War Doesn't Change Our Outlook for European Utilities

Morningstar DM Europe Utilities Index increased by 4% since the beginning of Russia's invasion of Ukraine on Feb. 24 while the rest of the market was flat. This is sensible to us since we viewed the sector as undervalued with a median price/fair value ratio of 0.92 on Feb. 23 while its exposure to Russia is limited and rising tensions with the West doesn't change our long-term view for European gas and power markets. As we wrote in our Feb 23. note, we think sanctions that disrupt the flow of oil and natural gas out of Russia are unlikely given the West's aversion to higher prices. Meanwhile, Russia is unlikely to withhold volumes given its reliance on related revenue. That said, it's certain the European Union will strive to reduce its dependence on Russian gas. Before the crisis, our scenario was gas consumption in Europe would fall by 15% by 2030. On the supply side, we expected a reduction in liquid natural gas, or LNG, imports and in indigenous production while the supply from pipelines including from Russia would be flat. Still, we posited U.S. LNG imports would remain the margin source of gas in Europe and therefore would determine gas prices. The invasion of Ukraine strengthens our view since a reduction in imports of Russian gas would be offset by higher LNG imports. Gas consumption could decrease by more than the 15% we anticipate on the acceleration of electrification of heating and of renewables investments further reducing gas plants' power output. Still, this does not change our stance that gas plants will remain the marginal source of electricity in Europe, setting power prices that we estimate at EUR 60/megawatt-hours in the long run. We still view the sector as undervalued with a 0.95 median P/FV and see a lot of value in renewables and integrated names. After jumping 17% since the beginning of the invasion, Orsted shares are still undervalued with a 0.85 P/FV. The offshore wind leader would benefit from an acceleration in renewables investments.

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