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UK Utilities
Contango Collapse – Look for
Regulated Exposure
We are bearish on UK wholesale gas and power
prices. Lower demand, with little sign of any recovery,
means UK gas and power markets are heavily
oversupplied. The change in supply-demand balance is
stark, and the system operator’s (National Grid) latest
view on expected demand growth is very bearish.
Contango collapse? Given the deterioration in the
supply-demand balance over the next 12-24 months, the
current forward curves – steep contango – appear
optimistic. The risk is of a contango collapse, putting
pressure on wholesale gas and power prices for
2010-13. This is bearish for all generators (especially
DRX and IP) and for gas producers (CNA).
Supply margins must be reasonable: We do not
believe that “super-normal” supply margins are
sustainable. Political and regulatory pressure will remain
high through the winter and is unlikely to ease in the
run-up to a UK election next year. We think investors
may be disappointed by EPS momentum at CNA.
Gas and power network regulation is pragmatic and
allows decent returns – NG and SSE the best plays.
NG is our top pick for its US upside, which could provide
material EPS surprise. We also like SSE for its balanced
business mix and scope to surprise to the upside, even
in a low commodity environment. We upgrade Centrica
to Equal-weight, but remain cautious on EPS
momentum here.
We downgrade DRX and IP to Equal-weight. DRX
looks particularly exposed to weaker gas and power
prices. IP has risk in all its merchant markets. We think
the chance of positive earnings surprises is low.
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