The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

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Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.

Russia – Will the Bear come in from the cold?

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Macro Letter – No 67 – 9-12-2016

Russia – Will the Bear come in from the cold?

  • In 2015/16 the Russian economy suffered in the sharpest recession since 2008/09
  • The RTSI Stock Index, anticipating a recovery, is up 78% from its January lows
  • Russian government bonds traded at 8% in August down from 16% in December 2014
  • The Ruble has stabilised after the devaluation of 2014/2015 and inflation is still falling

Since January many emerging equity and bond markets have staged a spectacular recovery. Russia has been among the winners, buoyed by hopes of an end to international sanctions and a, relative, rapprochement with the new US administration. A near-virtuous circle is achieved when combined with the country’s strengthening trade relationship with China and the rising oil price, stemming from the first OPEC production agreement in eight years.

Looking at the RTSI Index, a lot of this favourable news is already in the price:-

rtsi_2016_-_moscow_exchange

Source: Moscow Exchange

Since January the RTSI has rallied by 78% and, at 1082 is close to the highs of May 2015 (1092) from whence it broke down to the lows of January (607). Is it too late to join the party? A longer-term chart lends perspective:-

rtsi-1995-2016

Source: Tradingview

By a number of other metrics Russian stocks still look inexpensive. The chart below compares stock market capitalisation to GDP:-

russia-mktcap-to-gdp-guru-focus

Source: Guru Focus

The current ratio is 20%, the average over the period since 2000 is 65% – return to mean would imply a 19.25% annual return for Russian stocks over the next eight years. That would equate to a compound return of 409%.

The table below shows the P/E Ratios of four Russian ETFs as of 8th December:-

Symbol Name P/E Ratio
RSXJ VanEck Vectors Russia Small-Cap ETF 6.07
ERUS iShares MSCI Russia Capped ETF 7.33
RBL SPDR S&P Russia ETF 7.72
RSX VanEck Vectors Russia ETF 8.73

Source: EFTdb.com

For comparison, the iShares MSCI BRIC ETF (BKF) currently trades on a PE of 10 times.

Bonds, Inflation and the Ruble

Russian inflation has been declining rapidly this year as the sharp devaluation of 2014/2015 feeds through. The two charts below shows the USDRUB (black – RHS) and Russian CPI (blue – LHS) and Russian 10 year Government bonds (blue – LHS) versus CPI (black – RHS):-

russia-inflation-cpi-and-usdrub-1-1-14-to-8-12-16

Source: Trading Economics

russia-government-bond-yield-and-cpi-1-1-14-to-8-12-16

Source: Trading Economics

Whilst the Ruble has stabilised at a structurally higher level than prior to the annexation of the Crimea, the inflation rate has been brought back under control by the hawkish endeavours of the Central Bank of Russia. The benchmark one-week repo rate remains at 10%, down from 17% in December 2014 but still well above the rate of inflation – which the Central Bank of Russia forecast to fall to 4% by the end of next year. The yield curve remains inverted but that has not always been a structural feature of the Russian market. The chart below compares the one week repo rate (black – RHS) versus 10yr Government bonds (blue – LHS):-

russia-government-bond-yield-vs-interest-rate-2003-2016

Source: Trading Economics

Economics and Politics

The IMF WEO – October 2016 revised its GDP forecast for Russia in 2017 to +1.1% (versus +0.1% in July) although they revised their 2016 estimate to -0.8% from +0.4%. Focus Economics poll of analysts, forecast 1.2%, whilst Fathom Consulting’s Global Economic Strategic asset Allocation Model (GESAM) is predicting +0.8. Between 1996 and 2016 the average rate of GDP growth was 3.08%. As the chart below shows, the growth rate has been volatile and, like many countries globally, the post 2008/2009 period has been more subdued:-

russia-gdp-growth-annual

Source: Trading Economics, Federal Statistics Service

Oil and Gas

Russia’s largest export markets are Netherlands 11.9%, China 8.3% and Germany 7.4%. Their main exports are oil and gas. The chart below shows the price of Russian gas at the German border over the last 15 years:-

russian_gas_15_year-indexmundi

Source: Indexmundi

Whilst this may be good news for European consumers it has led to considerable political tension. Russia is developing a new gas pipeline – Nord Stream 2 – which will double Russia’s gas export capacity and avoid the geographic obstacle of the Ukraine. It is scheduled to be operational in 2019.

However the EU is developing another gas pipeline – the Southern Gas Corridor, avoiding Russian territory, which is scheduled to be operational in 2020 – to diversify their sources of supply. The Carnegie Moscow Centre – Gazprom’s EU Strategy Is a Dead End – December 6th 2016 takes up the story:-

The EU points out that Ukraine has never violated its gas transit obligations, while Russia shut off the tap during some of the coldest days in 2006 and 2009, and then sharply cut the volume of exports to Europe in late 2014, each time for political reasons. Brussels believes that the real threat to European energy security is not Ukraine but rather the unpredictability of Russian authorities.

US LNG exports are slowly increasing but producers are expected to focus on meeting demand from Japan and other parts of Asia, where prices are higher, first. The Colombia SIPA Center on Global Energy Policy – American Gas to the Rescue – September 2014 – made the following observations which still hold true:-

Although US LNG exports increase Europe’s bargaining position, they will not free Europe from Russian gas. Russia will remain Europe’s dominant gas supplier for the foreseeable future, due both to its ability to remain cost-competitive in the region and the fact that US LNG will displace other high-cost sources of natural gas supply. In our modeling we find that 9 billion cubic feet per day (93 billion cubic meters per year) of gross US LNG exports results in only a 1.5 bcf/d (15 bcm) net addition in global natural gas production. 

By forcing state-run Gazprom to reduce prices to remain competitive in the European market, US LNG exports could have a meaningful impact on total Russian gas export revenue. While painful for Russian gas companies, the total economic impact on state coffers is unlikely to be significant enough to prompt a change in Moscow’s foreign policy, particularly in the next few years.

