Is there a Gold Flush?

The gold market has recently been declared by several banks, including Goldman Sachs and Credit Suisse, to be at the end of its decade-long bull run. However I contend that it is a time to buy gold. With gold prices currently at US$1574 an ounce, this is near the low point in 2012.

There are several reasons that the aforementioned banks feel gold’s decade-long bull run has come to an end. Gold’s bull run coincided with the introduction of gold exchange traded funds (ETFs) that were launched in 2003. These gold ETFs offered investors a relatively low cost and easily tradable method of holding physical gold. The way they work is that the ETF buys physical gold and then issues shares that investors can buy and trade on an exchange. Collective ETF gold holdings globally are 2,491 tonnes – larger than all but two central banks, the USA and Germany. However since January of this year, ETFs have sold 140 tonnes of gold. The sell-off is partly due to broader negative sentiment towards gold as investors become more confident in the global economy and put their money into riskier assets such as equities. As investors grow more confident in the US and Chinese economies, they are shifting their allocations to equities. The Dow Jones Industrial Average surpassed its previous record high set in October 2007 by closing at 14,253 last week. Furthermore, regulatory filings reveal that George Soros and Louis Bacon have sold portions of their gold ETF holdings in February. As ETFs have become a major force in the physical gold markets, their recent sell-off could accelerate a dip in gold prices.

How can it be worth-less?

The ETF gold sell-off is also a surprise, when compared to previous periods of gold price weakness when ETF holdings showed investors stuck with the metal. The simultaneous fall of gold ETF holdings and the price could reflect the activity of a few hedge funds selling their gold investments. Yet it is also worrying that despite the US’s failure to avert signing budget cuts into law, gold has remained at its low price. Perhaps it is because there is less fear of unbridled inflation or a collapse in the USD’s value. Even on the Comex futures bets on falling gold prices is at the highest level since 2000. Moreover, the latest 5% drop in gold prices in the past two weeks due to uncertainty of the duration of the US Federal Reserve’s asset purchase programme has made the 50-day moving average price of gold fall below its 200-day moving average, intimating little support for the metal. Furthermore, with the US and Asia showing stronger economic activity, investors are opting for assets that benefit from GDP growth, pay interest or dividends. The gold sell-off may also have longer term roots. Gold soared from a low of US$253 in 2001 to a high of US$1920 in 2011. Many suggest that from a long-term perspective, the decade-long bull ran has rendered gold substantially overvalued both in absolute and relative terms.

In the last few years, the metal has failed to show any strong signs of a directional trend, typically trading within a range of $1570 to $1850. There are several explanations for the ETF sell-off that may be positive for gold. Perhaps there is a shift in the type of investors that allocate a proportion of their assets to gold in ETFs. The investors were generally individual investors and institutions such as pension funds or insurance companies that were more inclined to hold their gold during times of trouble as they were driven by longer-term considerations such as the need to hedge against currency debasements and unexpected inflation. However, it could be that gold ETFs, like many other asset classes, are becoming popular with shorter-term traders as well as long-term investors. Therefore, the recent sell-off of gold could be a short-term trend rather than an inflection point in the gold price trajectory. China’s launch of its first gold ETFs this year should also help increase demand for gold in 2013. As China, along with India, are the two largest physical markets for gold worldwide, the demand from these two players can have a major influence on the gold price. As China’s economy propels more of their citizens into the middle-class, their consumption of luxury items made of gold will likely increase. The Indian Rupee has also strengthened since the beginning of 2013, which should make gold more affordable for price-sensitive Indians. The patterns of demand for physical gold is also shifting with many other emerging markets in the Middle-East and South-East Asia now accounting for a higher proportion of gold demand. It is also emerging market central banks that are increasing their gold reserves as a hedge against inflation eroding the value of their substantial USD reserves.

The ranging of gold prices in the past few years between $1570 and $1850 suggests that perhaps gold has finished its bull-run. Yet it does not mean that the gold price will suddenly spiral downwards. On the contrary, if gold is trading within a range, we are near the bottom of the range signalling a good time to buy gold. The combination of strong physical demand growth for gold in emerging markets as well as the scarcity of gold should ensure that prices are supported within this range in the coming years. Therefore, I recommend taking a long position on gold and buying into an ETF, such as SPDR Gold Shares, and wait to sell at around $1800-1850.

