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Brexit -- Commodities Implications: A Platts news and analysis feature

Analysis: UK's energy costs fuel post-Brexit inflation

By Stuart Elliott, Nick Coleman and Henry Edwardes-Evans in London

  • Oil costs drive sharp rise in inflation in February
  • Slump in value of pound weighing on energy costs
  • Other factors also driving prices in post-Brexit UK

With the UK government set on March 29 to formally notify Brussels of its intention to the leave the EU, the impact of Brexit on the value of the pound and consequently on the country's energy costs is being ever more keenly felt.

Watch our related video: How much is the Brexit-related weaker pound impacting energy costs?

According to the UK's Office for National Statistics, the country's inflation rate jumped sharply in February to 2.3% from 1.8% in January, the highest level since September 2013, with the main contributor to the increase being the rising cost of fuel.

Rate of inflation starts rising quickly since Brexit

"Fuel prices tend to reflect movements in global oil prices and part of the increase in oil prices...can be explained by depreciation of the pound against the US dollar," the ONS said last week.

As a significant importer of energy, the UK has been exposed to the sharp fall in the value of the pound against rival currencies since the vote on June 23 last year to leave the EU.

Analysis continues below...

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The pound has dropped in value against the dollar from $1.49 on June 23 to just $1.25 now, while against the euro it has dropped from Eur1.31 to Eur1.16.

The relatively low wholesale commodity prices since Brexit have dampened somewhat the impact on retail prices despite the currency woes, with electricity and gas retaining steady weighting in the UK Consumer Prices Index.

But the UK remains import-dependent, given the large volumes of dollar- or euro-denominated commodities it buys.

For the third quarter of 2016, the period where the latest data is available, imports made up some 39% of oil consumption, 62% of gas demand and 65% of coal consumption in the UK.

UK dependent on energy imports in Q3

The UK became a net importer of energy in 2004 having been a net exporter fairly steadily from 1981-2003.

UK energy import dependency fluctuates

The UK economy has, however, proven to be fairly resilient since the referendum, flying in the face of some expectations of slowing economic growth, or even recession.

But rising inflation, combined with uncertainty over the future UK-related operations in certain sectors such as banking and airlines, raises the specter of a future worst-case outcome of Brexit -- that the UK could in the future be set for a period of potential "stagflation", a stagnant or weakening economy twinned with price and cost inflation due to a weaker pound.

As oil, gas and power imports become more expensive as a result of a weaker pound, any slump in demand could lead to stagflation.

At the same time, however, the UK economy is currently getting a boost from increased exports due to the weak pound.

Oil burden

The impact of Brexit and the weaker pound is not the only driver of energy wholesale price movements, but it has been an important factor, especially in oil, which is priced in dollars on world markets.

According to the ONS, prices for transportation fuels made the largest contribution to the inflationary rise, with its weighting in the index up to 107.9% last month versus 2015, compared with 97.1% in the month before the referendum.

Since June last year, the average price of a liter of gasoline has risen by 7.5% from GBP1.11/liter to GBP1.20/liter in February, according to data from the AA.

UK retail gasoline prices up since Brexit

The rise has mainly been focused on the petrol station forecourt -- air travel prices fell over the 12 months, thanks to airlines' hedging strategies and ability to absorb fuel price rises within their operations.

And not all of the increase in fuel prices is due to Brexit: global oil prices hit their lowest levels in over a decade this time last year, and have almost doubled since, due mostly to the move in November 2016 by OPEC and some non-OPEC countries to cut production.

UK fuel costs are, after all, still well below their levels five years ago.

One positive for the UK has been the rise in North Sea oil production, which was up in 2016 for the second year in a row.

Output rose by about 5%, which allowed UK refineries to source more UK crude, although in general they often prefer to refine cheaper crude from places like West Africa.

So far, UK demand for fuel has been robust, in line with the overall economy -- oil consumption increased by 2.5% last year. But it may be too early to get a full sense of the hit to the economy from pricier fuel.

