Weekly Bulletin #29
European Energy's "Lehman" Moment - Is There A "Tepper" Play?
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European Energy's "Lehman" Moment - Is There A "Tepper" Play?
Market risk is now arguably at its highest point since March 2020 when COVID crashed global markets. Central banks led by the Federal Reserve look set to continue hiking interest rates to combat inflation, meaning a very real risk of recession via a “hard landing.” And all this is happening as the war in Ukraine continues to escalate and the European energy crisis deepens. As such, now is clearly not the time to be aggressive, but rather to be cautious, thoughtful and patient in searching for opportunities in public equities.
Against this backdrop, in recent weeks I’ve been trying to think ahead of current events in anticipation of future market “sale windows.” In last week’s Bulletin #28, I discussed how there may be a window (or even a wave) of opportunity in Q4 and coming into 2023 as underperforming hedge funds hit by this year’s “tech wreck” will likely see significant investor redemption requests. I expect this to result in forced selling by these hedge funds to meet redemption calls, thereby creating a potential opportunity for value-focused investors to pick up equities at depressed valuations.
I also think another area of possible opportunity is the recently posited “Lehman moment” for the European energy market. This has been a market narrative that has gained traction in recent weeks, following Equinor’s warning that the European energy trading market faces possible collapse with margin calls of at least $1.5 trillion. The warning essentially indicates that the current energy crisis risks turning into a financial crisis that could collapse the wider European economy.
At the core of the issue is how electricity is traded and supplied. European electricity producers (i.e. utilities) typically hedge their sales by going short electricity futures contracts until they actually produce and sell power into the market. This allows these producers to lock in their selling price for the power to be sold. However, as power prices have again surged (due to Russia cutting of the gas supply into Europe), these hedges have resulted in very large paper losses for utilities, requiring them to post additional collateral with their hedge counterparties (brokers, banks or power exchanges).
The feared implication of these margin calls being unmet is economic disaster for Europe, moving quickly from major disruption in power markets, to financial crisis among utilities, banks and power exchanges, to the shutdown and likely collapse of the European manufacturing base and ultimately the European economy. This is the Lehman scenario for European energy, and is another possible instance of financial markets rhyming with history - essentially ongoing losses from electricity contracts and a collapse in energy supply could trigger a European economic crisis, similar to how subprime contagion triggered the GFC in 2008/2009.
Hence the various support measures and bailouts across Europe recently, most notably Germany’s €29bn nationalisation of Uniper, Sweden’s provision of €23bn in credit guarantees as emergency liquidity support to various utilities, Finland’s €10bn loan and guarantee scheme and the UK’s £40bn energy bill bail out for businesses via a price cap plan. To date, the cumulative cost of various emergency support measures has been estimated at ~€500bn - but note this is before winter has even arrived, and before yesterday’s news regarding the possible sabotage of the Nord Stream 1 and 2 pipelines and the threat of a total cut-off of Russian gas into Europe via Ukraine. It therefore remains to be seen whether the measures to date will be sufficient to avoid a Lehman scenario in Europe.
In considering this frightening scenario, it also strikes me that opportunity is often the partner of crisis, and in this context I’m prompted to recall the opportunity amid the original Lehman collapse. Specifically, I’m reminded of David Tepper’s play on US banking stocks in February/March 2009, right near the bottom of the GFC market crash. CNBC recounted Tepper’s rationale for betting on bank stocks at the time:
Tepper was sitting on a pile of cash, having sold out of most of his positions in the spring of 2008, and didn’t have any debt. So when the U.S. Treasury put out a white paper in February 2009 announcing its Financial Stability Plan, which included the Capital Assistance Program designed to shore up the capital of banks, he took his time and read the fine print.
The white paper and term sheet said the preferred stock the government was buying in the banks would be convertible to common shares at prices far above current trading levels at the time — which meant it was indeed a time to buy, buy, buy.
So he did. The fund began amassing sizable positions in bank-related securities: common and preferred shares, and junior-subordinated debt, to be exact. His targets, Bank of America and Citigroup in particular, as rumors circulating that the banking behemoths would be nationalized in early 2009 edged the stocks to near collapse.
Tepper was able to buy Bank of America preferred shares at just twelve cents on the dollar and Citigroup bonds at just nineteen cents. As those stocks rallied by the end of 2009, Appaloosa raked in the billions.
Looking at a chart of five bank common stock positions disclosed as being held by Tepper’s Appaloosa Management around that time (Citigroup, Bank of America, Wells Fargo, Fifth Third Bancorp, Capital One and Hartford Financial), their performance in the subsequent ~15 month period from when the U.S. Treasury published its Financial Stability Plan in February 2009 was an average return of ~344% across this basket of five names:
I believe the Tepper play on banking stocks during the original Lehman crisis is instructive for how investors might approach any Lehman-like moment today in the European energy market.
A current example of such an approach is the Uniper bailout itself which triggered a relief (or escape?) rally for Uniper’s previous majority shareholder Fortum Oyj (FORTUM:FH), which is up ~31% MTD:
To be clear, I do not believe we are at an equivalent moment of apparent collapse for Europe yet as the US financial system was post-Lehman in early 2009, but it is a scenario worth preparing for. Energy is essential for economic activity as the current crisis has proven, and it is perhaps now the ultimate “too big to fail” sector, meaning a Lehman-like scenario could put the European energy sector into play at very depressed valuations with the benefit of government backstops.
My current thinking means I am actively monitoring some selected European energy-related names, specifically in the utilities and energy services sub-sectors where there is some government ownership and diversified business models (i.e. activities spread across traditional energy, transition fuels and renewables, and other adjacent markets).
Any Other Business
Staying on the topic of energy, for this week’s AOB I’m sharing Bloomberg’s Odd Lotts podcast interview with Pierre Andurand from earlier this week, entitled What Europe Needs To Do This Winter.
Andurand is a hedge fund manager and one of the world’s most renowned energy traders, and is the founder and CIO of Andurand Capital, a commodities hedge fund specialising in oil and gas.
In this discussion, he shares his thoughts on how Europe can manage through the energy crisis this winter and perhaps strikes a more optimistic tone than other market commentators today, which is notable given his expertise.
The interview is well worth listening to and can be found here (Bloomberg) and here (Spotify).
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