A disagreeable blog about Finance

Why this could be Europe’s Lehman Brothers moment

CONTENT UPDATE: UK joins the bailout party too (Sep 8th 2022). Reference.

Sweden, Switzerland, Finland have just proceeded to bail out some of the biggest electricity producers and retailers. Why?

Hit where it hurts the most.

The cost of electricity has more than quintupled during the last 12 months due to the cost increase of the primary commodity that is being used to produce electricity: natural gas.

Europe has natural gas resources, which save for a few fields in Norway, are still untapped. Because of NIMBY government decisions of course. And, secondarily, because of conflicts of interest and corruption of government’s key figures due to decades-old ties with the Kremlin, which Europe is peppered out of.

But it doesn’t matter. It’s a done deal.
The end result is that Russia used to be the a major natural gas provider for the EU until yesterday. 
Today we all know how that choice played out.

In this turmoil, this bloodshed that has been going on due to the rising costs of every household item, energy first in line, the media has taken great care in telling us that utility companies have engaged in price gouging. Politicians have created self-serving marketing campaigns demanding money back, to the point of taking action by singling out specific companies and demanding profits back via extra taxation. An understandable proposition by some angles, but also a dangerous precedent.

The bailouts.

That was until today. Finland, Sweden and Switzerland have stepped in, and financed bailout loans to Fortum and Axpo, two of the largest domestic electricity producers, in what by all accounts may be seen as the tip of an incoming iceberg.

CountryEmergency bailout loanParty join date
Finland€10bnSep 6th 2022
Sweden €23.3bnSep 6th 2022
Switzerland€4.1bnSep 6th 2022
UK£40bn Sep 8th 2022
Here is the “gouging” so far.
Look how quickly things change.

Why? They weren’t those companies making ludicrous amounts of money at the expense of families and companies? That’s was the media has been repeating.

Reality is always more complex than what is shown.
And there is always a bigger fish.

In this case the bigger fish are the commodities futures markets. The literal core avenues where commodities are traded for the global market.

Why electricity companies where trading these securities?

Companies which engage in large scale purchases in the commodities market try to manage their risk by buying or selling futures contracts on the various exchanges of pertinence. This gives them ownership and delivery rights for the underlying assets (be it crude oil, or natural gas) at a certain expiration date and for a certain price.

Futures contracts trading is vital in order to balance offer and demand on a large and otherwise decoupled market. Futures are literally the exchange place where commodities are traded on a global scale.

Electricity providers engage in these trades routinely. For example in normal conditions (like when you are not engaged in a freaking war with your commodity provider) futures contracts are vital in order to offset the swinging costs of natural gas due to the changes in seasonality. These tools allow utility providers to secure the delivery of the commodity during the summer, at a discounted price, in order to have it delivered at contract expiration date. Or can be used as protection against falling prices of the commodity.

And futures contract positions involves a certain leverage. Entities which exchange ownership of a contract and establish a buyer-seller relationship are required to deposit margin to guarantee the viability of their investment. Unlike other securities that can also be negotiated on margin but do not materialize any positional gain or loss until the position is settled, futures contracts have the peculiarity of imposing end-of-day clearance.

Owners of futures contracts that went up in value during the trading day are entitled to receive immediate cash payment from their seller. The reverse is true if the contract value goes down. 

If the buyer or the seller have no margin in store to satisfy this cash clearance procedure, that is when a margin call happens. 

Well, due to the extreme volatility of the energy prices, energy companies have accrued large positions in the futures markets. And margin calls are starting to hit.

This is our case here.
That’s why the bailout were handed out, without fanfare and very quickly.

Lehman? Pfff. Step aside.

Reading this, one has to stop and think: would it be possible that there are more companies in desperate need of a bailout? Is there any chance that we are witnessing the very early signs of a delivery of chaos to follow?

(Here’s an introduction on Complex Systems and Chaos if you want more nightmare material).

And you know what? Norwegian energy group Equinor apparently asked the same questions, and has run the numbers. According to their findings, governments bailouts haven’t even started to scratch the surface of the problem. Because the total cost of the margin could amount to at least 1.5 trillion.

One and a half trillions. Euros.

… or US Dollar, doesn’t really matter at this point. 

The small part of the media that got wind of this is calling this the “Europe’s Lehman Brothers moment” and rightfully so. Because the scale of the damage which is ripe to be unleashed on the crippled European Union makes the crash of Lehman Brother in 2008 pale in comparison.

And on top of that, Goldman Sachs produced updated estimates about what the current outlook of the energy crisis will cost to EU households, in terms of cost differential in the next 12 months.

Another 2 trillions.

This comes while EU, USA and China are all, concurrently, dragging the world in what some estimate could go down as the worst economic downturn of the current and the previous century.

I have to be honest. I’m not even sure how to take this in.
At the time I’m writing this, the market has not yet started to account for this set of news. Sure Euro is in the dumps, a severe EU recession starts to be reality, ok. But this new development looks like a being handed an entirely new set of cards.

And I would have preferred to see none of those.

If things materialize as bad as they appear, we will be going through a lot of volatility. And as the chaos unfolds, lots of trade opportunities will show up.
I’ll keep you posted.