How managers are preparing for an energy market shock.
As the war in Ukraine continues, Europe is struggling to reduce its reliance on Russian energy sources. Energy costs are driving inflation higher, raising the possibility of rationing.
In Germany, conversations have already begun as to how to manage reduced supplies of gas over the winter months. The implications of such an outcome would be wide-ranging and damaging for confidence. To discuss how likely this scenario is and how our managers are planning to protect their portfolios, we spoke to Elma de Kuiper, Portfolio Manager, European Equity, RBC Global Asset Management (UK) Limited, and Robert Lambert, Portfolio Manager, Investment Grade, BlueBay Asset Management.
Germany is the engine of industrial production in Europe. If it starts rationing energy to its main industries, there will be a significant impact on production, confidence, and corporate investment. Who will be the winners and losers from energy rationing, if it comes to that?
Elma de Kuiper (EK): We have been engaging with the management of companies in our portfolios for a while now to understand how they have been dealing with supply chain issues. To an extent, energy rationing is an extension of the same problem. For months we have been seeing raw materials shortages, component bottlenecks and logistics issues that have driven up the cost of doing business. Energy shortages would be an additional input that companies would need to consider. It may require them to work hard to secure supply and perhaps even pivot business models or production processes to keep operating and meet customer demands.
Companies that are run by management teams with foresight will therefore be most likely to succeed, even if it requires additional investment to adapt factories to make them less energy intensive. We also see this as a boon to businesses that address sustainability demands. Finally, while there are many different factors that ultimately drive the gas price, there is a chance that this benefits those gas companies that can meet the short-term demand for gas from non-Russian sources.
Robert Lambert (RL): Within Europe, there are few winners from energy rationing. In terms of increased investment, I would expect gas and electricity infrastructure to get a boost given the need to address transmission imbalances across Europe and as they urgently seek to connect floating LNG terminals off the German coast. They should see accelerated investment and government subsidies. It is also possible that industrial competition outside of Germany, such as the French auto industry, may benefit from lower production and longer lead times for deliveries from German counterparts, driving customer switching.
The list of losers from energy rationing is long, starting at the residential user, which would have to ration hot water and heating. The most immediate impact has already been felt by utilities, highlighted by the bailout of Uniper. This will continue while gas supply commitments remain in place, which they have to meet at market prices.
There would be many losers in German industry, with warnings of production halts already coming from sectors such as steelmaking and chemicals. The longer-term implication is that Germany may become a less attractive place to do business until it can address its gas reliance as the prices passed on to consumers will be simply too high.
How else are you preparing for the possibility of energy shortages? Are you hedging, or looking at interdependent stocks?
RL: We have assessed our exposure, which is low, and would look at buying protection via index credit default swap (CDS) if we felt the risks were heightened. The nearer we are coming to winter, the more we understand Russia’s intentions. I believe the cuts are geared towards avoiding Europe filling storage and increasing Russia’s leverage in the winter months.
EK: In our conversations with management, we find they are holding more inventory, for example, and adding working capital to ensure they can deliver to customers on time, which is often critical for many of these businesses. It is an interesting tug of war currently between two different priorities: cash conversion does suffer when investing like this, but business continuity is otherwise at risk in the current environment. Given the uncertainty at the moment, wise management teams are prioritising the latter in the near term to ensure they are around to create value long term.
In terms of energy shortages, where a business has pricing power it will be able to pass cost increases on to customers. This resilience is a reason why we tend to prefer investing in more stable franchises. A lot of the companies we invest in are very diversified internationally and so they may be able to shift production around to different locations outside Europe in order to keep operating.
How do you assess the risk that Russia will turn off the gas supply?
EK: There are many inputs that impact the likelihood that Russia will turn off supply, and we cannot accurately predict all of them. We have a multifaceted approach to risk management that includes portfolio engineering: we monitor our risk exposures daily to a variety of different factors, and certain tolerances to each factor. While it is hard to model the likelihood that Russia will turn off supply, we can measure exposures to things like currencies, styles or countries and make assessments from there.
RL: We are actively monitoring gas flows and storage levels across Europe continuously and engaging with companies exposed to the risk to assess the potential impact.
EK: We also attempt to remove systemic, but difficult to measure, risks by virtue of our bottom-up approach. The businesses we invest in are diversified internationally, which provides more insulation from gas price disruption than if our portfolio holdings were domestic focused.
We are in a particularly uncertain period for financial markets and the global economy. We engage closely with companies to ensure corporate leaders are well prepared for adverse scenarios while also taking care to position their businesses for growth when circumstances allow.
Scenario planning and downside protection are important elements of portfolio management that we take very seriously. By building in such protections, managers can mitigate and minimise risks and position their portfolios to benefit from opportunities that may arise.