The debt crisis and European energy markets18 Jul, 2011
Global financial markets are increasingly influencing European energy markets
Two years ago a speaker at Flame, the annual European gas industry conference, gave a presentation on the outlook for crude oil. The financial crisis was in full swing and oil had plummeted to below $50 a barrel, so the audience were attentive. The presentation was well thought out 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. See this Oxford University paper for a useful empirical examination of financial market asset correlations.
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 but has fallen substantially since. However asset correlations have remained stubbornly high. 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 towards 60 per cent in recent weeks, an eye opening level for what should be a diversified basket of assets. The cause has been a resurgence in the threat of systemic risk, both from the European debt crisis and the deadlock in Congress over raising the US debt ceiling. The way these events evolve has important implications for value and risk in European energy markets, particularly through their 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 moves from riskier assets to the relative safety of the US dollar (the global reserve currency), AAA 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, gold 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, 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. 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.
Chart 2: The relationship between monetary easing and commodity prices
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. Some of the drivers of this are explored in more detail here.
- 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 a US debt default could certainly have a substantial impact on USD correlations. However 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.
Consider a simple example: a buyer of coal in the UK (with a short coal exposure). The buyer has an exposure to two correlated risk factors: the coal price (traded in USD) and the GBP-USD exchange rate. The prevailing behaviour of global asset correlations suggests that if there is an increase in risk aversion (e.g. due to an escalation in the debt crisis) it will likely result in a fall in the coal price along with other commodity prices (1. above) and a rise in the USD (2. above). At the same time the USD strengthening against GBP will act to some extent to offset the fall in the coal price given the associated reduction in the purchasing power of GBP (3. above). The strength and variability of the correlation between these two risk factors is a key driver of value and risk and can not be properly analysed using a single risk factor of coal priced in GBP terms.
If there is an escalation in the current debt crisis, 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.
Next week we will follow up with an article which specifically explores the impact of exchange rate movements on European power and gas markets.