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.

Where is the oil price heading in 2015?

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Macro Letter – Supplemental – No 1 – 13-02-2015

Where is the oil price heading in 2015?

  • Growth in oil demand remains anaemic
  • Supply will gradually fall as contracts expire
  • Consolidation and declining volatility are the most likely outcome

The price of crude oil has rebounded strongly since the end of January. Is this the beginning of a new trend, a short-term correction prior to a further decline or the start of a period of consolidation?

Here is the price action for March 2015 WTI futures over the last four months:-

4month Mar15 WTI

Source: Barchart.com

Before jumping to any conclusions about the next trend it is worth taking a look at a longer term chart. This is the spot price chart for the period since 2005, it shows the period of the leveraged boom and the collapse during the Great Recession:-

10yr Oil

Source: Barchart.com

The collapse during the Great Recession was largely due to a reduction in demand as the world economy slowed dramatically. The price decline since the summer of 2014 has been driven by a combination of a delayed reaction to increased supply – specifically from the US – and a moderation in the rate of increase in demand associated with the slowing of Chinese growth and its policy of “rebalancing” towards domestic consumption. An additional factor has been the slowing of growth in Europe. An IEA report last December estimated that global oil demand had increased by only 0.75% between 2013 and 2014 – better, by 3.6%, than the 2009/2013 period but not excessive.

During 2013 and early 2014 geopolitical tension in the Middle East and Ukraine kept prices elevated amid expectations of supply disruptions. These disruptions failed to materialise. This coincided with an increase in US oil production. Finally the markets woke-up to the lack of geopolitical risk, the slowdown of growth in the EU and China, and the acceleration in US production. The price began to correct downwards taking out the 2012 lows. From here on it gathered momentum and, having taken out the majority of trading stop-losses, stabilised last month, not far from the 2009 lows.

Another look at the 10 year price chart shows the recovery in 2010/2011. At this stage the improvements in fracking and drilling technology were already becoming widely known, had it not been for geopolitical concerns the price would probably have begun to decline from this point – around $85. The widening price spread between Brent Crude and WTI shows the effect of increased US production:-

brent wti spread Goldman Sachs ZeroHedge

Source: Goldman Sachs and Zero Hedge

WTI begins to lag Brent Crude towards the end of 2010. Here is a chart of US versus World Oil production:-

US_vs_world_Oil_production

Source: EIA and Carpe Diem Blog

 

Price Prospects

What we have seen during the last six months is a delayed reaction to the increased supply of crude oil from the US. The recent decline has been very rapid and may have run its course, or may have further to fall. Either way, volatility is heightened and the price is likely to remain variable.

From a technical perspective I would expect the corrective rally to continue possibly to test the 2012 lows around $75/barrel. After such a rapid rise in the last few weeks, however, the price may retest the low first; there is an outside chance that the market takes out the January low to retest the 2009 bottom. The $75 level may be retested in the autumn as forward contracts expire and supply shortages appear. From this point a renewed decline is most likely, this phase will also be marked by declining volatility.

I have one concern with this technically bullish prediction – the steep contango in the futures market. At close of business on Wednesday 11th February the WTI futures settlements were as follows:-

Contract Last
CLY00 (Cash) 48.87s
CLH15 (Mar ’15) 50.43
CLU15 (Sep ’15) 57.15
CLH16 (Mar ’16) 60.14s
CLU16 (Sep ’16) 62.39s

 

Source: NYMEX and Barchart.com

The shape of the forward curve suggests that oil producers are not feeling quite as much pain as is implied by the spot price, the supply overhang may last into 2016.

Market views, as always, vary. At this week’s International Petroleum Week conference in London Igor Sechin – CEO of Rosneft predicted that oil prices may surge later this year due to supply shortages as a result of the precipitous decline. Meanwhile at the same conference Ian Taylor – CEO of Vitoil, questioned where oil demand would emanate from. His outlook was decidedly more bearish.

Moody’s research, published earlier this week, put a price target for 2015 is $55/barrel which makes sense if global growth slows: they see no boost to growth in China, Japan or the EU from a lower oil price but expect it to benefit India and the US.

