Opinion

Opinion: Energy import costs likely to rise but structure of energy sector unchanged – Wood Mac

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The UK has voted to leave the European Union. A majority of 51.9% voted to end a 43-year membership of the EU.

Wood Mackenzie will be reviewing our macroeconomic outlook for the UK and EU over the summer on the basis of this result.

Implications: The UK must notify the European Council of its intent to leave, opening a two-year window to negotiate the terms of exit.

It is unclear when this will happen; there is no precedent. The negotiations will determine the long-term economic impact, setting out whether the UK: (i) retains free trade of goods and services; (ii) retains free movement of people and capital; (iii) remains subject to EU policies and regulations, and a whole host of other issues.

The negotiation period itself will create uncertainty, which will adversely impact confidence and economic growth through deferred investment and lower consumption. Prime Minister David Cameron has resigned (leaving office before October) adding to the political uncertainty.

A negative, short-term shock seems unavoidable for the UK economy, and likely for the wider global economy. Markets have reacted badly.

At the time of writing the pound has fallen 7% against the US dollar and the FTSE is down 4% since last night’s close.

Financial market turbulence is not confined to the UK; risk aversion is spiking globally. We have seen safe-haven assets like gold and the US dollar rally, while equity and commodity markets fall – Brent is down 4.5%. Commodity currencies have also fallen, adding to our concerns about economies such as South Africa and Brazil.

The UK exit risks prompting other countries to reconsider their EU membership. The Netherlands, Denmark, Sweden, and Czech Republic are potential candidates. At a time when Europe seeks ever closer union to rectify its structural problems, Brexit risks triggering disintegration.

The EU is the UK’s largest trade and investment partner. We expect to downgrade our current UK GDP growth forecasts of 1.9% in 2016 and 1.5% in 2017.

If exit negotiations increase trade barriers, reduce investment, and the UK trade deficit widens, there is downside for longer term growth prospects and the pound could lose as much as 20% of its value permanently.

As a net importer of energy since 2004 and with import dependency expected to grow (to reach 55% by 2030), the UK now faces higher energy costs arising from a weaker pound. With oil traded in US dollars, a permanently weaker pound against the US dollar will increase the cost of oil imported into the UK. This could feed down the supply chain to higher consumer prices.

Gas contracts/ imports from Norway, the Netherlands and Qatar, (accounting for more than 90% of total imports in 2015) are stipulated in GBP, therefore sellers bear an exchange rate risk. However, LNG imports from the US denominated in dollars, will have a increasing role in the UK gas supply mix.

Energy policy is unlikely to change greatly.

The UK has stand alone legislation, in the form of the Climate Change Act, governing long-term emissions reductions (at least an 80% reduction in 2050 from 1990 levels).

The Act establishes a policy background that is consistent with EU climate-energy targets and will support UK steps to become an individual signatory to the COP21 treaty.

Moving away from EU state aid control will be likely to influence the scope of environmental subsidies, although budget constraints will remain a controlling factor. The recent acceleration of coal’s decline in UK power supply is unlikely to be reversed.

In the UK upstream sector, we expect the impact to be limited. The sector is fully regulated by the UK government. However, the exchange rate may impact costs and margins. A sustained depreciation of GBP may benefit upstream operators from a lower cost base relative to the US dollar denominated oil and gas prices.

Peter Martin is senior economist: EMEARC region, Wood Mackenzie

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