Gazprom Should Invest in Western European Power Plants

by Bram Onck

On the 28th of January this year, German energy giant RWE announced an impairment – a devaluation of a company asset – of USD 4.5 billion as a result of losses incurred in its power generation activities. This announcement is part of a series of setbacks for European utility companies that are suffering from significant changes in commodity prices and an overall economic slowdown on the continent. While these European companies are taking their losses, great opportunities for Gazprom arise to expand its market share in the Western European power generation industry. This article explores how Gazprom could help itself – as well as European citizens – on the basis of current market conditions.

Recent Developments in Coal and Gas Prices

Gas prices on European spot markets have been rising during the last couple of years due to numerous factors. Firstly, Europe faces competition in the Liquefied Natural Gas (LNG) market from Japan and South Korea, where prices have been around 35 and 50 percent higher, respectively. The consequent preference for LNG exporters to direct their shipments to these Asian high profit markets has put pressure on European supply levels with price increases as a result. Secondly, general economic growth in non-OECD countries has boosted demand levels and tightened the LNG market. This market tightening is expected to last for another couple of years and has already come as a welcome surprise for Gazprom, which has seen its European export levels rise by 50 percent between June 2013 and the previous year.

EU spot prices of oil, coal, and gas. European Commission DG Energy, Quarterly Report 2013:2

While these European companies are taking their losses, great opportunities for Gazprom arise to expand its market share in the Western European power generation industry.

At the same time, coal prices have been decreasing since 2011 against the background of relatively stable demand levels. Indeed, the price fall can be attributed to its ongoing abundance in the market and to rising United States’ exports. This is due to the fact that the shale gas ‘revolution’ in the US has made gas a more competitive commodity compared to coal, which consequently led to an increase of US coal exports to European markets. In addition, prices of the EU’s Emission Trading Scheme (ETS) have been low, making coal-fired power generation a more attractive option. It is estimated by the International Energy Agency (IEA) that under current market conditions, ETS prices would have to increase eleven-fold for gas to become more competitive in power generation.

Consequences for Power Generation

The abovementioned developments seem to have been poorly anticipated by European utility companies. Gas-fired power generation had increased almost four-fold between 1990 and 2010, and was supported by ongoing investments in these power plants. The temporary drop in European gas prices that resulted from the US shale gas production has enhanced investments in gas-fired power plants. Now, a couple of years later, stagnant electricity demand and relatively high gas prices have turned the tables for European utility companies, which are now trying to dispose of their assets.

A staggering equivalent of 60 percent of the EU’s power production by natural gas is at risk of closure in 2016.

Gas consumption for power generation. European Commission DG Energy, Quarterly Report 2013:2

The graph shows that gas-fired power generation has significantly dropped on short notice, ranging from around 5 percent in the United Kingdom and Belgium, to levels over 30 percent in France, Italy, and Spain. According to Capgemini’s 15th European Energy Markets Observatory, a staggering equivalent of 60 percent of the EU’s power production by natural gas is at risk of closure in 2016. Apart from being unable to recover their fixed costs, major producers like RWE, E.ON, Vattenfall, and GDF Suez have faced billions of euros of impairments during the last couple of years. Already, many plants have been mothballed and companies are thus continuously losing money on their investment.

Future of Coal and Gas Prices

While the European Commission has recently forecasted in its Trends to 2050 outlook that the role of gas in power generation will continuously decrease until the end of the decade, it is expected to gain importance again before pre-crisis levels are restored in 2050. This outlook is in line with the IEA’s prediction that gas will restore its competitive position in the second half of this decade already, after which the share of gas-fired power production will rise again. Thus, it is expected that the current disparity between coal and gas prices is temporary and will eventually change again for the better of natural gas producers. Moreover, while electricity demand is relatively low at the moment as a consequence of the economic crisis, it is forecasted to hastily recover at the end of the decade.

Ratio of gas to coal price development. European Commission, Trends to 2050.