I listened to a panel debate at the ICMA/JSDA – Japan Securities Summit on Wednesday where Takahiro Sato of the BoJ alluded to the positive impact lower oil prices might have on Japanese growth. He inferred that it would mean the BoJ undershot its inflation target. Here is a brief extract:-

On the price front, the inflation rates in major countries, including Japan, have been declining as a trend mainly due to the recent drop in crude oil prices. Under those circumstances, central banks in major countries have a common concern that major economies are trapped in a feedback-loop — the decline in the inflation rates would lead to a fall in people’s medium- to long-term inflation expectations, and it would result in a further decline in the actual inflation rates. That is why the Bank decided to expand the QQE last October.

As I cast a dissenting vote on that decision, I may not be an appropriate person to explain this policy.

The NY Times reported – KKR profits were down 89% in Q4 2014 due to turmoil in the US energy sector. New drilling has dried up in the last few months and concerns are growing about potential defaults by over-leveraged energy companies. This could slow US growth if the financial sector is wracked with contagion.

The prospects for the oil price is unclear; it will remain so for the next six months. For this reason I expect Moody’s price target of $55/barrel to be reasonably accurate even if their growth expectations prove wrong.

Obvious risk factors which could undermine my expectations include:-

  1. A dramatic slowdown in China
  2. An unravelling of the Eurozone currency union
  3. Russia and the US going head to head in the Ukraine

I think China is more likely to surprise on the upside if it does surprise at all. The Eurozone is still a difficult situation to predict but I think the Euro currency will survive and lower oil prices will aid Germany among other countries in the Euro area. The US may be performing well economically but its appetite for foreign conflict when the country is heading towards energy independence makes little strategic sense. They are likely to deploy their resources on dealing with ISIS first.

My 2015 outside range for WTI crude oil is $40 to $75 with an average of $55/barrel.

Oil and Growth

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Macro Letter – No 24 – 21-11-2014

Oil and Growth

  • The oil price has fallen by 30% since the summer
  • Global inflation expectations are starting to be revised downwards accordingly
  • Global growth, led by energy importers will be revised higher

 

The Oil Price

Since the summer crude oil prices have fallen sharply from above US$105 to below US$75/barrel. This price move has led to discussion of lower demand stemming from a slow-down in global economic activity. Whilst I expect a benign influence on inflation I am not convinced that the price decline is due to a reduction in global demand. Here is a daily chart for Spot West Texas Intermediate crude oil (WTI) since November 2007:-

TWI Spot - November 2007 - November 2014

Source: Barchart.com

The precipitous decline in 2008 was driven by the global recession following the US sub-prime crisis. The liquidity fuelled recovery in the oil price and the world economy was engineered by the largest central banks. During the same period the US$ Index rose and then declined in a broadly inverse manner to Oil though the motivation for the vacillations in the value of the US currency is broader:-

US Dollar Index - November 2007 - November 2014

Source: Barchart.com

Aside from the steady strengthening of the US$ there are a number of factors which have conspired to drive oil prices lower. Firstly there has, and will continue to be, additional supply emanating from the US where improved energy technology has produced significant increase in production over the last five years –from 1.8bln barrels in 2008 to 2.3bln barrels in 2013. In May 2014 it hit a 25 year high of 8.4mln barrels and the Energy Information Administration (EIA) forecast 2015 production will hit the highest level since 1972. The economic impact of cheaper US energy underpins a manufacturing renaissance which is slowly gathering momentum across America.

The next factor is Saudi Arabian production which has not yet been reduced in response to lower prices. Perhaps this, in turn, is a reaction to the secular decline in oil demand from developed countries; though the announcement, last week, of an emissions reduction agreement by China and the USA may add to the downward pressure. Brookings – The U.S. and China’s Great Leap Forward opined thus: –

The world’s two largest emitters of carbon dioxide together pledged deep reductions – well in advance of the pressure they will face in the upcoming UN Climate Change negotiations that begin in Lima later this month, and which are scheduled to conclude a year from now in Paris.  They also did so at a level deeper than many had expected.  While both countries have already begun efforts to cut emissions, the timing of the announcement and the depth of the reductions went beyond what many diplomats, businesses and environmental groups anticipated.

