and would impact its bottom line (profits) by $50 million.

On June 10, AGL extended its estimated recovery time from August to the “second-half of September”. AGL attributed the outage extension to “global supply chain issues and the availability of specialised materials”.

On June 1, Origin Energy (ORG) said that its Eraring Power Station – Australia’s largest coal-fired power station – has been impacted by “ongoing challenges with coal supply”, with “the situation [deteriorating] significantly in recent weeks”.

ORG says that “equipment supply chains”, “production constraints” at mines, and “material under-delivery of contracted coal” have caused “lower output from the [Eraring] plant”.

These outages have contributed to shortfalls in electricity production at a time when coal-fired plants are scheduled to close amid a broader move to more renewable energy sources.

In fact, on February 17, ORG brought forward the closure of its Eraring Power Station by seven years.  ORG said that the “economics of coal-fired power stations” are being put under “increasing, unsustainable pressure” by “cleaner and low cost generation, including solar, wind and batteries”.

Increased dependency on coal-fired stations to provide electricity during at a time of production shortages may lead to closure plans being revised. Utility companies have to decide on whether it is worth continuing to invest and upgrade their ageing coal-powered plants, which they know have a relatively short life (low return on investment). 

As a result, there has been heightened merger-and-acquisition activity around coal-fired power plants.

AGL recently poured $160 million into a demerger proposal which it later withdrew. The demerger of its coal-focused generation business was rejected by Mike Cannon-Brookes, AGL’s largest shareholder.

Brookes argued that AGL’s proposed closure of its Bayswater power station in 2035 and its Loy Yang power station in 2045 needs to be accelerated. Brookes says that these power stations generate “very expensive energy”, are “unreliable” and “continue to break down more and more frequently”.

Despite the upfront cost, Brookes says that the transition to renewables will bring “lower prices to consumers” and “unlock financing” as “ESG investors … banks and other companies who lend money” will return.

 

Heightened energy demand

Disruptions to energy supply are coming at a bad time. Australia’s eastern and southern states are experiencing some of the coldest starts to winter in decades. Reportedly it is the coldest start to winter in Brisbane since 1904, in Melbourne since 1982, and in Sydney since 1989, according to the Australian Bureau of Meteorology.    

The Australian Energy Market Operator (AEMO) issued a statement on June 13, saying that if demand continued to outstrip supply, load shedding may be used as a last resort (cutting off power supply to certain consumers).

While it’s unknown whether colder-than-normal temperatures will continue, it does highlight the issue of energy volatility and ultimately energy security. Already, energy protectionism is on the rise, with large exporters like Australia, Indonesia and the US threatening to limit both coal and gas exports to keep a lid on domestic prices amid rampant inflationary pressures. Australia’s strategic supplies of refined petroleum have been questioned as pump prices straddle record highs. With decarbonisation expected to take decades, building up energy reserves for domestic consumption could build resilience, given increasing climate and geopolitical risks. 

Government initiatives

Australian federal and state government energy ministers held talks on June 8 to address surging coal, gas and electricity prices as the energy market became increasingly dislocated.

The ministers agreed to give power to the Australian Energy Market Operator (AEMO), to be able to withhold gas on the open market and keep it in storage facilities.

A “capacity mechanism” was also discussed, with an increasing focus on power providers storing emergency supplies. The former Head of Australia’s Energy Security Board, Dr. Kerry Schott, said that the capacity mechanism is “something that could have helped [smaller] retailers”. Smaller electricity retailers have recently urged customers to find alternative suppliers.  

New Federal Energy Minister Chris Bowen said the capacity mechanism was a “matter of urgency” and a draft policy would be prepared by the AEMO “imminently”, fast-tracked from the original plans for 2025. Minister Bowen said that work on the capacity plan was “well advanced” and that the Energy Security Board would have a draft in the next few days.

In order to protect consumers, AEMO capped spot power prices in East Coast states and South Australia – previously allowed to exceed $15,000 per megawatt hour – to just $300 per megawatt-hour. With many generators losing money on every megawatt-hour being sold, they refused to operate, reducing online generation capacity.

In response, the AEMO suspended the National Electricity Market (NEM) for the first time in history on June 15, and seized control of the supply of power from generators in an attempt to prevent blackouts. This means that the AEMO will set prices for each region and compensate generators for putting more supply into the grid. The AEMO will recoup the money through higher charges on retailers who will ultimately pass on these costs to consumers. 

But recently – after confirming that the “risk of any shortfall has reduced markedly” – the AEMO lifted its suspension on the NEM. Signs of recovery have also been seen elsewhere, after AGL restored two of its Bayswater power plant units and EnergyAustralia returned two of its Mt Piper station units.

But Australia still has two months of winter left, the Russian-Ukraine conflict is still ongoing and EnergyAustralia has delayed the return of its fourth unit by a week. Minister Bowen has cautioned that “risks remain in the system” but also said that “[normalcy] is within reach”.

Looking forward, energy ministers will meet in July to discuss a ‘National Transition Plan’.

 

How about oil and petrol?

In the space of two years, the price of oil has swung from multi-year lows to multi-year highs.

Since Russia’s invasion of Ukraine in late February, international sanctions against Russia’s economy have intensified, and countries globally have become reluctant to purchase Russian crude.