Asian Invasion into US Collateral Loan Obligations

Collateral loan obligations (CLOs) are a form of securitisation where leveraged loans from multiple corporate loans are pooled together in a special purpose vehicle (SPV). Leveraged loans are those loans extended to companies that already have considerable amounts of debt – as these loans are at higher risk of default, they cost the borrower more in interest. The SPV then issues bonds that are sold to investors in several different tranches with varying levels of rights to collateral and the payment stream. There are typically AAA rated (generally 64% of the total investment), AA, BBB, mezzanine, and equity (10% of total investment) tranches. CLOs are popular as arbitrage conduits that generate equity returns through leverage by issuing debt that is around 10 times their equity contribution. An alternative type is the market-value CLOs that are less leveraged, around 4 or 5 times, but that allow managers greater flexibility than the more tightly structured arbitrage CLOs. CLOs are typically rated by the major ratings agencies – Moody’s, S&P, Fitch. CLOs also enforce several covenant tests on the collateral managers covering areas such as minimum rating, industry diversification, and maximum default basket. The attraction of CLOs is that it makes it easier for companies to borrow by allowing banks to transfer loans they originate, as well as the risks attached to the loans, to institutional investors.

In 2006 and 2007, CLO volumes were roughly US$190 billion. CLO volumes dipped to negligible amounts in 2009 and 2010, before a resurgence in 2011 and 2012 during which US$70 billion of CLOs were recorded. In the current low-yield environment, the CLO market is making a comeback. The yield in a CLO rated BBB or in the equity tranches is much higher than in similar rated fixed income instruments. In particular, Asian investors, who have felt less of a sting from the financial crisis and who are cash-rich, are driving demand for CLOs as they seek higher yield. The keenest investors seem to be North Asian insurers struggling with high guarantees on their historic business, such as Sompo Japan Insurance, Tokio Marine, and KB Life Insurance. Already in 2013, we have seen 18 deals of around US$9 billion in January and US$6.5 billion of issuance in February. The market is expected to reach US$75 billion by year end. The typical client in the CLO market is also diversifying away from merely US investors with North Asian investors seeking more sophisticated asset classes. It is an important trend to take advantage of the US market for leveraged loans - worth around US$1 trillion – especially as in 2012 50% of new leveraged loans originated by banks were purchased by CLOs.

CLOs are safer than other forms of securitisation that had infamous roles in the subprime mortgage crisis and subsequent credit crunch. CLOs are a first derivative securitisation as the underlying assets are leveraged loans. However, CDOs are a second derivative securitisation as the underlying assets are other securitisations such as mortgage-backed securities, SME-backed loan securities, and CDOs. Therefore it is easier to evaluate a CLO portfolio than a CDO portfolio. In addition, trustees typically report every month to investors on the collateral, underlying credits, payment waterfall and the net asset value (NAV). Additionally, out of 41,120 tranches of CLOs rated by Moody’s from 1996 to 2012, only 32 tranches or 0.8% hit event of default and suffered losses on the principal investment at maturity. Therefore, CLOs had a low default rate before and during the financial crisis. 2013’s bullish prospects for US corporate credit, transparency in the underlying assets, good track record, and the added yield offered by CLOs are all factors that make purchasing CLOs attractive this year.

However there is one caveat. Regulation has impacted the CLOs market, which has ensured that the US market will see stronger growth than in Europe. Article 122a of the EU Capital Requirements Directive and the Dodd-Frank Act have both incorporated the concept of risk retention which require the CLO manager to retain at least 5% of the total size of the CLO until maturity. The rule in the Dodd-Frank Act does not come into effect in the USA until 2015, but there are attempts to exempt CLOs from the risk retention rule. Conversely European CLO is low as European banks have been unwilling to comply with the risk retention requirement due to low leveraged loan issuances in Europe as well as potentially high liability spreads across the different tranches of a CLO. Therefore, it is likely that demand will dampen for US CLOs if they are not made exempt from the risk retention rule.

