Investor view: upward pressure on energy prices will continue

“Despite the lower oil price, there will still be cost pressure for a retail energy price increase before Labour’s price freeze promise ends in 2017.”

Brent crude oil has moved sharply lower since the start of September, dropping from $105/bbl to $85/bbl. While the direct impacts on utilities may be modest, the weak global economy and falling inflation are more fundamental issues for the sector.

The drop in oil is not as precipitous as it seems at first glance. While oil for January 2015 delivery has dropped $20/bbl, oil in sterling for 2018 delivery has only eased from £59/bbl to £56/bbl. The oil price curve is upward sloping, suggesting some of the weakness may be short-term rather than structural. The weaker pound against the dollar is also mitigating the price move.

Nevertheless, one of the drivers of oil price weakness is the weak global economy. Inflation figures around the world have been dropping, including in the UK, whose annual consumer price index (CPI) inflation fell from 1.5 per cent in August to 1.2 per cent in September. Retail price index (RPI) inflation was more robust, at 2.3 per cent, down from 2.4 per cent in August. Breakeven RPI inflation (the future inflation rate at which real and nominal government bonds give the same return) to 2022 dropped from 3 per cent to 2.8 per cent.

What does all this mean for utilities? Despite the lower oil price, there will still be cost pressure for a retail energy price increase before Labour’s price freeze promise ends in 2017. UK gas prices would have to move down significantly to offset rising costs from renewable generation, network investments and energy efficiency spending.

The drop in CPI inflation highlights the importance to regulated networks of retaining indexation to RPI. Any renewed discussion of a switch to CPI inflation after the next price control would make investors nervous.

Weakening inflation generally means now is a great time to be contracting for capex projects – achieved project delivery costs may out turn significantly below estimates made using historic price metrics.

What is not yet clear is whether equity investors are willing to accept lower returns in a world of low inflation and low interest rates. Equity markets, including utilities, have moved lower over the past month, suggesting that not all investors are convinced that lower returns will be fully compensated for by a lower cost of equity.