Oil is a more global market and the 29th November OPEC production agreement, the first that OPEC members have signed in eight years, should help to stabilise global prices – that is assuming that OPEC members do not cheat. Russia, although not a member of OPEC, agreed to reduce production by 300,000 bpd. Russia had just achieved record post-soviet production of 11.1mln bpd in September, they have room to moderate their output:-

rusian-oil-production-2005-2016-bloomberg-energy-ministry

Source: Bloomberg, Russian Energy Ministry

Prospects for 2017

In 2015 tax from oil and gas amounted to 52% of Russian receipts – a stabilisation of the oil price will be a significant fiscal boost next year. Russia has been far from profligate since 2008, it runs a trade and current account surplus and, although the government is in deficit to the tune of 2.6% of GDP this year, the government debt to GDP ratio is a very manageable 17.17%.

Looking ahead to 2017 Brookings – The Russian economy inches forward – highlights a number of features which support optimism for the future:-

…the country seems to have turned the corner and growth is expected to be positive in 2017-2018. One key reason is that over the last two years, the government’s policy response package of a flexible exchange rate policy, expenditure cuts in real terms, and bank recapitalization—along with tapping the Reserve Fund—has helped buffer the economy against multiple shocks.

…The banking sector has also now largely stabilized. The consolidated budget of regional governments even registered a surplus in the first eight months of 2016. Indeed, on the back of projected rising oil prices, we expect the economy to enter positive territory in 2017 and 2018, reaching 1.5-1.7 percent.

With a growing federal fiscal deficit (3.7 percent of GDP by end 2016), one proactive step the government has taken is to reintroduce a three-year, medium-term fiscal framework, which proposes to cut the deficit by about 1 percent each year ultimately leading to a balanced budget by 2020. The budget is conservatively costed at a $40 per barrel oil price, and cuts are driven mostly by a reduction in expenditures in mostly defense/military and social policy. If adhered to, this medium-term framework will be an important step toward reducing overall policy uncertainty. 

China (and India)

In the longer term a major focus of Russian economic policy has, and continues to be, the development of trade with China. The first Russo-Chinese partnership agreements were signed in 1994 and 1996, followed by the Treaty of Friendship and Cooperation in 2001 and the Strategic Partnership in 2012 which was superseded by a further agreement in 2014 – signed by President Xi. Ratified shortly after the annexation of the Crimea and imposition of sanctions by the US and EU, the latest agreement has substance. Here are some of the more prominent deals which have emerged from the closer cooperation:-

  • Gazprom and China National Petroleum Corporation (CNPC) announced a 40 year gas supply deal, including plans to build the “Power of Siberia” gas pipeline.
  • Rosneft agreed to supply CNPC with $500bln of oil, potentially making Russia, China’s largest supplier of oil, surpassing Saudi Arabia. The Eastern Siberia-Pacific Ocean oil pipeline will be connected to Northeast China next year and a pipeline linking Siberia’s Chayandinskoye oil and gas field to China comes online in 2018.
  • The Central Bank of Russia signed a RUB 815bln swap agreement with the PBoC to boost bilateral trade. They had previously contracted business in US$.

The Diplomat – Behind China and Russia’s ‘Special Relationship’ – investigates the impact this new cooperation is beginning to have:-

…Russia has become one of the five largest recipients of Chinese outbound direct investment in relation to the Chinese government’s Belt and Road Initiative (BRI) connecting Asia with Europe. Meanwhile, China was Russia’s largest bilateral trade partner, in 2015; in spite of declining overall bilateral trade in U.S. dollar terms (mainly due to sharp declines in the ruble as well as the yuan), relative to 2014, trade flows continued to expand in terms of volume.

In this context, it was significant that Russia’s exports of mechanical and technical products to China rose by about 45 percent over the course of 2015 possibly signifying an important trend in the diversification and competitiveness of Russia’s non-energy sector in terms of bilateral trade prospects with China.

The Diplomat goes on to highlight the improved and increasing importance of Russian trade with India:-

The Russia-India-China (RIC) trilateral grouping is considered by its participants as an important arrangement in securing political stability, both globally and in the region. India and Russia’s relations have remained strong for several decades, with Russia being India’s largest defense and nuclear energy partner. However, while China’s and Russia’s relations have clearly improved in the last few years, the China-India relationship has somewhat lagged the development of the other two legs of the triangle. Consequently, Russia has played a role in bringing both sides closer together through its interactions in the RIC grouping.

The Trump Card?

US pre-election rhetoric from the Trump campaign suggested a less combative approach to Russia. Trump said he would “look into” recognising Crimea and removing sanctions, however, Republican hawks in Congress will want to have their say. Syria may be the key to a real improvement in relations – don’t hold your breath.

Conclusion and Investment Opportunities

The Ruble has stabilised and whilst Russia has some external debt the amount is not excessive. The effect of the devaluation of 2014/2015 has run its course and inflation is forecast to decline further next year. It may weaken against the US$ in line with other countries but is likely to be range-bound, with a potential upward bias, against its major trading partners.

The Central Bank of Russia has maintained tight grip short term interest rates, leaving it room to reduce rates, perhaps, as soon as Q1 2017. Russian government bond yields halved since their highs of 16% in late 2014, but have risen by around 60bp since August following the trend in other global bond markets. With short term interest rates set to decline, the inversion of the yield curve is likely to unwind, but this favours shorter dated, lower duration bonds – there is also a risk of forced liquidation by international investors, if US and other bond markets should decline in tandem.

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord. The VanEck Vectors Russia Small-Cap ETF (RSXJ) has very little exposure to oil and gas and therefore reflects a less commodity-centric aspect of the Russian economy. The chart below covers the five years since 2011. It has risen further than the major indices since January yet still trades at a lower PE ratio:-

rsxj-index-yahoo

Source: Yahoo Finance

Like the RTSI Index the small-cap ETF looks over-bought, however, the economic recovery in Russia appears to be broad-based, Chinese growth, in response to further fiscal stimulus, has increased and the oil price has (at least for the present) stabilised around $50/bbl. If you do not have exposure to Russia, you should consider an allocation. There may be better opportunities to buy, but waiting for trends to retrace can leave you feeling like Tantalus. The last two bull-markets – January 2009 to March 2011, and July 2004 to May 2008 – saw the RTSI Index rally 315% and 382% respectively. In the aftermath of the Russian crisis of 1998 the index rose from 61 to 755 in less than six years (1,138%). Don’t be shy but also keep some power dry.

