Energy supplier interest in investing in upstream gas assets is escalating - especially at Centrica - on the back of continuing high gas prices and security of supply concerns. Nigel Hawkins writes

Students of economics are quickly taught about the difference between vertical and horizontal integration. For many years, the UK utilities sector has fluctuated between the two options.

On the one hand, the New Electricity Trading Arrangements (Neta), for various reasons, strongly encouraged vertical integration. This gave rise to the dominance of the six integrated electricity supply companies.

On the other hand, utilities have traditionally sought to reassure their sceptical shareholders that they will stick resolutely to their core business. Of the six integrated energy supply companies, both Eon and RWE have considerable expertise in the gas sector. This has been key in negotiating long-term contracts for their UK combined cycle gas turbine (CCGT) plants. For EDF, there is a greater emphasis in ensuring its nuclear plants acquired from British Energy perform efficiently.

The Centrica policy has been different, albeit a refinement of the vertical integration strategy. And it has been largely shaped by its dominant position in the retail gas market. When Centrica emerged from British Gas in 1997, its exploration and production operations at Morecambe Bay were added to its existing supply business to provide some ballast – in the form of tangible assets – to its otherwise shaky balance sheet. In the intervening years, returns from Morecambe Bay have been pivotal in growing Centrica’s underlying profit.

Following Sam Laidlaw’s appointment as chief executive in 2006, the priority accorded to its upstream activities was enhanced as Centrica sought to reduce the very real risk of being caught short of gas. Furthermore, output from Morecambe Bay was falling as its reserves were progressively depleted.

Importantly, Centrica’s interest in acquiring upstream gas assets is shared by its competitors. Hence, the UK’s relatively small exploration and production sector, including companies such as EnQuest, has been one of the few market sectors whose shares have performed well in recent years as corporate activity – and speculation about it – increased.

Centrica has undertaken upstream gas deals since 2004. Recently, it has made several key moves to become far more of a vertically integrated gas business, despite its lack of a major gas distribution network. Its decision in July 2008 to enter the Norwegian sector of the North Sea (through the £190 million deal to buy gas assets in the Heimdal area) was pivotal. And, in late 2009, it paid a formidable £1.3 billion for a 50.3 per cent stake in Venture Production.

Subsequently, over the past 30 months, Centrica has spent around £2 billion on building up its upstream portfolio. The most eye-catching acquisition was the £965 million purchase of assets from Norway’s Statoil, with whom it has established a strategic partnership.

Aside from security of supply considerations, and the consequent reduction of risk, Centrica is implicitly assuming that European gas prices will remain high. The US shale gas boom seems most unlikely to be replicated here, and the demand for gas seems set to rise, especially as Germany phases out its nuclear power plants, all of which are due for closure by 2022.

Moreover, new nuclear-build in western Europe continues to stall, post Fukushima, as serious cost and time overruns are being reported from existing projects. There is also increasing scepticism about the economics of renewable generation, especially since expensive back-up plant is needed to cover when the wind does not blow.

Aside from acquiring upstream assets, Centrica, like other major energy suppliers, has signed long-term supply contracts with leading gas producers. Not surprisingly, Norwegian gas remains in big demand, especially since most other obvious suppliers – Russia, the Middle East and North Africa – come with heavy political risks.

While its gas activities are more modest, SSE has adopted a similar supply strategy, although it is less gas-centric. Prudently, SSE seeks to achieve a “lower risk of wholesale energy price volatility through reduced exposure to any single commodity”.

In implementing this commercial policy, SSE has signed two major long-term gas supply contracts. First, a ten-year contract has been signed with Statoil for the annual supply of no less than 500 million cubic metres of gas to be delivered, via the St Fergus gas terminal, to the Peterhead power station. Second, it has agreed a similar ten-year gas supply deal with Shell Energy Europe covering 790 million cubic metres of gas: delivery will begin in 2015.

Furthermore, last year SSE paid almost £300 million to acquire a portfolio of North Sea gas and infrastructure assets, some of which are located in the Everest and Lomond field, from Hess. More such deals are expected to follow.

Other major UK energy supply companies also recognise the importance of protecting their gas supply sources, especially since the cost of gas represents a disproportionately high percentage of the cost of CCGT-generated output. Indeed, with the UK’s mid-term generation portfolio under real scrutiny, CCGT output will be crucial, especially if the government’s new nuclear-build policy comes to nought.

EDF, Eon, RWE and Iberdrola are clearly major international energy players with operations in many countries in Europe and, in some cases, activities beyond it. Hence, their commercial strategy is necessarily less parochial than that of either Centrica or SSE, whose financial dependence on their core UK market is critical.

Nonetheless, the development of vertical integration in UK energy markets may be financially efficient and arguably mitigates risk. However, and certainly post the introduction of Neta, it has led to an established oligopoly whereby six integrated energy supply companies control up to 99 per cent of the market, to the exclusion of virtually any other player.

This consolidation and the high degree of overseas ownership bring very real risks in terms of future investment, which is estimated at around £110 billion over the next decade. If gas prices remain high during this period, which is a real possibility given all the uncertainty about new generation plant, Centrica’s decision to invest heavily in exploration and production will have been fully justified.

Nigel Hawkins is director of Nigel Hawkins Associates, which undertakes investment and policy research

This article first appeared in Utility Week’s print edition of 16th November 2012.

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