The debt crisis and European energy markets: a new episode05 Sep, 2011
The start of a new episode
August, usually a relatively calm month of empty meeting rooms and summer vacations, was this year marked by a sharp increase in global financial market volatility. The first three weeks of August saw the US credit rating downgraded by S&P, the European Central Bank forced to intervene in Italian and Spanish sovereign bond markets, $8 trillion of value wiped off global stock markets and economic data from the US, Europe and China pointing towards a rapid slowdown in economic growth. Markets have somewhat stabilised towards the end of the month. However the events of August mark the start of a new episode in the ongoing global debt crisis, the impact of which is likely to become a key driver of European energy markets.
On July 18th we published an article exploring the impact on European energy markets of an escalation in the global debt crisis. That escalation has now occurred and a lot has happened in the six weeks since. As a result we are publishing an updated version of the original article. The primary objective of doing this is to explore the impact of what appears to be the emergence of a new major trend in financial market risk appetite. In order to update the article we have retained the core of the previous article as context. New material has then been added covering the impact of recent events on European energy markets.
European energy markets are increasingly influenced by global financial markets
Two years ago a speaker at Flame, the annual European gas industry conference, gave a presentation on the outlook for crude oil. The first stage of the global financial crisis was in full swing and oil had plummeted to below $50 a barrel, so the audience were attentive. The presentation was interesting and well received. But the final question from the audience came from a market participant who wanted to understand the outlook for oil in EUR/barrel rather than USD/barrel. There was a long pause at the podium before the speaker had to decline an answer.
Until recently it has been a common approach to focus on the specific supply and demand fundamentals of energy markets in relative isolation from macro drivers such as exchange rate movements and correlations across traded asset classes. Five years ago this approach made some sense. The impact of macro drivers was generally overshadowed by fundamental drivers, particularly in the case of regional power and gas markets. But correlations between all traded asset classes (e.g. commodities, equities and currencies) have increased dramatically over the last five years as the financial crisis has unfolded.
Cross-asset correlations and asset price volatility are two warning indicators of the health of the global financial system. Asset volatility is a sign of fear and uncertainty, asset correlations are an indication of systemic risk. Volatility exploded as the financial crisis evolved in late 2008 and has again surged in the last six weeks. Asset correlations have remained stubbornly high since 2008. The average 20-day correlation between the USD, the S&P 500 stock index, corporate bond spreads, gold, crude oil and the VIX stock volatility index has risen above 60 per cent in recent weeks, an eye opening level for what should be a diversified basket of asset exposures.
At the core of the threat signalled by these indicators is an unsustainable level of sovereign debt across a number of the world’s developed economies. Debt levels are acting as an enormous drag on economic growth despite unprecedented monetary stimulus from central banks. In addition the decline in the value of sovereign debt held by European banks is threatening another systemic banking crisis. The escalation of the global debt crisis has important implications for value and risk in European energy markets, particularly through its impact on asset price correlations and exchange rates.
Global asset correlations: the new ‘normal’
Since the financial crisis global asset correlations have increased to the extent that swings in asset prices are now commonly described as being driven by a binary shift in risk appetite between a ‘risk-on’ and a ‘risk-off’ environment.
The ‘risk-on’ environment is broadly driven by optimism about the ability of unprecedented policy intervention to stimulate a recovery in global growth and a recapitalisation of ailing banks. Capital moves towards riskier assets as investors search for a yield greater than the negative real interest rates available from the relative safety of cash. So ‘risk-on’ conditions tend to result in a rise in the prices of higher risk assets such as equities and commodities, while low yielding assets such as the US dollar fall.
The ‘risk-off’ environment is essentially the inverse of ‘risk-on’, with pessimism about the impact of unprecedented debt levels on economic growth and solvency issues in the global banking system. In a ‘risk-off’ environment, capital tends to move from riskier assets to the relative safety of the US dollar (the global reserve currency), highly rated government bonds and cash.
Shifts in risk appetite between ‘risk-on’ and ‘risk-off’ influence the daily fluctuations in global asset markets. But there have been two dominant trends in global asset prices since the financial crisis began in earnest three years ago. These trends are illustrated in Chart 1 by focusing on three key global assets, oil, equities (represented by the DAX German benchmark share index) and the most liquid global market the EUR-USD exchange rate.
Trend 1 -‘Risk-off’ dominates: From mid 2008 to early 2009 an aggressive ‘risk-off’ environment prevailed as a systemic banking crisis spread through global financial markets. Commodities, along with other riskier assets such as equities, fell in a highly correlated fashion and the USD rose as capital fled to the safety of the global reserve currency. It is important to note from a European perspective that falls in commodity prices (e.g. oil and coal) were offset by a depreciation of the EUR (and other European currencies such as GBP) against the USD.
Trend 2 – ‘Risk-on’ dominates: From early 2009 to mid 2011 unprecedented central bank monetary easing (particularly in the US) and government stimulus (particularly in China) engineered a recovery in economic growth and a movement of capital from low yielding safer assets (e.g. USD cash) to higher yielding riskier assets including commodities and equities. The strong relationship between US Federal Reserve Treasury bond purchases (‘quantitative easing’) and commodity prices is shown in Chart 2. It is worth noting that the positive trend between EUR-USD and commodity prices was temporarily interrupted in the first 6 months of 2010. During this period an increasing realisation of the severity of the European debt crisis led to a more structural adjustment of the EUR lower against the USD despite commodity prices remaining strong.
A new trend? – ‘Risk-off’ dominates again: There is a strong case for mid 2011 being the start of a new major trend in risk appetite. The strongest evidence of this is an aggressive broad based selloff in riskier assets, particularly those exposed to a slowdown in global growth e.g. the German stock market fell 25% over the first 3 weeks of August despite Germany being the driving force behind Europe’s economic recovery over the last two years. However despite this re-assertion of the risk-off environment the USD has so far not responded by rising as it did in 2008-09. This has contributed to a more subdued reaction of commodity prices to the global asset selloff, with Brent crude oil falling by only about 10% since mid July.
There is prominent support for the theory that Chinese growth and further US monetary stimulus will continue to support commodity prices. We are not convinced and think that the risk of a sharp selloff in commodity prices over the next 12 months has increased significantly. We explore the sensitivity of the oil, coal and LNG markets to a slowdown in global growth here.
How does this impact value and risk in European energy markets ?
Three important macro effects that have influenced European energy markets since 2008, particularly during periods of heightened risk aversion, are listed below:
- Global energy prices (oil, coal and LNG) have exhibited a strong correlation to other commodities influenced by the ‘risk-on’/’risk-off’ phenomenon.
- The USD has exhibited a strong inverse correlation to commodity price movements
- As a consequence of 1. and 2. the impact of fluctuations in global energy prices on European energy markets has been offset by movements in the USD against European currencies (e.g. EUR and GBP).
It is important to note that correlation does not imply causation. Prevailing market behaviour is of course subject to sudden change. For example the inverse relationship between the USD and commodity prices has weakened significantly over the last two months, at least in part due to the political damage inflicted on the US credit rating.
It is also important to properly recognise the impact of these macro effects on operational decisions (e.g. hedging and asset optimisation) and in the analysis of value and risk. If there is a further escalation in the debt crisis over the coming months, gyrations in asset correlations and exchange rates may well cause some sleepless nights across European energy markets. But there are two principles that are likely to help with sleep patterns: (i) an explicit recognition of the impact of asset correlations and exchange rates on energy market exposures and (ii) rigorous stress testing of the impact of changes in correlations and exchange rates on value and risk.
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