Greek Stoicism

Zeno of Citium, the founder of Stoicism, promoted maintaining a balance of the mind so that errors of judgment did not occur and consequently manifest destructive emotions. After six straight years of recession, Greece is in need of just such stoicism to walk the tightrope between withdrawal from the Eurozone and staying within the monetary union’s relative prosperity.

Greece were the recipient of the biggest bailout in world history, a massive €240 billion from the troika of the EU, IMF and ECB. Continued funding from the Troika has built credibility.

However, Greece faces many challenges this year which could still result in a Greek default on its debt. If not that drastic an ending, such challenges will ensure ample opportunities to buy Greek bonds at high yields that could net profits like $500 million of US hedge fund Third Point last year.

Greece’s economy has wobbly foundations. Unemployment is at 26% and projected to hit 30% by June this year. 33% are living below the relative poverty line in Greece – meaning they earn less than €7,100 per annum. Greek GDP is also set to shrink by 4.5% this year, meaning that it has shrunk by 25% cumulatively since 2007. In addition, even after billions of euros in cuts, the Greek economy is in such a dire state that it is unable to absorb long-term reforms to kickstart economic growth. In order for the economy to function again, it is estimated that Greece will have to be absolved of at least 50% of its debt. Their current debt is 180% of its GDP. Despite these worrying signs, Greece will need to meet the expectations of international creditors who are keeping insolvency at bay.

Greece recently received €34 billion of rescue loans in December 2012. However, the trickledown effect will ensure that it takes a long time to reach the people. Critical steps to ensure Greece remains within the eurozone and on the pathway to recovery are:

·         There is a risk that the fragile Greek government coalition will not survive social rest in 2013 that could be exacerbated by the inevitable implementation of €9.2 billion in cuts this year. They will have to survive if Greece is to remain within the Eurozone.

·         Germany is set to elect its new government in September. Once a new government has been elected, they will be able to set the tone on whether an official writedown of Greece’s immense €340 billion debt burden is endorsed.

·         Clampdown on tax evasion – this is a major problem, particularly the ability of the wealthy elite to use their political influence to evade taxes. Tax evasion is estimated to cost the Greek government €30 billion annually in lost revenues.

Contemporary Greece - An Athens or Sparta?

·         Overhaul its current tax administration (condition of Troika funding) -  Greece attempted to collect overdue tax had a target of €2 billion in 2012, yet the government only raised €1.1 billion. It is also estimated that Greece has unpaid taxes of €55 billion, roughly 30% of their GDP. Tax reforms were announced in February 2013 that will further squeeze middle-class taxpayers by expunging tax exemptions for insurance premiums and interest on mortgage payments, increasing annual property taxes, and introducing a 20% capital gains tax for stock trading. Annual incomes of up to €25,000 will be taxed at 22%, whilst incomes over €40,000 will be taxed at 42%.  The corporate tax rate will increase from 20% to 26%.

·         Successfully complete privatisations – The government needs to raise €2.6 billion this year from sales of state-controlled companies. If revenues fall behind the target set by the Troika, the shortfall will have to be made up through immediate spending cuts. State-owned gas trader DEPA has been the subject of a €1.5 billion bid from Gazprom.

·         Attract foreign direct investment – in particular the Troika made it a condition of funding that the big four banks – National Bank of Greece, Eurobank, Alpha Bank, Piraeus Bank – attain foreign investment in them. However, they together hold negative equity of about €8 billion, which is a disincentive for investors to inject fresh capital as they are not willing to pay for pre-existing losses. Thus far, few fund managers and hedge funds have shown interest in buying shares in Greece’s big four banks. Without investment from foreign investors, the banks will be fully nationalised by the Hellenic Financial Stability Fund (the administrators of the Troika’s bailout money).

·         Tourist season begins in June – income is badly needed to be brought into the ailing economy.

To date Greece has managed to rein in its government spending and the Greek citizens must now also accept the pain of these cuts to allow a government to have the longevity to see out this period of recession. Private companies have cut monthly salaries to the minimum wage of €580 per month by renegotiating contracts with their employees. Meanwhile the government has capped the majority of public sector salaries at €5,000 per month. However the upside to the approximately 35% decrease in Greek wages over the past two years is that several multinational companies see Greece’s labour as highly competitive relative to other European countries. Companies such as Coca Cola Hellenic, Unilever and Procter & Gamble are either transferring production from other countries to Greece or planning increased output this year. Furthermore, the 10-year Greek government bond yield dropped below 10% for the first time in more than two years in February 2013, whilst Athen’s stock market has rallied 120% since June 2012. These are signs that, with some Greek stoicism, the Greek government can navigate through these difficult terms and chart the path towards economic recovery within the Eurozone. 

