Another energy price shock

Energy price shock, bad news for inflation and interest rates

Oil is back above $100 a barrel for the first time since 2022 and it is being reported the UK only has 2 days of gas in storage. However, this has been denied by the government.

After a dull and overcast weekend for much of the UK, fossil fuels (gas) supplied nearly 50% of the UK’s electricity. This feels like history repeating itself after the last ‘energy shock’ in 2022, due to the Ukrainian conflict.

What is changing and how prepared are we?

National Grid has recently agreed to an extended and upgraded 5-year financial framework to March 2031, with electricity regulator Ofgem. This will see National Grid invest £31bn in UK electricity transmission and £9bn in electricity distribution. The investment covers decarbonisation and energy security to accelerate demand growth from datacentres and the rise of AI (artificial intelligence), alongside the electrification of industrial demand.

However, Ofgem has acknowledged that the amount of power being sought by new datacentre projects in the UK could exceed the national current peak electricity consumption. Ofgem has said that there are currently 140 proposed datacentre schemes, driven by demand for AI, which could require 50GW (gigawatts) of electricity. That would be 5GW more than the country’s current peak demand!

Meanwhile, new renewable energy projects are not being connected to the national grid at the pace they are being built to help meet the government’s clean energy targets by the end of the decade. Ofgem said that the work required to connect the sheer number of new datacentres could mean delays for other projects that are critical for decarbonisation and economic growth. As a result, there are concerns that datacentres could drive demand for fossil fuels to meet short-term power needs. This news comes amid concerns over the rising cost of the UK’s electricity.

While the UK is increasingly pivoting towards renewable energy, it is still reliant on fossil fuels.

Recent events in the Middle East and risk to the Strait of Hormuz, from which the UK, Europe and Asia source vast quantities of LNG, add to the challenges. Ofgem recently announced a 7% reduction in the UK energy price cap from April following a mild winter. However, gas prices have spiked, alongside Brent oil, due to attacks on shipping in the Gulf, which does not bode well for the July energy price cap.

In the event of a prolonged war in the Middle East, energy prices could remain elevated, which would feed through into higher inflation. This would not be helpful for UK households or businesses. Markets had been expecting two further interest rate cuts from the Bank of England in 2026, but events in the Middle East appear to have dashed these hopes.

 

What have we been watching?

 

Fears of a more prolonged war in the Gulf spook global government bond and equity markets.

Brent oil surged as much as 25% higher to over $118 a barrel overnight following an Israeli strike on an Iranian oil facility. Fears that the Strait of Hormuz which carries 20% of the world’s oil, could remain closed to oil tankers and concerns that Iran is targeting oil infrastructure and production in neighbouring countries in the Gulf did not help.

This morning, Brent oil has settled back to $104 (+12%) as reports emerged that the G7 is considering a coordinated release of oil from strategic reserves with possibly as much as 300m-400m barrels to be released. Saudi Arabia is also believed to be increasing oil supply via its Red Sea terminal. However, this is only a temporary solution, as the release from the G7 strategic reserve would be equivalent to between 20 to 25 days of lost production from the Gulf region. Oil prices are likely to remain elevated while concerns remain about the Strait of Hormuz and if Iran continues to attack oil facilities in fellow Gulf states. It will also take time for damaged oil and gas infrastructure to be brought back online. Much rests now on America’s ability to guarantee the security of oil tankers through the Strait of Hormuz.

Adding to market concerns was the news that Iran has named the son of Khamenei as his successor, a hardliner with close ties to the Islamic Revolutionary Guard, signalling no change to Iran’s approach to the war. Iranian missile and drone attacks continued over the weekend. Markets have also become more concerned over the weekend about the split between the US and Israel over the eventual goal of the air campaign against Iran. President Trump appears to have shifted his stance from the elimination of Iran’s nuclear and long-range missile capabilities to regime change and fears have increased that we might see a repeat of the 1990-91 Gulf War when US troops invaded Iraq. Meanwhile, Israel wants to destroy the hardline Iranian regime once and for all.

Rising energy costs, with the spike in oil and gas prices, has raised concerns about the outlook for global economic growth and inflation. This has seen government bond yields climb around the world. For example, in the UK, the two -year Gilt yield had recently fallen to the lowest level since 2024, indicative of two further interest rate cuts from the Bank of England. The rise in the two-year yield last week due to events in the Middle East has blown this likelihood out of the water with markets no longer pricing in cuts. Higher oil and gas prices are now starting to impact the UK economy as banks are withdrawing fixed price mortgages and re-pricing them.

Finally, much now rests on events in the Middle East. Meanwhile, AI (artificial intelligence) disruption fears have not disappeared but have been overshadowed. Likewise, credit markets remain under pressure in the US. At the end of last week there were reports that BlackRock had curbed withdrawals from its $26bn private credit funds after client redemptions spiked. The current conflict in the Gulf is increasing risk aversion, and we can expect more volatility in the coming weeks despite Trump accusing PM Sir Keir Starmer of ‘seeking to join wars after we’ve already won.’

 

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