Centrica, SSE and Drax shares face strong headwinds amid rising costs

As living costs continue to rise, there have been talks of a windfall tax for UK energy providers. Investors appear unphased about the impact on oil and gas giants like BP and Shell, with both stocks reaching 52-week highs last week. Instead, the news has caused electricity stocks such as Centrica, SSE and Drax Group to fall from their highs.

The UK’s energy regulator Ofgem announced last week that there would likely be a further increase to the price cap on energy bills this winter from £1,871 to £2,800. Prior to 1 April, the cap had been set at £1,277.

Following the announcement on 25 May, the share prices of Centrica [CNA.L], SSE [SSE.L] and Drax Group [DRX.L] all declined 7.3%, 4.6% and 4.5%, respectively, by the close of the next day.

Pressure has been mounting on the UK government to provide assistance to households struggling due to soaring prices. Chancellor Rishi Sunak announced a £15bn support package on 26 May, which will include a one-off £400 grant that will be applied to energy bills from October.

This support package will be partly funded by a “temporary, targeted energy profits levy” of 25% on oil and gas companies. The levy will remain in place until energy prices “return to historically more normal levels”.

Oil and gas firms shake off worries

North Sea oil and gas firms will be able to receive tax breaks worth 91p for every £1 they invest in UK energy supplies, but the likes of BP [BP.L] and Shell [SHEL.L] have hit back at the government.

When announcing its Q1 2022 earnings on 3 May, BP pledged to invest £18bn in the UK’s energy sector by the end of 2030. But the levy has cast doubt on this level of investment with CEO Bernard Looney saying at the AGM on 12 May: “By definition, windfall taxes are unpredictable — and so would challenge investment in home-grown energy.”

BP reported a loss of $20.4bn in the first three months of the year due to a $24.4bn charge incurred after the company exited its stake in Russian-owned petroleum firm Rosneft. Profits in its oil production and operation business more than doubled to $3.8bn.

Shell registered a profit of $9.1bn in Q1 2022, its highest since 2008 and up from $3.2bn in Q1 2021. But, like BP, the producer has been critical of the levy, saying in a statement that it “creates uncertainty about the investment climate”.

Despite this, both the BP and Shell share prices recorded 52-week highs on 26 May and closed the trading week a little over a percentage point lower, suggesting that investors have shrugged off any concerns.

As Hargreaves Lansdown senior investment analyst Susannah Streeter explained: “A chunk of profit might still be scooped from the oil and gas majors. But the energy price levy will still represent just the cream on the top of fat volumes of cash being generated by energy giants due to the higher price of oil.

Overhang for electricity firms

The profits of electricity firms such as British Gas owner Centrica and SSE have been heating up as well. SSE’s underlying operating profits for the 12 months to the end of March were up 15% year-over-year to £1.5bn. Its thermal and gas storage division saw the biggest growth, up 118% to £337m.

“...risk looms over the power sector as well, with a windfall tax on power generators still firmly on the table.” - Citigroup analyst Jenny Ping

Although electricity firms haven’t been slapped with a windfall tax, Sunak could be planning a raid on their profits, saying that he was “urgently evaluating” the situation.

Citigroup analyst Jenny Ping wrote in a research note seen by Bloomberg: “That status looks to be gone. Whilst the precise details remain to be seen – and oil and gas firms are the initial target – risk looms over the power sector as well, with a windfall tax on power generators still firmly on the table.”

This risk has led to a cooldown for UK electricity stocks. The SSE share price set a 52-week high on 18 May and closed 8.7% lower on 30 May. Shares in Centrica similarly closed 13.6% below its 52-week high set on 23 May. Meanwhile, the Drax Group’s share price closed over 22% below its 52-week high set on 7 April.

The threat of a windfall tax could be an overhang for these stocks for some time yet. Electricity firms sell their output in advance and their earnings and profits are yet to reflect the rising energy prices.