Australia and Canada – Commodities and Growth

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Macro Letter – No 30 – 20-02-2015

Australia and Canada – Commodities and Growth

  • Industrial commodities continue to weaken
  • The BoC and RBA have cut official rates in response to falling inflation and slower growth
  • The RBA has more room to manoeuvre in cutting rates, Australian Bonds will outperform

The price of Crude Oil has dominated the headlines for the past few months as Saudi Arabia continued pumping as the price fell in response to increased US supply. However, anaemic growth in Europe and a continued slowdown in China has taken its toll on two of the largest commodity exporting countries. This has prompted both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) to cut interest rates by 25 bp each – Canada to 0.75% and Australia to 2.25% – even as CAD and AUD declined against the US$.

In this letter I will look at Iron Ore, Natural Gas and Coal, before going on to examine other factors which may have prompted central bank action. I will go on to assess the prospects for asset markets over the coming year.

Iron Ore

The price of Iron Ore continues to make fresh lows, driven by weakness in demand from China and Japan and the EU.

Iron Ore Fines 6 yr

Source: Infomine.com

Iron Ore is Australia’s largest export market, significantly eclipsing Coal, Gold and Natural Gas. It is the second largest producer in the world behind China. 2013 production was estimated at 530 Mt. Canada, with 40 Mt is ranked ninth by production but is the fourth largest exporter. Needless to say, Iron Ore production is of significant importance to both countries, although for Canada Crude Oil comes first followed by vehicle and vehicle parts, then Gold, Gas – including Propane – and Coal. It is also worth noting that the two largest Steel exporters are China and Japan – both major Iron Ore importers. The health of these economies is vital to the fortunes of the Iron Ore industry.

Natural Gas

Natural Gas is a more difficult product to transport and therefore the price differential between different regions is quite pronounced. Japan pays the highest price of all the major economies – exacerbated by its reduction of nuclear generating capacity – closely followed by Singapore, Taiwan and South Korea. The US – Henry Hub – and AECO – Alberta – prices are broadly similar, whilst Europe and Japan pay a significant premium:-

Chart-4-Global-Natural-Gas-Prices11

Source: Federal Reserve, World Bank, CGA

Here is an extract from the International Gas Union report – IGU Wholesale Gas Price Survey Report – 2014 Edition:-

Wholesale prices can obviously vary significantly from year to year, but the top two regions are Asia Pacific followed by Europe – both with average prices over $11.00. OPE* remains the primary pricing mechanism in Asia Pacific and still a key mechanism in Europe.

*Oil Price Escalation – in this type of contract, the price is linked, usually through a base price and an escalation clause, to competing fuels, typically crude oil, gas oil and/or fuel oil. In some cases coal prices can be used as can electricity prices.

Canada has significant Gas reserves and is actively developing Liquefied Natural Gas (LNG) capacity. 13 plant proposals are underway but exports are still negligible. It also produces significant quantities of Propane which commands a premium over Natural Gas as this chart shows: –

Chart-5-Energy-Commodity-Prices10

Source: StatsCan, Kent Group, CGA

Australia, by comparison, is already a major source of LNG production. The IGU – World LNG Report – 2014 Edition:-

Though Australia was the third largest LNG capacity holder in 2013, it will be the predominant source of new liquefaction over the next five years, eclipsing Qatari capacity by 2017. With Pluto LNG online in 2012, seven Australian projects are now under construction with a total nameplate capacity of 61.8 MTPA (53% of global under construction capacity).

Coal

Australia is the fourth largest Coal producer globally. According to the World Coal Association, it produced 459 Mt in 2013. Canada did not feature in the top 10. However when measured in terms of Coking Coal – used for steel production – Australia ranked second, behind China, at 158 Mt whilst Canada ranked sixth at 34 Mt.

The price of Australian Coal has been falling since January 2011 and is heading back towards the lows last seen in 2009, driven primarily by the weakness in demand for Coking Coal from China.

Australian Coal Price - Macro Business 2012 - 2014

Source: Macro Business

This is how the Minerals Council of Australia describes the Coal export market:-

Coal accounted for almost 13 per cent of Australia’s total goods and services exports in 2012-13 down from 15 per cent in 2011-12. This made coal the nation’s second largest export earner after iron ore. Over the last five years, coal has accounted, on average, for more than 15 per cent of Australia’s total exports – with export earnings either on par or greater than Australia’s total agricultural exports.

Australia’s metallurgical coal export volumes are estimated at 154 million tonnes in 2012-13, up 8.5 per cent from 2011-12. However, owing to lower prices the value of exports decreased by almost 27 per cent to be $22.4 billion in 2012-13.

Whilst the scale of the Coal industry in Canada is not so vast, this is how the Coal Association of Canada describes Canadian Coal production:-

Production

Canada produced 60 million close to 67 million tonnes (Mt) of coal in 2012. 31 million tonnes was metallurgical (steel-making) coal and 36 million tonnes (Mt) was thermal coal. The majority of coal produced in Canada was produced in Alberta and B.C.

Alberta produced 28.3 Mt of coal in 2012

British Columbia produced 28.8 Mt (most was metallurgical coal) – 43% of all production

To meet its rapid infrastructure growth and consumer demand for things such as vehicles and home appliances, Asia has turned to Canada for its high-quality steel-making coal. As Canada’s largest coal trading partner, coal exports to Asia accounted for 73% of total exports in 2010.

Steel-Making Coal

Global steel production is dependent on coal and more and more the world is turning to Canada for its supply of quality steel-making coal.

The production of steel -making coal increased by 5.5% from 29.5 Mt in 2011 to 31.1 Mt in 2012.

Almost all of Canada’s steel-making coal produced was exported.

Thermal Coal

Approximately 36 million tonnes of thermal coal was produced in 2012.

The vast majority of Canadian thermal coal produced is used domestically.

Currency Pressures

Until the autumn of 2014 the CAD was performing strongly despite weakness in several of its main export markets as the chart below of the Canadian Effective Exchange Rate (CERI) shows:-

CAD CERI - 1yr to sept 2014

Source: Business in Canada, BoC

Since September the CERI index has declined from around 112 to below 100.

For Australia the weakening of their trade weighted index has been less extreme due to less reliance on the US. There is a sector of the RBA website devoted the management of the exchange rate, this is a chart showing the Trade Weighted Index and the AUDUSD rate superimposed (RHS):-

AUD_effective_and_AUDUSD_-_RBA

Source: RBA, Reuters

Taking a closer look at the monthly charts for USDCAD:-

canada-currency

Source: Trading Economics

And AUDUSD:-

australia-currency

Source: Trading Economics

These charts show the delayed reaction both currencies have had to the decline in the price of their key export commodities – they may fall further.