… Internationally, both countries have a range of other issues to address – including working with the poorest nations which lack the resources to make similarly dramatic cuts, but who are deeply affected by a warmer, wetter world. Still, even with all those obstacles ahead, today’s agreement is the beginning of a great leap forward for climate protection.

Additional supply could swiftly come on stream from Libya. Further talks are scheduled between the rival Libyan factions in Khartoum, Sudan, on December 1st.  The chart below shows how swiftly Libyan production has declined:-

Libyan crude_oil_production EIA

Source: EIA

Also hanging over the market is the prospect of Iranian production increases as international sanctions are reduced. Between 2011 and 2013 Iranian oil exports declined from 3mln bpd to less than 1mln bpd. This year they have rebounded strongly, averaging more than 1mbpd. Iranian production has been running at around 3 mbpd but the National Iranian Oil Company expects an increase to 4.3 mbpd next year – though several commentators are doubtful of Iran’s ability to achieve this increase in output. For more detail on the Iranian situation this article – Al Monitor – Iran takes steps to reduce economic risk of falling oil prices may be of interest.

There are some demand factors which may also undermine prices. Chinese growth has been slowing but, more importantly, the Chinese administration has adopted a policy of re-balancing away from production towards domestic consumption. In theory this process should reduce China’s energy demand; off-set, to some degree, by increased export demand from other emerging market countries as they seek to supply China’s consumption needs. I believe lower energy prices will help Chinese exporters to increase margins or export volumes – or both.

The latest IEA Oil Market Report made these observations: –

Oil’s rout gained momentum in October and extended into November, with Brent at a four-year low below $80/bbl. A strong US dollar and rising US light tight oil output outweighed the impact of a Libyan supply disruption. ICE Brent was last trading at $78.50/bbl – down 30% from a June peak. NYMEX WTI was at $75.40/bbl.

Global oil supply inched up by 35 kb/d in October to 94.2 mb/d. Compared with one year ago, total supply was 2.7 mb/d higher as higher OPEC production added to non-OPEC supply growth of 1.8 mb/d. Non-OPEC production growth is forecast to ease to 1.3 mb/d for 2015 from this year’s 1.8 mb/d high.

OPEC output eased by 150 kb/d in October to 30.60 mb/d, remaining well above the group’s official 30 mb/d supply target for a sixth month running. The group’s oil ministers meet on 27 November against the backdrop of a 30% price decline since they last gathered in June.

Global oil demand estimates for 2014 and 2015 are unchanged since last month’sReport, at 92.4 mb/d and 93.6 mb/d, respectively. Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.

OECD industry oil stocks built counter-seasonally by 12.6 mb in September. Their deficit versus average levels, after ballooning earlier this year, fell to its narrowest since April 2013. Preliminary data show that despite a 4.2 mb draw, stocks swung into a surplus to average levels in October for the first time since March 2013.

Global refinery crude demand hit a seasonal low in October amid peak plant maintenance and seasonally weak product demand. The 4Q14 throughput estimate is largely unchanged since last month’s Report, at 77.5 mb/d, as robust Russian and Chinese throughputs offset a steeper-than-expected drop in US runs in October.

Set against these forces, driving the price of oil lower, is the geo-political tension between Russia and NATO, the ISIS insurgency in Iraq and the continued instability of the Middle East emanating from the civil war in Syria. It is difficult to estimate how far the oil price would decline if the civil unrest in Ukraine and Syria ended tomorrow, I suspect, another 20% to 25%% -during the Kuwait War in the month of October 1990 the price of WTI declined from $40 to $27/barrel even before the war was over:-

WTI Spot - July 1990 - March 1991

Source: Barchart.com

From a technical perspective the breakout from the 2011 range to the downside suggests support around $66, $62, $58, with a final capitulation target of $46. There are, however, reasons to be more optimistic about the prospects for oil, even near-term.

