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Investing in the supply story as the energy crisis bites


Following on from yesterday’s article on the current crisis in energy, today we’re going to look at how you might claw a bit of money back from the situation and invest into the energy boom.

The situation in the market is about demand and supply, and the demand and supply curves crashing into each other and creating a price vortex that is being reflected in your gas and electricity bill.

As discussed yesterday, since the end of lockdown, the demand for energy products rapidly increased as people went back to work. Although the UK is making the carbon transition, currently over 80% of the country energy requirement is derived from fossil fuels.

The UK was a net importer of energy in the 1970s, however with the discovery of oil and gas in the North Sea, the UK became a net exporter of energy by the 1980s. The country went back to being as net importer by the end of the 1990s, as production from the North Sea tailed off with an upswing in petroleum product imports in the late 2010s.

In 2020, 28% of energy used in the UK was imported, down sharply from the 2019 level due to the impact of the Covid-19 pandemic as the UK imported less fuel to meet reduced demand. However, this has subsequently increased once again.

Domestically the majority of UK homes and businesses still use natural gas for heat and cooking, with gas providing around 84% of the country’s heating requirements and generating around 42% of the UK’s electricity. Although as a proportion the UK uses very little gas from Russia (according to the Department for Business, Energy and Industrial Strategy (DBEIS), Russian imports supplied only 2.2% of energy used in the UK in 2021 with our main import partners being Norway, Netherlands and the Middle East), the disruption to the global energy market following Russia’s invasion of Ukraine has created market uncertainty, wholesale price volatility and an increased demand for non-Russian energy sources, as we can see in the chart below.

Natural Gas Chart 5yr

Renewables vs. Fossil Fuels

Although renewables – especially offshore wind – are providing an increased proportion of domestic and business electricity requirements, the UK still relies on fossil fuels to meet its energy needs. Renewables did provide 43% of electricity needs in 2020 according to the DBEIS, however as the country moved out of lockdown, energy demand increased. This was coupled with a reduction in supply as the renewable energy sector could not supply as much power due to atmospheric conditions.

In the transition, coal is gradually being phased out and coal-powered stations have been closed or converted to use natural gas or biomass as a fuelstock. Nuclear power’s contribution to the energy mix has also fallen as old stations are decommissioned and new stations not built, however, it seems that the government is hastily dusting-off its old plans for nuclear as a response to the current energy crisis.

In terms of transportation fuels, the majority of the cars and trucks on British roads remain diesel or petrol. About 2% to 3% of all vehicles in the UK are electric vehicles (EVs), and although hybrid petrol-electric and EVs are the fastest-selling type of vehicle in the UK, they have a lot of ground to make up before they are the preferred choice.

EVs and hybrids saw sales increase about 76% year-on-year between July 2021 and July 2022, according to SMMT, but still only made 11% of new car sales overall. All new cars and vans sold in the UK must be fully electric by 2035. The government is currently on course to ban the sale of new cars and vans powered entirely by petrol and diesel by 2030 and ban the sale of new hybrid vehicles by 2035.

However, there are still issues regarding the charging national network for EVs and hybrids, and to hit its ambitious target, the Department for Transport must oversee a massive investment in the charging infrastructure nationally. To date there have been no firm plans on how to implement this plan.

Which brings us onto the subject of where the power that goes into EV batteries comes from. Most of the electricity used in the UK is still derived from fossil fuels – primarily natural gas – so economically and environmentally we circle back to the supply side of the debate.

Following the supply curve

The easiest way to make some money out of the current situation is to look for those companies that are going to be supplying our energy needs into the future. This includes oil and gas producers, renewable energy companies that offer plant and machinery or energy units to the grid, uranium producers who supply fuel to powerplants and companies that will build the infrastructure.

To start with boring is best, Centrica [LON:CNA], supplies energy services to homes and businesses in the UK (mainly through British Gas) and Ireland (through Bord Gais Energy). This accounts for the majority of the company’s revenue. The company recently reported adjusted operating profits of GBP1.3bn in the six months to June – up from £262m a year earlier – most of which came from oil and gas drilling. British Gas’s retail supply profits, were GBP98m.

Centrica still dominates the UK energy market, by far the biggest of the big five. The energy service provider had a share of 27% of the gas supply market in the fourth quarter of 2020. Similarly, British Gas was the leader in the electricity supply market, with a market share of 18% at the end of 2020. However, these shares have been gradually decreasing in recent years as more green energy utility companies have entered the market and small, speculative suppliers have been nibbling bits of the BG behemoth around the edges.

However, as discussed in yesterday’s article, a lot of these small speculators have been caught up in the current crisis and gone out of business, with many of their customers being placed back with Centrica as primary supplier. Renewable Energy, though increasingly important, is not currently providing enough baseline power, and the fallback is natural gas, where Centrica is a leading supplier. The government is knee-jerking, so as not to appear clueless and inactive, and it is likely that new licences for exploration and drilling in the North Sea, and fracking will be issued. Although it takes on average 18 years for a exploration play to start producing commercially, the issue of new licences makes it look like the government is being active and decisive.