Central Bank Policy

The chart below shows the evolution of BoC and RBA policy since 2008. Australian rates are on the left hand scale (LHS), Canadian on the right:-

australia and canadian -interest-rate 2008 - 2015

Source: Trading Economics

To understand the sudden change in currency valuation it is worth reviewing the central banks most recent remarks.

The BoC expect Oil to average around $60/barrel in 2015. Here are some of the other highlights of the latest BoC monetary policy report:-

The sharp drop in global crude oil prices will be negative for Canadian growth and underlying inflation.

Global economic growth is expected to pick up to 3 1/2 per cent over the next two years.

Growth in Canada is expected to slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015.

Canada’s economy is expected to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016, with a return to full capacity around the end of 2016, a little later than was expected in October.

Total CPI inflation is projected to be temporarily below the inflation-control range during 2015 because of weaker energy prices, and to move back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.

On 21 January 2015, the Bank announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent.

…Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016.

The RBA Statement on Monetary Policy – February 2015 provides a similar insight into the concerns of the Australian central banks:-

…Australia’s MTP growth is expected to continue at around its pace of recent years in 2015 as a number of effects offset each other. Growth in China is expected to be a little lower in 2015, while growth in the US economy is expected to pick up further. The significant fall in oil prices, which has largely reflected an increase in global production, represents a sizeable positive supply shock for the global economy and is expected to provide a stimulus to growth for Australia’s MTPs. The fall in oil prices is also putting downward pressure on global prices of goods and services. Other commodity prices have also declined in the past three months, though by much less than oil prices. This includes iron ore and, to a lesser extent, base metals prices. Prices of Australia’s liquefied natural gas (LNG) exports are generally linked to the price of oil and are expected to fall in the period ahead. The Australian terms of trade are expected to be lower as a result of these price developments, notwithstanding the benefit from the lower price of oil, of which Australia is a net importer.

…Available data since the previous Statement suggest that the domestic economy continued to grow at a below-trend pace over the second half of 2014. Resource exports and dwelling investment have grown strongly. Consumption growth remains a bit below average. Growth of private non-mining business investment and public demand remain subdued, while mining investment has fallen further. Export volumes continued to grow strongly over the second half of 2014, driven by resource exports. Australian production of coal and iron ore is expected to remain at high levels, despite the large fall in prices over the past year. The production capacity for LNG is expected to rise over 2015. Service exports, including education and tourism, have increased a little over the past two years or so and are expected to rise further in response to the exchange rate depreciation.

…Household consumption growth has picked up since early 2013, but is still below average. Consumption is being supported by very low interest rates, rising wealth, the decision by households to reduce their saving ratio gradually and, more recently, the decline in petrol prices. These factors have been offset to an extent by weak growth in labour income, reflecting subdued conditions in the labour market. Consumption growth is still expected to be a little faster than income growth, which implies a further gradual decline in the household saving ratio.

…Prior to the February Board meeting, the cash rate had been at the same level since August 2013. Interest rates faced by households and firms had declined a little over this period. Very low interest rates have contributed to a pick-up in the growth of non-mining activity. The recent large fall in oil prices, if sustained, will also help to bolster domestic demand. However, over recent months there have been fewer indications of a near-term strengthening in growth than previous forecasts would have implied. Hence, growth overall is now forecast to remain at a below trend pace somewhat longer than had earlier been expected. Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained. In addition, while the exchange rate has depreciated, it remains above most estimates of its fundamental value, particularly given the significant falls in key commodity prices, and so is providing less assistance in delivering balanced growth in the economy than it could.

Given this assessment, and informed by a set of forecasts based on an unchanged cash rate, the Board judged at its February meeting that a further 25 basis point reduction in the cash rate was appropriate. This decision is expected to provide some additional support to demand, thus fostering sustainable growth and inflation outcomes consistent with the inflation target.

Real Estate

Neither central bank makes much reference to the domestic housing market. Western Canada has been buoyed by international demand from Asia. Elsewhere the overvaluation has been driven by the low interest rates environment. Overall prices are 3.1% higher than December 2014. Vancouver and Toronto are higher but other regions are slightly lower according to the January report from the Canadian Real Estate Association . The chart below shows the national average house price:-

 

 

Canada natl_chartA04_hi-res_en

Source: Canadian Real estate Association

The Australian market has moderated somewhat during the last 18 months, perhaps due to the actions of the RBA, raising rates from 3% to 4.75% in the aftermath of the Great Recession, however, the combination of lower RBA rates since Q4 2011, population growth and Chinese demand has propelled the market higher once more. Prices in Western Australia have moderated somewhat due to the fall in commodity prices but in Eastern Australia, the market is still making new highs. The chart below goes up to 2014 but prices have continued to rise, albeit moderately (less than 2% per quarter) since then:-

Australian House Prices 2006 - 2014

Source: ABS

This chart from the IMF/OECD shows global Price to Income ratios, Canada and Australia are still at the expensive end of the global range:-

House pricetoincome IMF

Source: IMF and OECD

The lowering of official rates by the BoC and RBA will not help to alleviate the overvaluation.

Bonds

This chart shows the monthly evolution of 10 year Government Bond yields since 2008 in Australia (LHS) and Canada (RHS):-

australia-canada-government-bond-yield

Source: Trading Economics

Whilst the two markets have moved in a correlated manner Canadian yields have tended to be between 300 and 100 bp lower over the last seven years. The Australian yield curve is flatter than the Canadian curve but this is principally a function of higher base rates. Both central banks have cut rates in anticipation of lower inflation and slower growth. This is likely to support the bond market in each country but investors will benefit from the more favourable carry characteristics of the Canadian market.

Stocks  

To understand the differential performance of the Australian and Canadian stocks markets I have taken account of the strong performance of commodity markets prior to the Great Recession, in the chart below you will observe that both economies benefitted significantly from the rally in industrial commodities between 2003 and 2008. Both stock markets suffered severe corrections during the financial crisis but the Canadian market has steadily outperformed since 2010:-

canada australian -stock-market 2000-2015

Source Trading Economics

This outperformance may have been due to Canada’s proximity to, and reliance on, the US – 77% of Exports and 52% of Imports. The Australian economy, by contrast, is reliant on Asia for exports – China 27%, Japan 17% – however, I believe that the structurally lower interest rate regime in Canada is a more significant factor.