A factor, mentioned by the IEA, which may lead to a reduction in supply, is the outcome of the forthcoming OPEC meeting due to take place on 27th November. Qatar has already begun, reducing production from 800,000 bpd to 650,000bpd last month. At the end of November they will reduce production further to 500,000 bpd – in total a 40% cut. They are not the only countries to be reducing production. The tables below are taken from the OPEC Monthly Report November 2014 which included Secondary Sources: –

OPEC-Secondary-Sources  September 2014

Source: OPEC

Whilst oil prices may trend somewhat lower the term structure of the TWI futures market has recently returned from several years of backwardation to contango – Brent Crude has been in contango for some while. This suggests that lower prices are beginning to reduce US domestic over-supply as smaller US operators cease to be able to produce oil profitably. Below $65 the EIA forecast for 2015 will probably need to be revised lower. Prices are likely to be better underpinned at their current levels.

Another encouraging factor is US domestic demand from refiners. US Crack spreads – the price spread between crude oil and its products – has started to widen in recent weeks. Oil demand should increase in response to higher product margins. The cracking margins have risen most dramatically for Gasoline but Heating Oil margins have also improved and may catch up if predictions of an exceptionally cold winter in the Northern hemisphere prove to be correct. NOAA – Winter Outlook from last month is reasonably sanguine – warm in the West and Alaska, cold in South and Rockies – but substantial snowfall in Siberia (the largest in October since 1967) is cause for caution.

Global Growth

This brings me on to the impact of lower oil prices on global growth. Obviously the large crude oil exporting countries will suffer from reduced revenue but the importers of oil – and gas, since many gas contracts are referenced to the price of oil – should be beneficiaries.  This recent article from Brookings – Oil – A Question of Economics – reminds readers of some of the ubiquitous benefits to the global economy of lower energy prices: –

Virtually all businesses will benefit from lower transportation costs by expanding their profit margins or passing the benefit to consumers at lower prices. The lower income groups, who spend a higher proportion of their incomes on transport, will see their disposable incomes rise, benefiting retailers who serve their needs and thereby increasing demand in the economy. Food prices are also likely to fall, as food production, processing and sales distribution are energy intensive activities, thereby benefiting lower income groups further. Increased consumption will stimulate aggregate demand, creating investment opportunities and economic growth. Governments in the west may also have the opportunity to increase fuel taxes to cover the real cost of the negative externalities of carbon emissions, or raise revenue to improve public transportation systems. Furthermore, governments in the Middle East and Asia will reduce spending on their fuel subsidies and may take the opportunity to improve the workings of market forces, which the IMF and Western powers have been seeking for them to do.

The effect of lower oil prices is felt quite rapidly by consumers globally. Oil consumers, at the household level, receive an immediate boost to their real income. This “wind-fall” is then either spent or saved. An explanation of these effects can be found in this Gavyn Davies article in the Financial Times – Large global benefits from the 2014 oil shock (Some of you may need to subscribe to this “limited free service”). He uses IMF data to produce two very interesting charts: –

Oil and GDP - IMF Fulcrum

Source: IMF and Fulcrum

The fall in inflation will be of greater concern to the ECB than the other major central banks. The BoJ has already acted aggressively in response to the economic slowdown in Japan, the Abe government has deferred a scheduled tax increase and announced an early election. The Federal Reserve, having completed its tapering of QE, will be focussed on wage growth. As central bank to the world’s second largest and rising oil producer, the Fed will be concerned about the drag on growth from a slowdown in the energy and utility sectors; market expectations of interest rate increases will be deferred once again. If the ECB act aggressively to head off the chimera of deflation this may be enough to improve global confidence – I believe this makes the blue line prediction more likely. If WTI should plummet towards $60, the improvement in economic growth should be even greater.