Bonding over Dim Sum

Dim Sum bonds are bonds denominated in Chinese RMB and issued outside China, typically in Hong Kong. Dim Sum bonds provide exposure to yuan-denominated assets to foreign investors, as China’s capital controls currently limit foreign investment flows in mainland Chinese debt. Issuers of Dim Sum bonds are usually corporations from China or Hong Kong, however there are many foreign companies that also issue them. Dim sum bonds can be issued as either retail bonds settled in RMB or synthetic bonds settled in other currencies such as EUR or USD. Retail bonds must be approved by the People’s Republic of China (PRC) Central Bank and PRC National Development and Reform Commission (as regulator of foreign debt) and only institutions in China and Hong Kong are allowed to issue them. Retail bonds must have a registered prospectus to enable retail investors as well as institutional investors to buy into them. Proceeds from retail bond issues also must be taken back into the PRC and cannot remain in Hong Kong or elsewhere. Synthetic bonds do not require any PRC or Hong Kong approval.

The China Development Bank was the first to issue dim sum bonds in July 2007. This nascent bond market has seen further growth since then and especially as a currency play for foreign investors seeking to take advantage of RMB appreciation. Hopewell Highways Infrastructure issued the first synthetic dim sum bond in July 2010. McDonalds were the first non-financial overseas company to issue dim sum bonds in September 2010. Many multinational issuers have issued synthetic dim sum bonds including the World Bank, Unilever, BP, Volvo, and Caterpillar. There has even been an issuance requiring an islamically structured dim sum bond issue by Khazanah. More recently in November 2012, China Construction Bank became the first Chinese bank to issue a one billion yuan dim sum bond in London. Furthermore, growth in dim sum issuance has been exponential from 36 billion yuan issued in 2010, 131 billion yuan in 2011, 265 billion yuan in 2012, and an expected 350 billion yuan in 2013.

Expectations for 2013 are highly positive for the Dim Sum bonds market. Bond prices and yields have an inverse relationship and companies have had to issue their bonds at higher yields to compensate for a more uncertain yuan as a result of PRC Central Bank’s policies that targeted the yuan’s appreciation. However, these yields have had the positive effect of attracting investors to the dim sum bond market with average interest paid on corporate dim sum bonds around 4.25%, comparing favourably with US corporate bonds with the same maturities yielding 3.95%. Additionally, 2013 looks to be a better year for RMB trading, with an expected 3.5% appreciation. Investors in dim sum bonds would therefore earn both the yield plus any yuan appreciation. That the PRC Central Bank keeps the yuan within a narrow trading range also provides more security to investors by reducing the risk of sudden currency moves wiping out bond returns.

Tighter Bonds this year?

The attractiveness of the dim sum bond market will also be helped by statistics suggesting the end of the Chinese economy’s two-year slowdown. China’s economy grew by 7.8% in Q4 2012 and the CSI300 index of Shanghai and Shenzhen listed stocks rose 33% since the beginning of December 2012. The pool of yuan deposits held in Hong Kong bank accounts is also at 624 billion yuan and dim sum yields are more attractive than the average yield for other Asian bonds. Just this week, speeches from the PRC’s incoming leaders Premier Li Keqiang and President Xi Jinping, committing to liberalizing the economy and exchange rates as well as the RMB strengthening to a 19-year high against the USD at 6.20 yuan is spurring Chinese companies to increase issuance of dim sum bonds. Furthermore, February 2013 has been the busiest month for corporate dim sum bond issuance since March 2012, with 7.5 billion yuan raised.

