Thread by @LilyWrites4

Hi, it's been a minute since I made a thread (I deleted a prior one two weeks ago). This thread will be about natural gas and the United Kingdom, mostly since I have a research post about it coming out probably soon. I am not a natural gas trader unless you count FCG.

I do not claim complete accuracy, and you're more than welcome to correct nicely if there's any misinformation, or get blocked otherwise. Anyhow --
1/n

As I posted yesterday, something weird is going on with natural gas in the United Kingdom. Natural gas prices are going up worldwide from a combination of factors: industrial output returning after COVID-19, mismatched reserves to demand needs, climate factors in a few places 2/

Specifically, we can compare the price history of UK Natural Gas futures (left) below to Henry Hub spot prices, which is the catch-all pricing name for U.S. natural gas, given the Henry Hub distribution center in Louisiana (right). Woofda that's a major differential.

And I'm not comparing apples to oranges here (Henry Hub is in $ per million BTU, futures spec is 1,000 therms per day during delivery period). Just the magnitude of increase is quite different. So what's going on exactly in the UK?

The UK gets about 50% of its domestic needs for natural gas from the Continental Shelf, which is a fancy way of saying the territorial waters it has rights to:
What that means is about 50% of its natural gas needs come from outside the UK, aka importing.

This historically comes from big NG exporters like Russia. This system works well enough in practice, but ran into a big issue due to a global supply shock. Russia this year and other exporters realized they have more NG needs at home, and basically turned off the spigot.

Normally this wouldn't be a Big Deal, but there are two other factors which really added to the pain. The UK is one of the global hubs of decarbonization, and gets a large bulk of power normally from solar & wind producers. In fact, the UK got around 30% of power needs from both.

^ independent.co.uk/climate-change…
However, climate-wise, we've been in an unusually calm weather season (aka no wind there), coupled with reduction in solar power normally seen in the fall and winter months. As part of decarbonization, the UK also has tacked on carbon credits/tax -

To natural gas production, after doing similar to coal. qz.com/1192753/a-carb…
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What happened to carbon credits this year, thanks to market demand and technical factors? Let's check our favorite meme stock, $KRBN (disclosure: I have a position:

So the price of carbon credits is also weighing on natural gas providers, and has pushed the cost up, up, and up. Unlike equities for example, commodities are very region-local, due to the difficulty of transporting. So there's no arbitrage really between Henry Hub and UK NG

unless you have a really big boat and a lot of time to carry fuel across the ocean.
The last major factor at play is COVID-19, yet again. While it also nuked the supply and hence reserve calculations going into winter months as part of industrial shutdown last year, many

believe that the work-from-home paradigm will increase energy consumption even more in the winter, due to the difficulty of heating thousands of homes versus a single office building during the daytimes. Who knows, though.

The UK energy market is fairly deregulated (thanks Thatcher), with a major exception -- in the last few years, Ofgem (Office of Gas and Energy Mkts) has set caps on what companies can charge for energy to both fixed and variable rate customers. This is normally fine.

NG and other commods were cheap for many years, so a lot of smaller, newer companies were able to undercut large rivals, assume a ton of debt, and gain market share by offering cheaper (breakeven or even at loss) pricing. Before this year, there were about 55 NG suppliers.

In Normal Theory (TM), suppliers who aren't vertically integrated should hedge their supply needs, and many do to some degree. For example, CF Industries, a fertilizer producer (NG is needed to produce fertilizer) hedged about 19% of supply needs of NG in 2020.

However, again with the undercutting - it's likely many of the smaller suppliers skimped on costs and underhedged, or poorly forecasted. Coupled with a cap on how much they can charge consumers, oh boy. Profit margins slashed. Servicing debt - woof.
And so we're seeing firms nuke

I'll talk a bit more later about the Supplier of Last Resort system, but hope you enjoyed the thread!

Hi, back for a bit. So Ofgem has a bit of a problem. As I mentioned, the smaller firms have the most risk, because they tend to be the most levered and least profitable -commods tend to compete on price, which lends naturally to monopolies and oligopolies if you've taken Econ 101

So far this year, 12 firms out of the Ofgem approved suppliers have declared bankruptcy/defaulted, and Ofgem has in place a system to insure that consumers don't shoulder a massive catastrophe if their supplier shuts off NG. As part of it, they have the Supplier of Last Resort -

What this means is they arrange on assumption of administration for a firm (aka bye-bye) another supplier to take over the customers, with an express cap on how much more the new supplier can charge (the tariff cap). So we've seen a lot of consolidation rapidly as smaller firms

have folded, with their customer base being transferred to new, larger suppliers. The problem with this is prices are spiking rapidly enough that the existing tariff cap, which is changed twice a year by Ofgem, is causing many suppliers to basically provide energy at net loss

to customers, especially if the supplier isn't vertically integrated (aka buys NG on wholesale markets and exposed to day-forward prices) and especially especially if they have a large amount of fixed rate customers. This in general is bad, because adding new customers

to even solvent firms currently may increase their risk of default/folding. So it's likely there will be second-order knockback effects on large suppliers who are being burdened by the government to assume more customers, and some or many might *also* go insolvent.
Fin.

Net net long term this will likely reduce competition in the energy sector, leading to higher end consumer costs, increased inflation due to energy prices, and potential requirement of government bailout if contagion spreads to large suppliers due to SoLR.