As recently as last month the IMF – World Economic Outlook – forecast for Oil prices was $102.76 for 2014 and $99.36 for 2015. They continue to cling to their forecasts based on expectation of increased geo-political tensions. Given that their 2015 forecast is around 30% above current levels if they are mistaken and the oil price remains subdued their global growth forecast could be around 0.6% too low.

Last month The Economist – Cheaper Oil: Winners and Losers – took up the theme of lower oil prices:-

A 10% change in the oil price is associated with around a 0.2% change in global GDP, says Tom Helbling of the IMF. A price fall normally boosts GDP by shifting resources from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. If increased supply is the driving force, the effect is likely to be bigger—as in America, where shale gas drove prices down relative to Europe and, says the IMF, boosted manufactured exports by 6% compared with the rest of the world. But if it reflects weak demand, consumers may save the windfall.

The authors go on to discuss farmers as the main direct beneficiaries of cheaper oil. India especially but other economies with a large agricultural sector as well: –

Energy is the main input into fertilisers, and in many countries farmers use huge amounts of electricity to pump water from aquifers far below, or depleted rivers far away. A dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods, says John Baffes of the World Bank. Farmers benefit from cheaper oil. And since most of the world’s farmers are poor, cheaper oil is, on balance, good for poor countries.

Take India, home to about a third of the world’s population living on under $1.25 a day. Cheaper oil is a threefold boon. First, as in China, imports become cheaper relative to exports. Oil accounts for about a third of India’s imports, but its exports are diverse (everything from food to computing services), so they are not seeing across-the-board price declines. Second, cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment.

Third, cheaper oil cuts India’s budget deficit, now 4.5% of GDP, by reducing fuel and fertiliser subsidies. These are huge: along with food subsidies, the total is 2.5 trillion rupees ($41 billion) in the year ending March 2015—14% of public spending and 2.5% of GDP. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. As in China, cheaper oil should reduce the pain of cutting subsidies—and on October 19th Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

The price move has also prompted a response from the researchers at the Dallas Fed – Oil Prices Fall Despite Global Uncertaintywhilst their concern is broadly domestic they note that it is Non-OECD demand which is driving the increase in oil demand. The largest beneficiaries of lower oil prices will be oil importing emerging market countries: China, India and, to the extent that they are still considered an emerging economy, South Korea. Other candidates include Singapore, Taiwan, Poland, Greece, Indonesia, South Africa, Brazil and Turkey.

Conclusion and Investment Opportunities

Foreign Exchange

The fall in oil prices has been mirrored, inversely, by the rise of the US$. This trend is already well established but I expect it to continue. This is not so much a reflection of the strength of the US economy as the moribund nature of growth expectations in the EU and Japan.

Government Bonds

Lower inflation expectations, combined with central bank inflation targets, should ensure a delay to interest rate tightening even in response to a resurgence of wage growth. Bond prices will continue to be underpinned. At any sign of a slowing of economic growth, yield curves will flatten further. Convergence of EZ bond yields will continue.

Equities

The chart below shows the relative performance of the S&P500 Index vs MSCI Emerging Market ETF (EEM) over the last five years, after an initial rebound from the Great Recession the US stock market began to outperform other stock markets, driven by the economic boon of oil and gas technology, the implementation of TARP  and the highly accommodative policies of the Fed. With the current round of QE at an end, US investors may need to look further afield in search of value :-

EEM vs SandP 5yr

Source: Yahoo Finance

Expectation of “Lower for Longer” interest rates and cheaper oil is supportive for stock markets in general although there will be sector specific winners and losers. Geographically, lower oil prices will favour those economies most reliant on oil imports, especially if their exchange rate is pegged to the US$. Given the under-performance of many emerging market equities over the last few years I believe this offers the best investment opportunity going forward into 2015. Those countries with floating exchange rates such as India have already benefitted from currency devaluation of 2013; however, there is still potential upside for equities, even after the strong performance of 2014. The SENSEX Index (BSE) started the year around 21,000 and is currently making new highs at 28,000, but during the last three months it has tended to track the performance of the S&P 500 Index – despite the fall in oil prices. I anticipate a general re-rating of emerging market equities next year.