It is not just Chinese companies that make up the issuers; foreign companies are also getting in on the act. In fact in Q1 2013, Russian companies have issued more dim sum bonds than Chinese companies, emphasizing the dim sum bond market’s appeal as a cheap source of funding for emerging market borrowers. Yields have become less competitive for investment-grade multinationals, yet it has made dim sum bonds an increasingly attractive alternative for lower-rated borrowers, even after accounting for the costs of swapping RMB raised into USD or EUR. Yet investment-grade multinationals desiring to expand in mainland China would consider issuing dim sum bonds due to their cost of funds averaging around 3%, which is roughly 3.5% lower than their average 6.5% funding cost for a two-year RMB loan from a mainland Chinese bank. This is a strategy followed by several of the multinationals, including McDonalds, who tapped the dim sum bond market to fund expansion in the mainland Chinese market where they themselves own the majority of their restaurants.

There are a few reasons to be cautious about the dim sum bond market. It is a nascent market and there can be liquidity problems when investors are looking to sell their bondholdings to buyers. There are also many investors who prefer to buy RMB directly to gain exposure to China. Furthermore, investors are concerned that many dim sum bond issuers are not rated by credit rating agencies such as Moody’s, S&P, and Fitch. Yet, this is improving with 70% of dim sum bonds issued by companies with credit ratings, up from 48% in 2011. In addition, rumours that the PRC’s new leadership will open up the mainland Chinese bond market, with the allure of higher yields, would divert investment flows from the offshore RMB market. The mainland Chinese RMB bond market has outstanding volumes of 24 trillion yuan.

However the dim sum bond market is not expected to be affected – after all, it affords greater flexibility and transparency than any potential access to the mainland Chinese bond market. The dim sum bond market is also expected to continue to expand as long as there is a surplus of RMB deposits offshore (namely in Hong Kong). These deposits are inevitably going to continue to expand, with the result that dim sum bonds become even more widely issued and traded in the years ahead. 

Oil Price Differentials leading to shift in Market?

There has been growing consensus in the marketplace that the international benchmark for crude oil has shifted to Brent Crude. West Texas Intermediate (WTI) is virtually unavailable outside the USA, whilst the North Sea’s Brent Crude is traded more widely internationally. In 2013, the outlook for crude oil looks relatively stable, yet there is potential for greater regionalisation of world crude oil prices due to wider spreads between the different oil prices.

Currently WTI crude oil is trading at around US$91 per barrel and Brent crude oil at US$110 per barrel. This represents a spread of around $19 between the two crudes in a market where the prices of different streams of crude oil, as a truly global market with low shipping costs, usually move together due to the arbitrage opportunities. The spread has also widened noticeably from January 2013 when it was around $10. It is my contention that new demand and supply dynamics is transforming the global crude oil market into a regionally sensitive one. Enhanced oil recovery technologies have increased the number of potentially recoverable reserves, particularly in shale formations, tar sands, subsalt reservoirs, and deepwater wells. This increase in potentially recoverable oil reserves has enabled consumers to source crude oil locally, the consequence of which is the beginning of a decoupling of the global oil market. This is most evident in the USA and Canada where shale plays and tar sands have enabled local sourcing of oil to the extent that the current infrastructure is unable to accommodate the oversupply (Cushing, Oklahama is experiencing an ongoing glut due to inadequate pipeline infrastructure).

Even in the Middle-East and Asia, the same trend is observable. Dubai-Oman crude oil is trading at US$105 per barrel, resulting in a $5 spread relative to Brent. The spread has widened substantially from around $3 in January. This reflects doubts over OPEC’s spare capacity as a cushion for any potential shocks to world oil supply and security concerns over Iran and Syria. Furthermore, increased preference that investors are showing for Brent futures rather than other crude futures contracts is affecting the pricing of underlying crudes.

Therefore, my estimate for crude oil prices for 2013 is that Brent trades at around an average of $115 per barrel, WTI at an average of $90, and Dubai-Oman at an average of $108. Price differentials are likely to widen as a result of increasingly local sourcing of oil by consumers. With wide stockpiling of spare capacity, there is also less need to draw on supplies from other areas of the world. Global spare capacity is around 2 million barrels per day and projected to increase to 3.5 million barrels per day by July 2013, roughly 3.5% of oil demand and well above the danger zone of 1% that would induce a price spike. However, although unlikely, a supply shock could lead to price differentials closing among the various streams of crude oil. Global demand growth for crude oil is also modest whilst supply is growing modestly, which should also help moderate oil prices.