Conclusions and investment opportunities

With industrial commodity prices remaining under pressure neither Canada nor Australia is likely to exhibit strong growth. Inflation will be subdued, unemployment may rise. These are the factors which prompted both central banks to cut interest rates in the last month. However, both economies have been growing reasonable strongly when compared with countries such as those of the Eurozone. Canada GDP 2.59%, Australia GDP 2.7%.

The BoC has little room for manoeuvre with the base rate at 0.75% but the RBA is in a stronger position. For this reason I believe the AUD is likely to weaken against the CAD if world growth slows, but the negative carry implications of this trade are unattractive.

Canadian Real Estate is more vulnerable than Australia to any increase in interest rates – although this seems an unlikely scenario in the near-term – more importantly, in the longer term, Canadian demographics and slowly population growth should alleviate Real Estate demand pressure. In Australia these trends are working in the opposite direction. Neither Real Estate market is cheap but Australia remains better value.

The Australian All-Ordinaries should outperform the Canadian TSX as any weakness in the Australian economy can be more easily supported by RBA accommodation. The All-Ordinaries is also trading on a less demanding earnings multiple than the TSX.

The RBA’s greater room to ease monetary conditions should also support the Australian Government Bond market, added to which the Australian government debt to GDP ratio is an undemanding 28% whilst Canadian debt to GDP is at 89%. The Canadian curve may offer more carry but the RBA ability to ease policy rates is greater. My preferred investment is in Australian Government Bonds. Both Canadian and Australian 10 year yields have risen since the start of February. The last Australian bond retracement saw yields rise 46 bp to 3.75% in September 2014. Since the recent rate cut yields have risen 30 bp to a high of 2.67% earlier this week. Don’t wait too long for better levels.

German growth prospects – the ECB and Russian gas

400dpiLogo

Macro Letter – No 19 – 12-09-2014

German growth prospects – the ECB and Russian gas

  • The ECB cut rates and implemented the first phase of OMT
  • Russia continues to retaliate against European sanctions
  • European Natural Gas prices have risen but shortages seem unlikely

Last week I started researching the risks to German growth of a gas embargo by Russia. This could become a reality if the geo-political situation in the Ukraine should deteriorate further. Before I could put pen to paper, ECB Governor Mario Draghi had implemented a pre-emptive strike; cutting the repo rate to 0.05% and announcing the ECBs intention to embark on outright monetary transactions (OMT) initially in the asset backed securities (ABS) market. The ECB – Statement – provides fuller details. It’s still a little light on content but JP Morgan estimates that the ECB will purchase Eur 47bln of newly issued ABS securities over a three year period.

Whilst these measures stopped short of purchasing Eurozone (EZ) sovereign bonds, European government bond markets reacted favourably. French T-Bill rates turned negative, so too did the yield on 2 year Irish Gilts. The Spanish, not to be outdone, issued 50 year Bonos at a yield of 4%.

Here is a table of some European short term rates from Monday 8th September: –

 

Security Yield Spread vs Germany Inflation Real Yield
Austria 1Y -0.032 0.027 1.8 -1.832
Belgium 3M -0.05 0.029 0 -0.05
Belgium 6M -0.025 0.038 0 -0.025
Belgium 1Y -0.043 0.016 0 -0.043
Bulgaria 1Y 1 1.059 -1 2
Croatia 6M 0.95 1.013 -0.1 1.05
Croatia 9M 1.15 1.218 -0.1 1.25
Croatia 1Y 1.38 1.439 -0.1 1.48
Czech Republic 3M 0.01 0.089 0.5 -0.49
Czech Republic 6M 0.03 0.093 0.5 -0.47
Czech Republic 1Y 0.11 0.169 0.5 -0.39
Denmark 3M -0.06 0.019 0.8 -0.86
Denmark 6M -0.01 0.053 0.8 -0.81
Denmark 1Y 0.15 0.209 0.8 -0.65
France 3M -0.027 0.052 0.5 -0.527
France 6M -0.03 0.033 0.5 -0.53
France 9M -0.011 0.057 0.5 -0.511
France 1Y -0.029 0.03 0.5 -0.529
Germany 3M -0.079 0 0.8 -0.879
Germany 6M -0.063 0 0.8 -0.863
Germany 9M -0.068 0 0.8 -0.868
Germany 1Y -0.059 0 0.8 -0.859
Greece 3M 1.47 1.549 -0.7 2.17
Greece 6M 1.86 1.923 -0.7 2.56
Hungary 3M 1.52 1.599 0.1 1.42
Hungary 6M 1.55 1.613 0.1 1.45
Hungary 1Y 1.84 1.899 0.1 1.74
Ireland 1Y 0.08 0.139 0.3 -0.22
Italy 3M 0.083 0.162 -0.1 0.183
Italy 6M 0.144 0.207 -0.1 0.244
Italy 9M 0.193 0.261 -0.1 0.293
Italy 1Y 0.217 0.276 -0.1 0.317
Latvia 3M 0.2 0.279 0.8 -0.6
Latvia 6M 0.374 0.437 0.8 -0.426
Latvia 1Y 0.258 0.317 0.8 -0.542
Lithuania 6M 0.3 0.363 0.2 0.1
Lithuania 1Y 0.4 0.459 0.2 0.2
Netherlands 3M -0.072 0.007 1 -1.072
Netherlands 6M -0.092 -0.029 1 -1.092
Norway 3M 1.259 1.338 2.2 -0.941
Norway 6M 1.118 1.181 2.2 -1.082
Norway 9M 1.248 1.316 2.2 -0.952
Norway 1Y 1.276 1.335 2.2 -0.924
Poland 3M 2.65 2.729 -0.2 2.85
Poland 1Y 2.044 2.103 -0.2 2.244
Portugal 6M 0.15 0.229 -0.9 1.05
Romania 6M 2.289 2.352 1 1.289
Romania 1Y 2.25 2.309 1 1.25
Spain 3M 0.058 0.137 -0.5 0.558
Spain 6M 0.072 0.135 -0.5 0.572
Spain 1Y 0.153 0.212 -0.5 0.653
Sweden 3M 0.211 0.29 0 0.211
Sweden 6M 0.202 0.265 0 0.202
Switzerland 3M -0.11 -0.031 0.1 -0.21
Switzerland 6M -0.05 0.013 0.1 -0.15
Switzerland 1Y 0.05 0.109 0.1 -0.05
UK 3M Yield 0.43 0.509 1.6 -1.17
UK 6M Yield 0.546 0.609 1.6 -1.054
UK 1Y Yield 0.509 0.568 1.6 -1.091

Source: Investing.com and Trading Economics

I have omitted Finland since I was unable to locate prices for shorter maturity than 2 year. Two year Finnish bonds yield -0.026% and inflation is running at +0.8%.