The above graph demonstrates that the market is currently on a plateau of an unfavorable gas to coal price ratio that will not sustain after 2020. This changing ratio can first of all be attributed to the fact that ETS emission rights will become much more expensive, making it relatively attractive for producers to switch to cleaner resources such as renewable energy sources and natural gas. Moreover, Australia is in the middle of investing tens of billions of dollars in additional LNG production destined for Asian markets, which will bring both Asian and European gas prices down. Furthermore, potential US gas exports will put extra downward pressure on European prices. Altogether, the favorably changing gas to coal ratio is yet another reason for investors to keep a close eye on gas-fired power production.

Market Opportunities and Threats for Gazprom Group

Gazprom’s strategy to expand in Western European downstream markets has been taking shape during the last couple of years. Through its subsidiaries Gazprom Germania and Gazprom Marketing & Trading, as well as through several joint ventures, the Russian gas giant is gradually gaining importance in downstream markets with high profit margins. While Gazprom’s presence in Western Europe is predominantly focused on industrial retail, trading, and storage, it has only marginally included power generation assets in its portfolio. The abovementioned developments might just open a great window of opportunity for Gazprom to expand in the European power generation market.

A Gazprom subsidiary would be among the few that could make these power plants profitable again through cheap gas deliveries by the parent company.

The current failure of Western European utility companies to profitably run their gas-fired power plants have made them mothball these plants or even look for potential buyers. In its capacity as a gas producer and its de facto vertically integrated structure in the European market, a Gazprom subsidiary would be among the few that could make these power plants profitable again through cheap gas deliveries by the parent company. Moreover, it can be expected that the current and forecasted market situation will further give an incentive to European utility companies to sell their assets with some discount, as they will continue to lose money on a yearly basis for as long as they own it.

Even when electricity demand and prices indeed remain low for the next couple of years, owners of gas-fired power plants have a bright future ahead due to relatively decreasing gas prices and restored electricity demand at the end of the decade. Although distribution will remain the most profitable market segment, it would not be bad for Gazprom to invest in European power generation with a presumably consistent rising cash flow pattern and short payback periods. This might be of particular relevance to its ambition to remain a dominant market player in Europe, especially after recent economically irrational investment decisions – such as South Stream – have threatened this objective.

Even though there exist interesting investment opportunities for Gazprom, there seem to be two major threats to this story. Firstly, the US Energy Information Administration expects the United States to become a net gas exporter by 2016. As we have seen in the past, even the potential of US exports can already significantly affect European gas prices. If Gazprom waits too long with acquisitions in the power generation industry, it might just miss the perfect opportunity to take over unprofitable power plants. Hence, it seems that timing will be a crucial factor in this potential success story.

If Gazprom waits too long with acquisitions in the power generation industry, it might just miss the perfect opportunity to take over unprofitable power plants.

This timing factor is also relevant to a second complication, namely that it is doubtful whether Gazprom currently has the financial means to acquire new assets. On top of expensive investments in Nord Stream and South Stream, the company will have to reserve large amounts of money to replace current production. Add to this the projected costs to diversify their supplies to Asia, and it should become clear that Gazprom has many investment opportunities, but little money. Lucky enough, though, the Russian government’s requirement for Gazprom to cut costs by ten percent annually does not directly apply to investments in new assets, even though consequent operating expenses will further worsen their expense level.

Conclusion

Recent developments in coal and gas prices have threatened the profitability of gas-fired power plants. As a result, these plants are either mothballed or will be closed within a couple of years. Gazprom’s unique position in the European gas market allows the company to be among the few that could potentially make these power plants profitable again on short notice. Hence, even though the power generation market might not be the most profitable segment in the gas industry – especially not until the end of this decade – there does exist a great window of opportunity for Gazprom to take over unprofitable Western European gas-fired power plants that will be of use for Gazprom in its endeavor to retain its position in European markets. Nevertheless, it should keep a close eye on developments in the United States and it should critically assess whether it can afford to allocate capital to purchase European assets in the first place.

Bram Onck is an ENERPO alumnus and current student of Petroleum Economics and Finance at the University of Aberdeen.

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