It should be said that price differentials will only last as long as the spread does not get too big that arbitrage opportunities become too lucrative to refuse for IOCs. There is potential for US refiners - Marathon Petroleum Corp, HollyFrontier Corp and Tesoro Corp – to take advantage of the price differential between WTI and Brent Crude. These companies can provide excellent arbitrage exposure for investors interested in the current oil market.

A 10 Year Primer for Oil Demand and Supply

Crude oil, as one of the world’s most important energy sources, has a bright future. Crude oil can look forward to incrementally increasing world demand as well as increasing world production in the next decade.

Both current and expected levels of economic growth and activity can influence oil demand and prices. Commercial and personal transportation activities, manufacturing processes consuming oil as fuel or using it as feedstock, and oil used for power generation tie the price of oil to economic activity. Oil prices tend to rise when economic activity and in turn oil demand is growing strongly. Yet, it is also true that economic growth and activity has more room to grow in developing countries as vehicle ownership per capita is already high in OECD countries and OECD countries have much larger tertiary and quaternary sectors that are less energy-intensive. Thus, oil consumption in OECD countries has declined in the past decade. However 50% of oil demand still comes from these OECD countries. Energy policies in OECD countries, such as higher fuel taxes and tax incentives to encourage clean energy, will slow their oil demand. Increased research into gas-to-liquid and even coal-to-gas products as well as increased natural gas reserves should supplant some oil demand in OECD countries. In the next decade, developing country oil demand will grow to around 60%, largely driven by China, India and Saudi Arabia. These countries have greater economic growth to look forward to, which will feed into greater oil demand. As incomes rise in developing countries, more people will have aspirations to vehicle ownership and contribute to higher oil demand. Many developing countries, such as Indonesia, control or subsidize end-use prices of oil products, which reduces the demand response to prices and strengthens the importance of economic growth as a driver of global oil prices. In addition, developing countries are experiencing rapid population growth translating into more people requiring more oil consumption. Although developing countries will boast a larger middle class by 2020, a major proportion of their economies will still be manufacturing, which is more energy-intensive than service industries. Therefore, developing countries will largely drive oil demand in the next decade.

Future pyramids of oil?

On the oil production side, there is also the potential for increases to stave off the threat of a peak oil scenario, which is a period where the maximum rate of global oil extraction is reached and after which the rate of production will terminally decline. This doomsday scenario has been pushed back several decades due to technological innovations. Major international oil companies, such as Shell, BP, Exxon Mobil, Statoil and Gazprom are spending billions on exploring the Arctic – estimated to hold around 13% of the world’s unfound oil reserves. This is equivalent to around 400 billion barrels of oil, roughly nine times the total oil produced in the North Sea to date. The innovations of combining horizontal drilling with hydraulic fracturing has also opened up tight oil reserves in the USA – oil production in The Bakken shale formation has increased from 150,000 barrels per day in 2008 to 700,000 barrels per day in 2012. In fact, it is estimated that the USA will surpass Saudi Arabia as the world leader in oil production by 2022. Brazil is projected to become a top 10 producer globally, particularly due to unconventional sources such as the Tupi subsalt reservoirs. Innovation has unlocked bitumen from Canadian tar sands by transforming it into synthetic crude oil. Additionally, there are over 200 deepwater wells worldwide currently that supply 8% of the world’s oil and this figure is expected to double by 2021. These technological developments should increase oil production from countries outside OPEC from 60% of world oil production currently to 70% by 2023. However, this increase in production from non-OPEC members is unlikely to affect OPEC’s influence on international oil prices in the next decade as they will still export a majority of the world’s oil. Consequently, OPEC spare capacity will still provide an indicator of the world oil market’s ability to respond to potential supply shocks. As a result, if OPEC spare capacity reaches low levels in the next decade expect oil prices to rise due to incorporating a risk premium. Markets will also still be influenced by geopolitical events within OPEC countries, which is a significant risk in the coming decade with unresolved issues with a nuclear Iran and the recommissioning of oil production in Iraq as well as the potential for popular revolutions among OPEC members. Furthermore, the increase of extreme weather as a response to global warming will play a significant role in oil supply in the coming decade. Hurricanes and tsunamis can shut down oil production and refineries and severely cold winters can stretch the capability of markets to supply products. Nations such as China, Japan and the USA are also expected to add aggressively to their national strategic oil reserves. Therefore, whilst oil supply will increase in the next decade there are potential disruptions to supply that can not be foreseen.

