Intervention and commodity markets17 Sep, 2012
For the last 12 months, the dominant price trend in European power and gas markets has been downwards as global commodity prices have declined and Europe has fallen back into recession. But since the end of June, commodity prices have staged a recovery on the back of a barrage of new intervention measures from central banks and the Chinese government.
Central bankers have a reputation for choosing their words carefully. But the rhetoric that has accompanied recent intervention has verged on defiance. Both the ECB and the Federal Reserve have made declarations of open ended monetary intervention accompanied by statements along the lines of “we will do whatever it takes”. But will this form the foundations of a longer term recovery in commodity prices?
The markets for hydrocarbons
Global market prices for hydrocarbons (oil, gas and coal) are the primary driver of the cost of energy supply in Europe. We have written previously about the ‘risk on’ vs ‘risk off’ mentality that has been a feature of global financial markets since 2008, as the influence of central bank monetary stimulus has increased. The resulting high levels of correlation between movements in commodity prices and other global asset prices (e.g. equities, bonds, currencies) has continued to be a dominant force.
But within the hydrocarbon based commodity markets there has been an interesting divergence taking shape in 2012:
- Coal: Coal prices have been hit hard by the slowdown in economic growth of the world’s largest coal consumer, China. The ARA price has plummeted 20% since the start of the year, despite stabilising around $100/t over the summer.
- Oil: Ongoing geopolitical concerns in the Middle East and tight global production have supported Brent crude oil prices. After a selloff in Q2 towards $90/bbl, prices have recovered sharply back above $115/bbl where they started 2012.
- Gas: European gas hub forward curves have been buffeted by movements in oil prices, global LNG prices and expectations of European economic weakness. Prices have fallen since Q1 but not by nearly the same extent as coal prices.
Despite these differences, the renewed bout of financial market intervention has emerged as an important factor driving price movements over the last three months.
Administering the painkillers
There have been 3 substantial market intervention programs announced since the end of June:
- ECB bond purchases: The ECB has announced that it is prepared to make open ended purchases of the short term bonds of eurozone countries that formally request a bailout. This action has so far eased the threat of Italy and Spain being closed out of debt markets due to prohibitive rates of borrowing.
- Chinese stimulus: China has announced an infrastructure spending stimulus package of $150bn, focused on roads, ports, subways and waterworks, with the intention of boosting economic growth.
- Federal Reserve QE3: The Fed has announced its third program of massive monetary stimulus, an open ended program to purchase mortgage related debt (MBS) at a rate of $40bn a month.
The Chinese stimulus package is relatively small in size (less than a quarter of the 2009 stimulus) and is likely to exacerbate the overcapacity and credit issues that China faces rather than stimulate a sustainable pick up in growth. For an interesting overview of issues with further Chinese stimulus see here.
European and US central bank intervention is on a grander scale. Diagram 1 shows the magnitude of G4 central bank intervention since 2008 (although this doesn’t yet illustrate the impact of the QE3 MBS purchases announced last week).
While this intervention is impressive in its scale, what matters for commodity markets is sustainable economic growth. Monetary expansion may have prevented the global financial system from spiralling downward into cardiac arrest, but the lasting benefits for economic growth are less clear.
What does seem clear is that each fresh shot of monetary intervention has had a diminishing effect, rather like a patient who is treated with opiates. In fact central bankers appear to be acting increasingly out of frustration (in the case of the Fed tackling unemployment) and desperation (in the case of the ECB defending the euro).
Opiates may temporarily help with the symptoms but are of little benefit without some surgery to address the underlying illness. Far from this, central bank intervention has taken the pressure off governments to address the structural issues that caused the financial crisis: a dependence of economic growth on debt fuelled investment and consumption.
The underlying illness
Regardless of the merits of monetary stimulus, central banks are now working against a cyclical global downturn in economic growth. Diagram 2 shows a key indicator of industrial economic strength, the Manufacturing Purchasing Managers Index (PMI). Both the European and Chinese PMIs have been contracting (a reading below 50) for the last 18 months. This has been the driving factor behind weakening global commodity prices and there is little evidence of any positive impact from the increase in stimulus shown in Diagram 1.
The mechanism that fuelled growth prior to the financial crisis looks to be broken. Despite central banks engineering historically low interest rates, consumers and companies in developing economies are focusing on repairing their balance sheets rather than borrowing to invest or consume. The debt overhang across most of the developed world is acting as a brake on economic growth.
Importantly for commodity markets, this slowdown is weighing on Asia, where economic growth has relied on foreign investment and consumption. Marginal demand growth in Asian economies has been instrumental in driving the price of coal, LNG and most industrial commodities over the last decade. Monetary intervention may cause some short term pain relief in global commodity markets. But it is not going to address the structural issues that lie behind weakening commodity prices.