The Weakest Link in Germany’s Economic Engine Is Fraying

(Bloomberg) — Germany’s energy security hinges on a utility whose bets on Russian energy are backfiring in the geopolitical standoff over President Vladimir Putin’s invasion of Ukraine.

Most Read from Bloomberg

Amid volatility on gas markets, Uniper SE — created six years ago to run aging fossil-fuel assets — has shown increasing signs of financial strain, raising the prospects that Chancellor Olaf Scholz’s government and parent Fortum Oyj may have to extend the Dusseldorf-based company even more money.

The latest blow came earlier this month when S&P Global Ratings downgraded Uniper to the lowest investment grade, with a “negative” outlook. The energy company had already warned that such a move could prompt lenders to restrict access to credit and peers to demand more collateral to back trades.

“This war in Europe is a watershed — also for Uniper,” Chief Executive Officer Klaus-Dieter Maubach at the company’s annual general meeting on May 18. “No one can predict how the situation will develop in the coming weeks and months.”

The utility, whose name is a mashup of “unique” and “performance,” has emerged as the weakest link in the network that powers Europe’s largest economy. If tensions with Moscow leads to a further squeeze on gas supplies, Uniper would suffer and the ripple effects would hit the industrial companies and local utilities it supplies.

Uniper epitomizes Germany’s cozy relationship with Russia over energy, an issue that Berlin failed to see until tanks rolled toward Kyiv three months ago. Scholz’s government is now trying to unwind decades of dependence, with plans to phase out Russian coal and oil imports by the end of the year. Gas though is trickier, and Uniper is at the center of that reliance.

Read more: Cold War Relic Threatens Europe’s Plans to Ditch Russian Oil

The company’s problems are tied to its creation in 2016. With Germany setting the wheels in motion to gradually shift to wind and solar energy, hulking power plants that burn coal and gas were no longer in vogue. To focus on operating renewable capacity, EON SE pooled these assets into Uniper and spun it off.

With its remit focused on milking these facilities until the end of the fossil-fuel era, Uniper had little incentive to do anything else than seek out the cheapest energy available.

The company continued to cultivate links to Russia, with huge supply contracts and an investment in Gazprom PJSC’s controversial Nord Stream 2 pipeline — which would have bypassed Ukraine to send Russian gas directly to Germany if certification wasn’t halted amid tensions over Ukraine. Uniper bought coal from Moscow and its gas purchases were 13 times more than those of larger German rival RWE AG before Russia’s invasion.

“Uniper is facing real problems right now,” said Patricio Alvarez, a Bloomberg Intelligence analyst. “It is too exposed to the threat of Russia turning off the taps.”

Germany can ill afford to let Uniper stumble. It sent that signal already in January when state-owned development bank KfW extended the company 2 billion euros ($2.1 billion) in loans to help cover margin calls as gas prices shot up, even before the war in Ukraine.

Since then, gas transit via Ukraine has already been curtailed after an important receiving point was put out of service amid the fighting. Russia, which cut off Poland, Bulgaria and Finland, has also curbed flows to Germany in retaliation over Berlin seizing local Gazprom units.

Read more: Germany Girds for Day of Reckoning in Russian Gas Showdown

While these cuts haven’t had a major impact on supplies to Europe, they roil energy markets and the volatility makes Uniper’s trading counterparts nervous as the company would have to cover any shortfalls as prices spike.

“The market has been concerned that if Russian gas stops being delivered to western Europe, for whatever reason, Uniper would still be on the hook to deliver this gas to its customers,” said Sam Arie, head of European utilities research at UBS.

The turmoil for Uniper is compounded by its Unipro unit, which operates five power plants in Russia and accounted for almost a fifth of the utility’s earnings last year. Sanctions, which block access to those profits, and international pressure prompted the company to restart a process to sell the unit.

“Even if Uniper found a buyer for its Russian business, it’s unclear how or when it would be able to get the money outside of Russia,” said Andrew Moulder, senior European utility analyst at CreditSights. “The variation of margin payments in power hedges is also putting stress on the company’s liquidity.”

Uniper’s net-margin requirements were at 4.5 billion euros at the end of March, and liquidity will continue to be a challenge for the company, S&P said. The company has said its discussions with counterparties over additional collateral will determine its liquidity position.

Uniper shares have tumbled 27% since Russia invaded Ukraine, while Fortum has fallen 15% and former parent EON is down 19%. RWE has actually climbed 8%. Bonds issued by Fortum and due in 2029 have lost 12% of their value over the period and were quoted at around 89 cents on the euro on Friday, a value typically considered stressed territory.

Fortum owns about 75% of Uniper. The Finnish government in turn holds 50.8% in Fortum and can’t reduce its stake to less than 50.1% without parliamentary approval. That means it would have to buy shares in any rights issue but state loans might be easier, if an influx of capital is needed.

That’s not the case right now. At the end of March, Fortum — which extended 8 billion euros of credit to its subsidiary in December — had access to 5.9 billion euros of undrawn financing and possessed liquid funds of 6.4 billion euros. While that’s a sizable cushion, Uniper had a negative cash flow of almost 1.9 billion euros in the first quarter and had about 3.8 billion euros in cash at the end of March.

Read more: How Europe Became So Dependent on Putin for Its Gas: QuickTake

Regardless of Fortum’s exposure, Germany has too much at stake to let Uniper fail. Aside from its market power, the company is playing a key role in helping the government set up infrastructure to import liquified natural gas to offset Russian deliveries via pipelines.

“There is a very good and established contact and alignment with the German government,” a Uniper spokesman said in a response to Bloomberg questions on whether it’s seeking more financial help. As the country’s biggest gas import and storage company, Uniper is “highly relevant for Germany’s energy supply going forward.”

Uniper says it’s more financially robust than it was in December, thanks in part to the financial headroom from the KfW and Fortum loans. And the low credit rating is familiar territory as Uniper started its journey at the same level and kept the rating until 2018. Also, the German government is putting legislation in place to allow gas companies to reset prices to customers in case of a supply emergency, which could give Uniper a release valve.

“We will continue to strive for and are committed to take all necessary actions within our powers to protect our investment-grade rating,” Chief Financial Officer Tiina Tuomela said.