Gas value

The weaker pound means the relative cost of importing gas has also increased for UK wholesale gas buyers, although the impact has been muted somewhat by very low European gas prices generally.

Nonetheless, the price of UK NBP gas in pence per therm has been as much as 20% higher than the same gas priced in euros since June 23, according to a Platts analysis.

There has also been much gas price volatility since the referendum given the fluctuating exchange rate.

On June 25, Platts assessed the NBP day-ahead price at 35.1 p/th, up from the previous day's price of 33.6 p/th.

But in Eur/MWh terms, the NBP day-ahead price dropped from Eur14.96/MWh on June 24 to Eur14.67/MWh on June 25.

Price in P/Th higher than in Eur/MWh on NBP

Again, on July 7, the NBP price rose day on day in terms of pence per therm, but fell in terms of Eur/MWh.

The NBP price since June has been driven by other factors, however, notably the inability to inject gas into the major Rough storage facility.

In the summer, the price slumped due to a lack of demand from Rough leading to an oversupply in the UK, while in the winter it rose given limited gas withdrawal capacity at Rough.

The expiry at the end of 2016 of long-term contracts to use the BBL pipeline from the Netherlands also meant less gas coming from the continent, weighing on prices.

UK power, gas prices track apart from winter power spikes

The UK is increasing its gas imports -- it imported 5.8% more gas in 2016 as demand rose due to less coal use in power generation.

Higher domestic gas production and fewer exports to Ireland due to the startup of the Corrib field were unable to offset higher imports.

According to provisional UK government data, UK gas imports rose to 47.4 Bcm last year, with Norway supplying the lion's share of 30.6 Bcm.

Power impact

With the UK's Carbon Price Floor reducing coal's role in power generation, gas is the main price-setting fuel, so most attention should be on the Brexit-driven euro/pound exchange rate.

Recent data from the ONS show the UK electricity price index basically stable over the last 12 months. At 99.7, the index has barely changed since 2015, while that for gas is down slightly over the same period.

For euro-reporting utilities, however, UK wholesale market earnings have been in steep decline.

On June 22, 2016, the day before the referendum vote, UK year-ahead baseload power was assessed by S&P Global Platts at GBP42.28/MWh, converting that day to Eur55.03/MWh.

By March 10 this year, a year-ahead assessment of GBP42.26/MWh converted to Eur48.15/MWh.

A 2 pence/MWh drop in sterling value has translated into a near-Eur7/MWh for euro-reporting generators like RWE and Uniper.

Less clear as a genuine driver behind retail price hikes is volatility in spot and near curve contracts over the winter, largely due to tightness in the French power market.

Utilities hedge well beyond these time periods and should be largely insulated from the risks and rewards of spot volatility.

Retail prices

Nevertheless, domestic power bills in the UK have risen this year, with foreign-owned Big Six utilities noting falling UK revenues.

Four of the major six gas and power providers in the UK have already announced price rises in 2017 -- EDF Energy, SSE, Scottish Power and npower -- with the industry blaming the increases on higher wholesale costs.

Even smaller suppliers such as Octopus, Co-operative Energy, Bulb and Flow Energy have said they would increase prices by as much as 15%.

UK Prime Minister Theresa May said earlier this month that energy was "one market that is manifestly not working for all consumers."

But Dermot Nolan, the head of the UK energy regulator Ofgem, told a parliamentary committee last month that wholesale price rises were always going to be an issue for the UK.

"Costs are the main driver of prices. By the end of 2016, the wholesale cost of energy had risen by 15%, mainly because of rises in the price of gas and fossil fuels. Of that 15%, 12.5% was fossil fuel price rises, predominantly driven by the price of gas, oil, coal," Nolan said.

For electricity, UK retail bills are split into various components and all are exposed to weakness in the pound -- wholesale energy accounts for over 50% of most bills.

The ONS said utility bills were a negative contribution throughout 2015 and 2016, but that has subsided in recent months as retail prices increase.

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