Centrica isn’t bothered by the length of time it takes to prove and produce a new field. It will remain, despite the energy transition, a major player in the energy supply market. Centrica isn’t a secret squirrel of a company, it is a FTSE100 stalwart. That said it can still make money for an investor. The company is in a lot stronger financial state, having offloaded some of its non-core assets, it has around GBP360m cash in the bank, compared to the pile of debt it was carting around for the last few years. Trading on a p/e ratio of seven, that is a big draw if it has a 2H22 as good as its 1H22. It is also bringing back a dividend.

On the downside, Centrica is not in the same place it was five years ago where it was trading at 160p (it opened today at 81p and had fallen to 74p by mid-morning trading) and there is talk of windfall taxes, which might hit its bottom line as will the growth in clean energy. However, as a short-term haven, until energy prices stabilise, Centrica could be a company to back.

Distribution and Transmission

To build out the kind of energy infrastructure needed to charge all the EVs that will be on the roads and support the growth in smaller-scale renewable energy platforms, its going to take a lot of wire and a lot of pylons.

That’s why looking at the kind of companies that will supply the raw materials for the transition may be a good call. BHP Group [LON:BHP], the Australian resources company is in the right place to supply the raw materials the world needs to grow and decarbonise. Copper for renewable energy. Nickel for electric vehicles. Potash for sustainable farming. Iron ore and metallurgical coal for the steel needed for global infrastructure and the energy transition. It also currently produces oil and gas, recently merging its petroleum products with Woodside Energy [ASX:WDS]

Again, BHP isn’t really an undiscovered company, its one of the world’s biggest commodity producers. However, its big because it is good at what it does, and earlier this year posted its highest ever full-year profit on record commodity prices, The mining giant’s attributable profit for the 2022 financial year stood at USD30.9bn, a 173% increase compared with USD11.3bn a year ago.

BHP’s growing copper production should support higher dividend payments. Historically, the company aims for a minimum dividend payout ratio of 50% of its cash flow. It often pays out additional dividends from its excess cash and repurchases shares.

For the foreseeable future, BHP will be a significant part of the discussion about the energy transition, a key reason why we added the stock to our Tactical Trading portfolio back in January..

Going nuclear

Although derided by environmentalists, nuclear power is a solution to baseline energy supply. Following the Fukushima nuclear disaster in 2011, nuclear became the bête noire of energy and governments, keen to champion their responsibility and green credentials, announced the phasing out of their plants and their intention to not commission any new facilities. But given the crisis created by Russia cutting its gas supplies to mainland Europe, ministers across the continent are scrambling to find the drawer they kept the plans for new nuclear in. Japan is back in the game too.

This could be a boon for uranium suppliers, who have long been the ginger stepchild of mining. Over the last month uranium mining stocks shot for the moon, and arguably we could be entering a golden (or at least yellowcake) time for uranium suppliers. Nuclear is likely to provide the low carbon bridge between phasing out fossil fuels and bringing on renewable capacity.

A resurgence of nuclear energy in Japan could encourage other nations to reconsider their stance as well and nuclear is a good bridge for developing countries to quickly ramp up their power production. Egypt is building its first nuclear plant and India is planning a mega-nuclear reactor as it strives to reduce reliance on coal for its power needs.

All that highly radioactive waste we have to get rid of? The next government can deal with it.

Listed holding company Yellow Cake [LON:YCA], another Armchair Trader pick due to its direct exposure to uranium stockpiles as opposed to listed miners is a good place to start. But Cameco Corporation [NYSE:CCJ] which produces and sells uranium is another good long-term option. Cameco operates through two segments, Uranium and Fuel Services.

The Uranium segment is involved in the exploration for, mining, and milling, as well as purchase and sale of uranium concentrate. The Fuel Services segment engages in the refining, conversion, and fabrication of uranium concentrate, as well as the purchase and sale of conversion services. This segment also produces fuel bundles or reactor components for CANDU reactors. The company sells its uranium and fuel services to nuclear utilities in the Americas, Europe, and Asia. Cameco Corporation was incorporated in 1987 and is headquartered in Saskatoon, Canada.

The company has ramped up production at its Australian and Canadian mines – adding about 70 million pounds (mlbs) uranium in long-term contracts 2021 and has around 450mlbs of uranium reserve. Its is also exploring in Kazakhstan. It had cash-in-hand of USD1.3bn and long-term debt of USD996m and should produce around 5mlbs of uranium this year.

They have the world’s largest, high-grade uranium mine. Utilities are scrambling to find non-Russian uranium. Cameco is poised to triple earnings next year based on rising demand and prices. It has a good dividend policy and with the potential for nuclear to become a central part of energy strategy could be a good long-term investment that pays a steady income. Shares have risen but will continue to rise with an analyst consensus share target price of around USD44.

There are a number of angles to play in this energy crisis – there will be winners and there will be losers, but by being canny, an investor can create opportunity out of this situation.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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