This has a global impact because Russia is (was) the third largest producer of oil and the world’s second largest exporter of crude oil. Russia exports about 12 per cent of global oil.

Before the war, Russia accounted for around 30 per cent of Germany’s oil imports, 23 per cent of the Netherlands’ oil imports and around 11 per cent of the UK’s oil imports. Interestingly, these countries have significantly reduced their purchase of Russian crude and have all recently experienced multi-decade high inflation rates.

Australia imported just 1.2 per cent of its total oil last year from Russia. But Aussie refineries import around 90 per cent of crude that they then convert into fuels. Most comes from Asia and around a quarter comes from Singapore. Interestingly, around 20 years ago, we had eight refineries that met nearly all of our domestic demand.

It is also worth noting that Australia doesn’t have a significant amount of domestic fuel supply. In March, Australia had around 19 days of diesel supply, and 53 days of petrol supply left (source: Australian Department of Industry, Science, Energy and Resources). As a result Australia is vulnerable to global forces acting on the oil market.

The reduction of Russian oil supplies hasn’t been the only factor driving prices higher for crude oil and its products. Covid has served to constrain production by major oil producers such as OPEC.  

Rising demand has also pushed prices higher. Globally, major economies continue to reopen after Covid – shipping and transport have resumed and people are starting to travel again. Jet fuel prices are skyrocketing on increased aviation demand.

In Australia, soaring crude oil prices have pushed up national retail unleaded petrol prices, forcing the previous federal government to halve the fuel excise tax in an attempt to reduce prices. The fuel tax cut is set to expire in September. The lift in petroleum prices has been a key contributor in Australian headline consumer prices hitting a 21-year high of 5.1 per cent in the March quarter. RBA Governor Philip Lowe now expects rising electricity and gas prices to inflame price pressures, pushing up the annual inflation growth rate to near 7 per cent by the end of this year.   

 

The Impact on the Sharemarket

On June 1, Origin Energy (ORG) withdrew its guidance for the 2022/23 year and downgraded its 2021/22 forecasts amid disruptions at its Eraring Power Station and volatile commodity markets. ORG slipped 13.7 per cent and caused the broader defensive Utilities sector to experience its largest daily decline since the onset of Covid-19 in March 2020.

There may also now be higher risks associated with investments into utility companies given that the government can intervene with operations. A clear example of this is the suspension of the NEM by the AEMO for the first time in history.

However, the utilities sector is the second-best-performing sector this year. Year-to-date (to June 24), the utilities sector is up around 13.1 per cent.

As mentioned above, the best performing sector is the Energy sector, which is currently up 22.3 per cent.

The relatively higher exposure of the Australian sharemarket to the resources sector has helped it avoid sharp losses that its more tech-exposed global peers have experienced.

Over 2022 to-date (June 24), the S&P/ASX 200 index is down 11.6 per cent and is outperforming its US peers – the S&P 500 index (down 17.9 per cent), the Nasdaq index (down 25.8 per cent) and the Dow Jones index (down 13.3 per cent).

While beneficial for downside protection in the sharemarket, rising commodity prices have been behind the lift in the annual inflation rate in Australia. In response, the Reserve Bank of Australia (RBA) raised cash rates by 25 basis points (bp) in May and 50bp in June – the latter being the largest hike in 22 years.

Higher interest rates increase borrowing costs for businesses and consumers.

CBA Group economists expect the cash rate to rise further in coming months: 50bp in July and then 25bp moves in August, September and November, taking the cash rate to 2.1 per cent by year end. 

While rate hikes don’t directly solve supply chain issues or rising coal and oil prices, the aim of the RBA and other global central banks is to slow down spending (demand) until production (supply) catches up.

Higher energy and transportation costs, as well as higher borrowing costs, place pressure on companies selling non-essential or discretionary goods and services because their delivery and shipping costs increase. The consumer discretionary sector is down around 23.1 per cent year-to-date and is the second-worst performing sector.

Increased oil prices also weigh on airlines. Even though airliners hedge their fuel costs, they are still sensitive to large swings in the price of oil that have been seen over the past few months. In fact, rising fuel costs add to the lockdown headwinds that airliners have had to deal with recently.

Higher fuel costs may also partly explain why shares of United Airlines, Delta Airlines, American Airlines, Qantas and Lufthansa airlines are all at least 30 per cent below their pre-Covid levels.

The Queensland government unexpectedly lifted coal royalty taxes in its budget last week. The new rates will be 20 per cent for prices above $175, 30 per cent for prices above $225, and 40 per cent when prices exceed $300. The impost will likely increase the tax burden on Aussie-listed coal producers, weighing on net profits, with the potential to lower dividends paid to investors.    

Finally, investors should also consider the impact of rising interest rates and the potential for a US recession on commodity prices. Worries about lower demand have already begun weighing on oil, iron ore and industrial metals prices. That said, Chinese President Xi Jinping has recently pledged to achieve the country’s economic goals for the year, with Chinese economic activity struggling under the burden of the country’s “Covid-zero” policy. Pronounced policy stimulus could yet support commodity prices, but so far Chinese authorities have been more focused on targeted fiscal policies to support households and businesses impact by persistent virus lockdowns.

Originally published by CommSec