It is estimated that one in twelve of the largest oil tankers are being used for storage, rather than transportation, of oil. This estimation reveals the important role inventories play in balancing oil demand and supply. When production exceeds consumption, crude oil can be stored for future use. Inventory building tends to correlate with increases in future oil prices relative to current prices (and vice versa). As inventories satisfy either current or future demand, their level is sensitive to the relationship between the current oil price and oil futures prices. A change in market expectations towards either stronger future oil demand or lower future oil production, futures contract prices will likely increase, which encourages inventory building to satisfy the prospect of a tightening future balance. When futures prices rise relative to the current spot price, incentives to store oil and wait to sell at the higher expected price strengthen. Conversely, a loss of current production or unexpected increase in current oil consumption tends to increase spot oil prices relative to future prices and encourage inventory drawdowns to meet current demand. Alternatively, an increase in inventory levels can indicate that current production is greater than current consumption at the prevailing spot price, which will push spot oil prices down to rebalance supply and demand. Increased sophistication of inventory building will likely mean that inventory levels have a greater impact on oil prices in the next decade.

The past decade, particularly in the ongoing financial crisis, crude oil has conformed to the risk-on risk-off pattern seen in many financial assets. Crude oil tends to move in the same direction with stocks. In periods of rising risks, stocks and crude oil prices tend to decrease. Conversely, in periods of lessening risk or recovery, stocks and oil prices tend to increase. Oil prices have also been observed to have an inverse relationship with investment-grade bonds - as investors become more worried about future returns in higher risk assets such as crude oil they tend to increase allocations to investment-grade bonds in their portfolio. Thirdly, oil prices have an inverse relationship with the exchange value of the USD. Oil benchmarks are traditionally priced in USD, and therefore a depreciation of the USD decreases the effective oil price outside the USA. This decreased cost of oil acts as an incentive for consumers to purchase oil, which adds upward pressure on oil prices. In addition, investment in crude oil is also more attractive to US-based investors as a hedge against inflation, as a depreciation of the USD tends to increase inflation expectations. Therefore, greater interest from a variety of financial market players in crude oil will continue in the next decade and therefore these are important trends to take note of. 

Turning up the Gas

There are many benefits of natural gas. It is the cleanest burning fossil fuel releasing 117pounds of carbon dioxide per million British Thermal Units (mmBtu) compared to oil (160pounds) and coal (200pounds). It is also a cheap and quick source of power generation as natural gas plants are cheaper and quicker to build than any other source of electricity including coal, nuclear, wind or solar. Recent energy market dynamics combined with natural gas’ inherent benefits are turning 2013 into an exciting year for the world natural gas market.

The New Energy Frontier?

 The shale gas boom has made the USA the world’s largest producer of natural gas. The NYMEX Henry Hub Spot Natural Gas is trading around US$3.50/mmBtu, a recovery from the drop below US$2 in 2012 after international oil companies (IOCs) - such as Shell, BP, and Exxon Mobil - reacted by changing their development plans to focus more on shale plays with a higher yield of tight oil and natural gas liquids (NGLs). Despite the recovery, the US price of shale gas should trade in a range of US$3.50 to $4.50/mmBtu this year. The USA is currently producing around 65 billion cubic feet per day (cf/d) of dry natural gas and total storage capacity utilization is at 90%. Even Hurricane Sandy in Q4 of 2012 did not disrupt natural gas prices sharply upwards. In addition, IOCs continue to supply natural gas even whilst the price remains below the US$4 profitability level due to the fact that dry gas is produced as a by-product of the development of NGLs. Technological innovations such as longer laterals, horizontal drilling, multi-stage fracturing and multi-well pads have reduced operating costs of shale gas wells and increased well productivity. The majority of the 19 recognized shale basins in the USA are also still in early exploratory or development stages. Clearly US natural gas supply is outpacing demand and will maintain Henry Hub spot prices at a range of US$3.50 to $4.50/mmBtu in 2013. The price should move towards US4.50/mmBtu as a result of greater demand from US refiners utilizing natural gas in feedstock as well as the development of new gas-fired power plants. Furthermore, the significant price disparity between US domestic natural gas prices and foreign prices has opened up arbitrage opportunities for IOCs to export liquefied natural gas (LNG). However, there will be a lag in the exporting of LNG as IOCs must apply for export licences with the US government. If granted, exports of 20 billion cf/d of natural gas would make the USA the largest exporter globally. The anticipation of US LNG exports should also help narrow the price disparity between US natural gas prices and foreign prices, putting slight upward pressure on Henry Hub.