Europe and its periphery are benefitting from low or negative real interest rates. Even this seems insufficient to stimulate robust, sustainable growth.

The Economic Cost of Geo-politics

When I last wrote about the Ukraine earlier this year, I concluded: –

I believe the Ukrainian situation may reduce the likelihood of a rapid increase in tapering by the Fed and increase the prospects for ECB Outright Monetary Transactions. In aggregate that amounts to more QE which should support stocks and higher yielding bonds.

To date, the economic impact on Europe has been limited. The fed have continued to taper in the face of a robust recovery from weak US Q1 GDP data. The EZ, however, has struggled to follow the US lead and the ECB has been forced to act repeatedly to avert further disinflation.

As we head into the winter, it seems an appropriate time to review European Natural Gas, in light of the escalation of tension between Russia and NATO. This is especially pertinent to Germany where, along with its north European neighbours, winter Natural Gas demand is three times greater than during the summer.

This week has seen an escalation of European sanctions against Russia. The European Commission (EC) has curtailed the ability of three of the largest Russian Oil companies to raise capital beyond a one month maturity. Since around half of all longer term gas contracts are priced in relation to the oil price this seems a strange way to avoid disrupting the European gas price. The Russian’s have responded by threatening to ban aircraft access to Russian airspace and, more significantly, to disrupt gas supplies. The Financial Times – Russia aims to choke off gas re-exports to Ukraine picks up on this theme: –

In an effort to offset lost volumes from Russia, Ukraine has sought to secure more gas from the EU, principally through “reverse flows” – re-exports of Russian gas via countries such as Poland, Hungary and Slovakia. But Gazprom, Russia’s state gas company, has long complained about the re-exports, with Alexei Miller, its chief executive, denouncing them as a “semi-fraudulent mechanism”. Senior officials in the European Commission and in eastern European governments say Russia has been raising the prospect of reducing export volumes so their customers have no gas left over for reverse flows to Ukraine. “They say this pretty openly,” said one central European ambassador.

To understand the importance of Russian energy exports to Europe the following table is a useful guide: –

Main origin of primary energy imports - Source EuroStat

Source: Eurostat

An insight into EU energy policy is provided by the European Commission – Energy Economic Developments in Europepublished in Q1 2014. The section on Natural Gas starts at Page 33:-

In the European Union the majority of natural gas is supplied through bilateral long-term contracts which are negotiated between two parties, importer and exporter, and traditionally indexed to the price of oil. Currently, half of natural gas supply in the EU is still indexed to oil while across the EU a wide variation in import prices of piped gas and LNG has been observed. This is remarkable as at the same time a growing share of gas is traded on spot markets where short-term contracts are concluded on the basis of the market price determined by actual demand and supply. Spot market prices in the EU have been constantly lower than long-term contracts’ prices, at least since 2005.

In both the US and in the EU, spot-market gas prices have progressed in a similar fashion over the past decade and have followed the movements in the oil price.

In 2005, however, these gas prices have started to clearly fall below the level of the oil price. Between 2008 and 2009 they fell significantly in both regions, likely as a consequence of declining demand due to the economic downturn.

The fall in energy consumption has led to an excess supply of gas on the gas markets around the world and both US and the UK spot markets temporarily converged, trading at around 4/5 USD/MBtu in mid-2009, while the German hub prices fell less evidently, trading still above 8 USD/MBtu in 2009. From 2007 onwards, the US gas spot price has fallen under the price level of the other gas spot markets, which most likely reflects the effect of the surge in domestic shale gas supply. This becomes quite clear after 2009, when energy consumption picked up again following the recovery of the economy. Statistics from more recent years show that while the US spot prices remained low (around 4 USD/Btu in 2011), the EU spot prices (both in the UK and German hub) kept increasing. Wholesale gas prices have continued to rise in the EU while economic activity contracted and consequently natural gas consumption in the EU has been declining: the first half of 2012 represented the EU’s lowest first half year consumption of the last ten years. It was 7% and 14% less than the first half of 2011 and 2010 respectively.

The continued rise in EU wholesale gas prices despite the slump in gas demand and the lower gas spot prices vividly depicts the kind of vulnerability the EU is exposed to due to its high import dependency: as the Asian markets offer higher returns and more robust demand, gas producing countries have increased their trade with Asia lowering supply to Europe. As a consequence wholesale gas prices in Europe have increased while in the US, which now can rely more heavily on domestic production, prices have remained low. US prices were shielded from potential upwards pressure from export demand because of export restrictions (generally expected to be gradually lifted). Furthermore, the impacts on the EU have been further aggravated in this context due to the oil-price indexation of many long-term gas import contracts.

This chart from Schneider Electric shows the divergence in gas prices between US (yellow) EU (red) and Asia (blue): –

Natural Gas price comparison - Schneider Electric-page1

Source: Schneider-Electric

European Natural Gas prices are down from their December 2013 highs but have recently started to recover from the July 2014 lows. The chart below is for Dutch TTF (Title Transfer Facility) Gas: –

TTF Gas Daily Reference Prices - source EEX

Source: EEX

By way of comparison here are the one year charts for US Natural Gas and West Texas Intermediate Crude Oil: –

US Spot Nat Gas 1 yr

Source: Barchart.com

Understandably, the US Natural gas market is less concerned about Russian sanctions, and also cognisant of the long lead time between receiving an export license and the US capacity to increase exports of LNG.

WTI Spot 1 yr

Source: Barchart.com

The US Crude Oil market is seemingly unperturbed by the politics of Russia or the Middle East. Or, perhaps, it is the combination of continuous improvements in US supply coupled with rising concern about the slowing of China. A similar pattern is evident in the Brent Crude price.

Returning to Europe: establishing a generic price for European Natural Gas is difficult as this article from Natural Gas Europe – European Natural Gas: So What’s the Real Price? explains. It is also worth noting the seasonality in gas prices. The last major spikes occurred in February/March 2013 and January/February 2012, coinciding with the advent of cold European winter weather.

