The downside risks to energy markets have intensified

10 Oct, 2011

Will 2011 be a turning point for global energy markets?

2011 has been dominated by concerns about the impact of tightness in global energy markets on regional European power and gas market pricing.  The oil, coal and LNG markets have all seen buoyant demand from developing economies, with Asian LNG demand particularly strong in the wake of the Fukushima disaster.  Each of these markets has also faced supply constraints: geopolitical tensions in the oil market, production disruptions in the coal market and concerns around the timing of new production capacity in the LNG market.  Market sentiment has been re-enforced by analysis in support of the continuation of a major energy bull market, published by influential investment banks such as Goldman Sachs and Barclays Capital.

But as the year has progressed, individual market fundamentals have increasingly been overridden by concerns about the impact of a rapid slowdown in global growth.  In our view the risk of a major selloff in energy markets and an associated increase in price volatility has intensified.  The downside risks to energy markets have been a theme through our articles over the last few months:

  • In June we explored the vulnerability of energy markets to a slowdown in Chinese growth, particularly given the lack of responsiveness of short term supply, here
  • In July we focused on the threat to energy markets of systemic risk from the global debt crisis, here
  • In August we explored the idea that a new major trend in risk aversion had begun accompanied by a slowdown in global growth, here

As the final quarter of 2011 commences all these factors appear to be in play.  Expectations of yet another European bailout package have contributed to a recent recovery in prices.  But any good news in Europe looks to be outweighed by forward indications from currency and commodity market pricing suggesting that downside risks continue to grow.  This threat is compounded by the fact that energy market positioning across much of 2011 has been driven by a consensus view of continuing structural tightness rather than the threat of a selloff.

Global growth is the key risk factor

Daily movements in energy markets have been dominated by events relating to the European debt crisis over the last few months.  This has to some extent diverted attention away from the increasing evidence of an underlying slowdown in global growth, across the US, the Eurozone and most importantly the key developing economies of Asia.  Chart 1 shows the recent decline in the Eurozone and Chinese Manufacturing Purchasing Managers Index (PMI).  The weakness of the new orders component in the Chinese PMI index is of particular concern on a forward basis.   The European debt crisis may be intensifying this slowdown in growth, but it is only one of a number of factors dragging on the global economy.

Chart 1: Chinese and Eurozone Manufacturing PMI

The economic recovery of 2009-11 appears to be unusual in a historical context.  The first stage of this recovery was driven by massive fiscal stimulus (particularly in China) and the rebuilding of inventories after the severe contraction in Q4 2008.  But the debt levels of the developed world appear to be acting as a huge drag on the subsequent momentum of the recovery.  Asset markets, particularly commodities such as energy, have responded to aggressive Asian demand and central bank monetary stimulus.  But to some extent this has been out of step with the underlying strength of the economic recovery.  As the risks of a second global recession rise, near zero interest rates and ballooning sovereign debt levels have left policy makers with limited flexibility to respond to a renewed economic downturn.

Watch China, copper and currencies for clues

The dominance of China in driving marginal commodity demand growth means that a continuation of robust Chinese economic growth is critical to sustaining commodity prices around their current levels.  The shorter term lack of responsiveness (or inelasticity) of commodity market supply has been a key driver of rising prices over the last two years as Asian demand has surged.   But if Chinese economic growth stalls, this same supply inelasticity will be likely to drive sharp price declines and an increase in volatility.  The available economic data is yet to shed light on the nature of the slowdown in China but there are two factors of key concern:

  • The Chinese economy is driven by exports to developed economy consumers (less than 40% of Chinese GDP is driven by domestic consumption), so a recession in Europe and the US would substantially impact Chinese growth
  • Unlike in 2008-09, the Chinese authorities are currently tightening monetary policy in response to fears of domestic inflation, rampant credit growth and a commercial property bubble.

Accurate Chinese economic data is notoriously hard to come by but there are market indicators that can provide some useful forward insight.  Copper is an essential commodity input for a broad range of industrial and construction activities and has been tagged ‘Doctor Copper’ by commodity traders based on the tendency of the copper price to provide a useful forward indicator of commodity market strength.  Copper is also a useful barometer of Chinese economic strength given that China is responsible for around 40% of global copper demand.  Chart 2 shows this indicator flashing a warning signal, with the spot copper price falling sharply in September on high volume.

Chart 2: CME spot copper price (source

A second market-based warning signal is coming from the sharp rise in the US dollar in September.  The dollar rally is consistent with a contraction in global financial market liquidity and flight to the safety of the global reserve currency in response to the increasing risks posed by the debt crisis and slowdown in global growth.  A continuation of this dollar rally would be likely to re-enforce commodity price weakness given the prevailing negative correlation between the USD and commodity markets.

Chart 3: US Dollar Index (source

Energy markets are unlikely to be immune

Hardened energy market bulls would argue that a temporary setback in global growth is not enough to alleviate the structural tightness in global energy markets.  Indeed in the short term there are specific fundamental drivers, particularly in the LNG market, which may cushion the impact of a global slowdown and support a price recovery.  A cold winter in Europe accompanied by supply disruptions may still result in tightness in regional gas and power markets.

But the bullish argument becomes very tenuous if a rapid slowdown in global growth continues.  It is hard to build a case around energy prices remaining buoyant if other commodity markets suffer steep losses.  Market warning signals such as copper and the US dollar are already flashing amber and should provide useful indicators going forward.  But if the global economy loses Chinese leadership, energy prices will very likely follow other commodity markets in a major selloff.  A selloff in energy prices could well be intensified by a readjustment of market consensus away from a view of structural energy market tightness.