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The UK's Energy Price Surge Could be Just Getting Started

- Record highs for power prices
- Amidst rising global prices
- Lack of wind blamed
- Fire in Kent import station
- More rises to come say economists

Windfarm workers inspecting

Image © Adobe Images

UK natural gas wholesale prices surged in the region of 20% midweek taking them to a fresh record high after a large fire at Britain’s main electricity subsea cable with France reduced imports and exacerbated concerns that further significant price rises were building.

Indeed, the fire comes at the most inopportune time: tight gas markets and a lack of wind had resulted in UK and European day-ahead power prices reaching their highest levels since 2008 on Monday, having hit £540 per megawatt hour.

The National Grid said the fire broke out at the IFA1 interconnector site in Sellindge near Ashford in Kent.

Traders quickly bid UK gas prices higher on an assumption that the UK will have to fire up more gas generators to account for lost supply.

Gas prices UK

Above: ICE UK Natural Gas Oct '21 (NFV21). Image: Barchart.

Increased gas generation demand comes amidst a lull in wind across the British Isles, reducing output from the country's wind farms.

"Adding to the drama, renewable generation has waned as wind utilisation this summer dropped below levels seen in 2018-2020, requiring thermal generation to fill the gap," says Kyle Czirr, Commodities Strategist at Bank of America.

The world’s biggest offshore wind farm developer, Orsted, said in August "extraordinarily poor" weather conditions will eat into profits and that out of 88 quarters on record, it is an extraordinarily poor wind quarter.

Orsted's Chief Executive Mads Nipper told the FT, "it is very serious. It is like you’re a farmer and it doesn’t rain."

These UK-specific drivers of energy inflation come amidst a broader backdrop of rising global and European energy inflation, to which the UK's gas market is interconnected.

"Europe, but to some extent the U.S., is undergoing an energy shock right now with galloping electricity and energy prices," says Peter Garnry, Head of Equity Strategy at Saxo Bank.

Eurozone gas inflation

Image courtesy of Pantheon Macroeconomics.

"The UK remains a net importer of fuels, running a small surplus in oil trade and a slightly larger deficit in natural gas," says Shreyas Gopal, Strategist at Deutsche Bank.

"The UK's reliance on imports has undoubtedly increased this year," he adds.

UK energy inflation therefore won't simply dissipate once the wind starts to blow and the Kent connector is fixed.

Gas inflation in France and Italy reached 24% and 34% respectively in July,

Consultancy Pantheon Macroeconomics anticipate European wholesale gas price inflation to double in the coming months, hitting 30% in November.

"What's more, we expect further increases heading into the new year as gas prices are likely to rise further," says Clause Vistesen, Chief Eurozone Economist at Pantheon Macroeconomics.

European baseload prices

Above: Baseload forward month power prices. European power prices have surged to the highest levels in over a decade with prompt month baseload futures topping €100/MWh. Image courtesy of Bank of America.

Vistesen says European gas demand was unexpectedly high following a cold snap earlier this year. A hot summer in Italy meanwhile created a surge in demand to power air conditioners.

Apparently European importers were loathe to restock capacity as prices rose, but are now being forced to do so anyway as Autumn arrives.

"A combination of low inventories of natural gas combined with lower than normal production from solar, wind, and hydro, is causing prices to soar and just as winter is fast approaching," says Saxo Bank's Garnry.

Garnry says the combined effect is higher imports of coal to increase the baseload on the European grid, but these fossil fuels come with higher costs due to rising carbon emission prices in Europe sitting at their all-time highs.

"Gas to coal breakevens became more competitive helping push up coal prices and with it carbon prices, creating a vicious cycle of ever increasing European energy prices," says Bank of America's Czirr.

He adds that after facing a record storage surplus last summer, the European natural gas market is now struggling to find the needed gas volumes.

Power costs

Above: Power generation carbon costs. Carbon costs of generation have doubled from last year's levels and EUAs soared from ~€30/t at the end of 2020 to over €60/t currently. Image courtesy of Bank of America Global Research.

"The timing of all these trends come at a bad time with Europe’s intention to accelerate its decarbonisation which may include an EU carbon border tax elevating prices on goods," says Garnry.

Rising gas prices are also underpinned by elevated oil prices which have settled at levels higher than before the crisis began, supporting energy inflation.

Vistesen say there is a lag of between one and three months between oil price rises and energy inflation.

Looking for solutions, eyes have inevitably turned to the controversial Nord Stream 2 pipeline from Russia and the Kremlin on Wednesday argued for its rapid deployment.

But operator Nord Stream 2 AG still needs to be approved by EU authorities as an independent pipeline operator.

"Even with Nord Stream 2, Russia’s own gas inventories are low, so the likelihood of elevated gas prices is high over the winter months," says Garnry.

Bank of America say that while Russia has maximised its remaining capacity, including an incremental 15 Mcm/d of capacity throughout the summer, this has not been enough to offset a tighter European market.

"In addition, Russian flows suffered an outage in August as a fire at a processing facility near Novy Urengoy cut flows on the Yamal pipeline, which sent TTF prices higher. The lack of additional Russian supplies, despite record European prices, has primarily been thought of as a tool for Russia to help push Nord Stream 2 over the finish line," says Czirr.

Looking ahead, Bank of America tell their clients they anticipate asymmetric upside risk to European natural gas prices throughout this winter and potentially next summer given the current low inventory environment.

"With a limited storage cushion, any disruptions to supply from Russia, Norway, or LNG or simply a cold winter could send TTF prices and European power prices soaring," says Czirr.

The prospect of a stubbornly high fuel prices will therefore likely underpin consumer inflation in Europe and the UK.

For UK consumers, developments in the energy market could not come at a worse time given the ONS on Wednesday said the rise in CPI inflation in the 12 months to August 21 constitutes the "largest ever recorded increase" since the current series began in 1997.

Economists warn even bigger inflation surprises await.

Economists anticipate further rises in coming months that could take CPI to between 4.0% and 4.5%, attributing a scheduled rise in utility prices as the cap is lifted.

The existing cap stands at £1,277, following a rise in the cap in August 2021 which should reflect in upcoming CPI readings.

But given the unprecedented pressures being exerted on the energy market further rises in the cap now look to be inevitable.