The EU Commission and national governments are taking no chances this year, as this article from Reuters –  Europe drafts emergency energy plan with eye on Russia gas shut-down makes plain:-

A source at the EU Commission said it was considering a ban on the practise of re-selling to bolster reserves.

“In the short-term, we are very worried about winter supplies in southeast Europe,” said the source, who has direct knowledge of the Commission’s energy emergency plans.

“Our best hope in case of a cut is emergency measure 994/2010 which could prevent LNG from leaving Europe as well as limit industrial gas use in order to protect households,” the source said.

European Union Regulation number 994/2010, passed in 2010 to safeguard gas supplies, could include banning gas companies from selling LNG tankers outside of Europe, keeping more gas in reserve, and ordering industry to stop using gas.

The Russian threat to reduce gas supplies to the EU in order to reduce the re-sale of gas to other countries seems rather hollow when the EC would appear to be preparing to take these steps anyway. Nonetheless, if Russia reduces supply what can the EU importing countries do?

Norway is not in a position to make up the shortfall. 96% of Norwegian gas is already exported. At the Flame gas conference in Amsterdam this May, Statoil spokesman Rune Bjornson told delegates, “I think many producers, including us, can adjust on the margins, but most of the production capacity from Norway is typically designed to produce at maximum in winter and that is what we’ll do.”

European governments have, however,  been actively improving storage capabilities. This process has been on-going since the first Russian/Ukrainian dispute in 2006 – according to recent estimates EU-28 storage is at 90% of capacity which is around 74 bcm. Businessweek – EU Need for Russian Gas Via Ukraine Wanes as Stores Fill gives a good overview: –

EU-28 Gas Storage-Bloomberg

Source: Bloomberg

Europe’s reliance on Russian natural gas shipments via Ukraine is declining after the region pumped a record volume of the fuel into underground inventories, minimizing the risk of shortages during the coming winter.

Given that Geo-politics seems to have had little impact on the performance of world financial markets in the long run should we be worried in the short run and especially with respect to Germany this winter?

The Council for Foreign Relations – The Geopolitical Paradox: Dangerous World, Resilient Marketsopines on this subject this week. The article is concerned mainly about disruption to the oil market: –

It is often noted that the vast majority of postwar recessions have been associated with energy shocks. Rising turbulence in the Middle East has raised the prospect of a long-term disruption in the region, where national borders could be rewritten through violent upheavals. The threat of a Russian cutoff of gas to Europe also hangs over markets. Consequently, it is surprising that energy markets, and oil markets in particular, do not ask for a premium in futures markets for secure energy supplies. At present, current oil contracts are higher than longer-term futures contracts, and though there are technical reasons for this downward trend (“backwardation”), it hardly is suggestive of disrupted or anxious markets.

They go on to discuss Europe describing it as the weak link: –

There are a number of reasons why Europe is the channel through which political risk could reverberate in the global economy. Europe is most vulnerable to disruptions in trade and financial relationships with Russia, though I have argued elsewhere that these costs may be small relative to the costs of inaction. Weak growth in China and elsewhere in the emerging world could significantly affect exports, particularly in Germany. Significantly, though, Europe also faces these challenges at a time of economic stress and limited resilience. Growth in the region has disappointed and leading indicators have tilted downward. Further, concern about deflation is beginning to weigh on sentiment and investment. The persistence of low inflation—well below the ECB’s goal of around 2 percent—is symptomatic of deeper structural problems facing the eurozone, including an incomplete monetary union, deep-seated competitiveness problems in the periphery, and devastatingly high unemployment. Homegrown political risks also threaten to add to the turmoil, as rising discontent within Europe over the costs of austerity is undermining governing parties and fueling populism. The result is a monetary union with little capacity or resilience to defend against shocks. The ECB has responded to these risks with interest-rate cuts and asset purchases, and is expected to move to quantitative easing later this year or early next, but the move comes late, and is unlikely to do more than address the headwinds associated with the ongoing banking reform and continued fiscal austerity. Overall, a return to crisis is an increasing concern and political risks could be the trigger.

The limited impact on financial markets since the beginning of the Ukrainian crisis in February can be seen in the table below: –

Market/Security Price 28 Feb Price 9 Sept Change % Change
TTF Gas 22.85 19.78 -3.07 -13.44
GPL Gas 23.23 20.06 -3.17 -13.65
US Nat Gas 4.74 3.96 -0.78 -16.46
WTI 102.58 91.71 -10.87 -10.60
E.ON 13.82 14.31 0.49 3.55
RWE 29.02 31.43 2.41 8.30
DAX 9692 9700 8 0.08
S&P500 1859.45 1995.69 136.24 7.33
10yr Bund yield 1.63 1 -0.63 -38.65
Gold 1327.6 1249.4 -78.2 -5.89

 

Source: EEX and Investing.com

Germany – the weakest link?

Since the Hartz reforms of 2002 Germany has emerged from the strain of unification to re-establish its credentials as the powerhouse of European growth. Latterly – and especially since 2008 – its preeminent reputation has become tarnished. The Bundesbank raised its growth forecast in June to 1.9% for 2014 vs its December 2013 forecast of 1.7%. Their optimism has been dented since then by concerns about the politics of Eastern Europe. The Deutsche Bundesbank – August 2014 Monthly Report makes the following observations: –

The global economy appears to have got off to a good start in the second half of the year. As regards the industrial countries, Japan’s economy is expected to rebound in the third quarter. The US economy is likely to remain on a growth path, although it will probably be impossible to maintain the rapid pace of growth attained in the second quarter of the year. Following second- quarter stagnation, the euro area is looking at a resumption of positive economic growth, albeit not at the pace predicted by many analysts in the spring. The underlying cyclical trend in some euro- area countries is turning out to be weaker than expected. At the same time, the geopolitical tensions in Eastern Europe owing to the Ukraine conflict as well as in other parts of the world are now appearing to weigh more heavily on corporate sentiment. Although they will only affect a small percentage of EU exports directly, the recently enacted EU sanctions and the Russian response are likely to dampen sentiment.