However, present difficulties involving in transporting natural gas from one continent to another have caused the price in regional markets to decouple. Europe’s natural gas is sourced locally from major producers Norway and the Netherlands as well as through imports by pipeline from Russia and from the Middle-East. Current price of benchmark UK National Balancing Point of around £0.67 per therm, or US10/mmBtu, is around three times that of the US Henry Hub. However, impending developments should narrow the price disparity. Qatar had ramped up its LNG terminals in anticipation of shipping more LNG to the USA, yet the shale gas boom has forced them to shift their strategy to Europe. Moreover, the planned development of another pipeline from Algeria to Europe linked through Sardinia (to add to the Maghreb-Europe pipeline) should depreciate European natural gas prices. More recently, these developments, as well as the prospect of US LNG exports to Europe, resulted in Russia accepting a lower price as a result of a series of re-negotiations with some of their customers. It is anticipated that these future developments will put downward pressure on the natural gas price in Europe, yet we must make allowance for some sharp movement in the price in a region where there have been recent gas pricing and pipeline disputes between the EU, Poland and Russia.

Yet, Asia sees the highest current price for natural gas, around US$19/mmBtu, due to high demand from Japan, South Korea, China, India and Taiwan. In particular, natural gas is growing fast in China where it is seen as a way to reduce urban pollution problems. Meanwhile Japan is the world’s largest importer of gas as half of their energy requirements are dependent on the commodity. Liquefaction facilities, LNG tankers, and regasification facilities are very expensive and have not reached a large enough number of installations to transform natural gas into a truly world market. However in the next few years, we should witness a decoupling of the natural gas price from being oil-indexed due to several developments:

·         Presence of major shale gas reserves in China – in May 2010 Sinopec reported the successful extraction of shale gas in Guizhou province. Lack of bureaucracy and foreign acquisitions and JVs, initiated by PetroChina, CNOOC and Sinopec, to acquire expertise in shale gas should enable China to develop shale gas reserves quickly;

·         Australia is developing several LNG terminals and is set to be the world’s leading LNG exporter by the end of the decade;

·         A further 15 LNG import and export terminals are being developed in South-East Asia to open in the next three years;

·         Re-development of the Panama Canal will be completed in 2014, which should facilitate US LNG exports to major Asian consumers;

·         Russia is developing LNG production plants and testing navigation through the Arctic ocean in order to access Asian consumers;

·         Anticipation of cheaper natural gas prices has had an impact on suppliers – in November 2012 BP’s Singapore business agreed to supply Japan’s Kansai Electric Power Co with approximately 700,000 mm cf/d of natural gas for 15 years at a price linked to Henry Hub.

Oil price indexation was first introduced for natural gas because it was thinly traded so made economic sense as oil was a fuel substitute with similar delivered costs. The regional decoupling of the price of natural gas markets is starting a shift from negotiating oil-indexed contracts to contracts tied to regional natural gas prices. Further developments in LNG exports as well as the supply of US LNG pegged to Henry Hub will hasten this shift. However, with the increased supply of gas globally the Gas Exporting Countries Forum (GEFC) and Russia in particular (having earned US$66billion from natural gas in 2012) will seek to use their control of half the world’s export volumes to maintain higher prices. This is not expected to have much bearing on world natural gas prices. Unconventional shale gas resources now account for about half of the world’s natural gas resources. Combined with the estimate that the Arctic holds around 30% of the world’s undiscovered natural gas and concerted efforts to explore this region should ensure that world natural gas prices continue to converge on the US Henry Hub spot price in the next few years and trade at around US$4/mmBtu.