The Bundesbank are still predicting an increase in GDP growth for 2015 before moderating once more in 2016. Below is a chart of annual GDP since 2002: –

German GDP - 2002-2014

Source: Trading Economics

The momentum seems to be dissipating. According to the Federal Statistics Office, in 2013, 69% of Germany’s exports were to other EU countries.  Asia came second with 16% and the USA third with 12% – a slow down in Asia, specifically China, would be problematic, but the UK, US and peripheral EZ countries might be able to absorb the slack. What is clear, however, is that Germany is vulnerable.

This brings me to the risks to Germany this winter due to rising Natural Gas prices and a curtailment of supply. The IEA – Germany Oil and Gas Security Report 2012 provides a comprehensive overview of the German market: –

Germany has very little domestic oil and natural gas production and relies heavily on imports. It has well diversified and flexible oil and natural gas supply infrastructure, which consists of crude, product and gas pipelines and crude and oil product import terminals. Natural gas is imported into Germany exclusively by cross-border pipeline. The country has no LNG infrastructure, although some German companies have booked capacities in overseas LNG terminals.

Oil continues to be the main source of energy in Germany although it has declined markedly since the early 1970s. It now represents approximately 32% of Germany’s total primary energy supply (TPES).

Natural gas consumption in Germany has declined 10% since 2006. Demand was 90 bcm in 2010, down from 100 bcm in 2005. According to government commissioned analysis, the total consumption of natural gas in Germany is expected to continue to decline over the long term. The share of natural gas in Germany’s TPES is currently around 22%.

The decline in Natural Gas demand is evident across Europe. Earlier this year the Oxford Institute for Energy Studies estimated that, across 35 European countries, demand had fallen from 594 bcm in 2008 to 528 bcm in 2013 – an 11% decline. This is largely due to the high price of Natural Gas relative to Coal and the Europe-wide policies mandating increases in renewable energy production. For those who want to read more about EU renewable energy developments,  Bruegal – Elements of Europe’s energy union , published this week, looks at the policy challenges facing Europe between now and 2030.

Germany’s declining demand for Natural Gas and increase in storage capacity will mitigate some of the potential disruption to supply – in 2012 Natural Gas represented 22% of supply vs Oil 32% and Coal 24%. Added to which Germany has adopted some of the most aggressive policies to develop renewable energy, offset, to some extent, by their closure of Nuclear Power plants: –

Under existing government policies the trend towards an increasing share of renewables looks set to continue. The Energy Concept 2010 established a goal for Germany to increase its share of electricity generated from renewable sources to at least 35% of total consumption by 2020. Conversely, the trend towards an increasing share of nuclear in the energy mix looks set to reverse following the government announcement in 2011 of its decision to phase out all German nuclear power plants by the end of 2022.

Germany imports Natural Gas primarily from Russia (39%) followed by Norway (35%) and the Netherlands (22%). Germany has no Liquefied Natural Gas (LNG) capacity but the GATE (Gas Access To Europe) terminal in Rotterdam – opened in 2011 – was operating at 10% of capacity in April 2014 and is purported to be capable of supplying 12 bcm (Billion Cubic Metres). This is still a drop in the ocean – Russia supplied Germany with 140 bcm last year. German domestic demand is less than 100 bcm leaving a substantial amount for re-export. Further LNG supply is available from Spain but there are bottlenecks with the trans-Pyrenean pipeline.  In any case, Spanish LNG prices are high. The table below shows the divergence in prices for LNG globally, even more than in pipeline supply LNG prices are a function of logistical supply constraints: –

World LNG prices - June 2014 AEI and FERC-page1

Source: FERC and AEI

Germany’s Natural Gas storage capacity (2012) is 20.8 bcm, making it the highest in Europe, although there are plans to increase this further. In H1 2013 German Natural Gas consumption was 50 bcm – the high levels of storage suggest that Germany is well placed to weather a Russian go-slow this winter.

The complex and diverse nature of Germany’s cross-border pipeline capabilities are shown in the map below, however the largest pipelines by potential capacity are (2012 data): –

 

Country Pipeline Capacity
Ukraine Bratstvo 120 bcm
Norway Norpipe, Europipe I and II 54 bcm
Russia Yamal 33 bcm
Russia Nord Stream 27 bcm

 

Source : IEA

Germany - Gas Grid - IEA-page1

Source: IEA

 

Conclusions and financial market implications

After two interruptions to Russian Natural Gas supply in less than a decade, Germany – along with other gas importing countries within the EZ have taken precaution. The most vulnerable countries in the event of a complete cessation of gas supply by Russia are probably the Baltic States, Hungary and Bulgaria. However, Russia is also very dependant on the EU for sales of Gas, Oil and Coal. Nearly 60% of state revenue comes from this trade. This trade is worth $80bln per annum to Gazprom alone. Germany is Russia’s third largest trading partner, whilst Russia ranks 11th on Germany’s list.

If Russian sanctions lead to a cessation of Gas exports then a number of large German utility companies will suffer – most notably E.ON and RWE. However it is most unlikely that German supply will run out. Price increases will either be passed on through higher prices or lead of margin compression due to the disinflationary forces emanating from elsewhere in the economy.

John W Snow – the US Secretary to the Treasury under George W Bush – is quoted as saying, “Higher energy prices act like a tax. They reduce the disposable income people have available for other things after they’ve paid their energy bills.” This is the potential that a reduction in Russian gas supplies and commensurate rise in prices is likely to have on the wider German economy. The ECB has cut rates and started down the road to QE even before the onset of winter. Mario Draghi knows that monetary policy works slowly and many commentators believe the ECB are demonstrably behind the curve due to their attempts to impose austerity on the more profligate member states.

German Bunds may have hit their high for this year, especially since the ECB are now buying ABS, but they remain a “hedge short” at best. The quest for yield hasn’t gone away, EZ high yielding sovereign names will be supported still.

European Equities will be nervous in this environment despite some 52% of Eurostoxx 600 companies beating their earning forecasts for Q2, according to Reuters data. After a summer shakeout, the DAX has regained its composure, but it is already trading on a P/E ratio of nearly 22. Technically it’s a “Hold” until a break of 9,000 on the downside or 10,000 on the upside. But don’t forget that when Mr Draghi uttered, “whatever it takes” the DAX was toying with 5,000

European Natural Gas prices should be supported through the winter but a full-blown “Gas Crisis” is unlikely. A “Winter Squeeze” such as 2012 or 2013 could see spot prices double under normal market conditions. German growth will continue to be hampered by political uncertainty but, all other things equal, it should rebound on any sign of detente and will benefit from the continued recovery of the UK and US economies.