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. 

A Contrarian Bet Against the Rising Sun

Amidst the rapid decrease of the Japanese Yen since Shinzo Abe won election as Japan’s next prime minister in December 2012, the fundamentals concerning how the depreciation would impact global markets practically have been forgotten.

Attention of market participants has been fixated on Abe-rhetoric, which has driven the yen down 7.2% since December 2012 without any quantitative easing from Japan’s Central Bank thus far. In fact, Abe’s rhetoric has transformed market sentiment more successfully than Japan’s last US$100billion attempt to drive the Yen down in November 2011. Furthermore, market participants see the near future outlook for the Yen weighing towards further weakening due to:

Will the Sun continue to rise this year?

1. Japan Central Bank’s likely stance to utilize monetary easing until an inflation target of at least 2% is achieved;

2. The delay in increasing the consumption tax will add pressure on Japan’s fiscal position and weigh on the yen; and

3. Rumours of a ratings downgrade would likely increase sales of Japanese government bonds and capital outflows, which would depreciate the yen.

However, an examination of the fundamentals suggests that Japan’s devaluation of the Yen will not be allowed to go so far, for both political and economic reasons. Politically, Shinzo Abe’s rhetoric and ultra-nationalism has provoked neighbouring countries China, South Korea and Taiwan. Japan and South Korea’s relations soured over Japan’s decision to celebrate Takeshima Day in February 2013, a celebration concerning the Takeshima Islands or Dodko (as they are known in South Korea), as well as continued issues regarding Japan’s refusal to acknowledge its misuse of Korean comfort women. Japan’s relations have soured with China and Taiwan over its decision to nationalize the disputed Senkaku Japanese) or Diaoyu (Chinese) islands last year. Then there is the added competitiveness between China and Japan as to who is the giant in Asia and the stage is set for political confrontations. On the economic side of the coin, Japan’s major trading partners – China, South Korea, Taiwan, Hong Kong, and Saudi Arabia – all have something to lose in a global marketplace with a weaker Yen. A weaker Yen directly affects these countries’ imports and exports. Furthermore, these countries all compete with each other in global markets. For example, a cheaper yen can slow these countries’ export growth to key markets such as the USA and Eurozone. When one combines the political will of these countries when confronted by Japan along with the economic detriments for them of a weaker Yen, there is incentive to negate Japan’s efforts.

The next question then is do these countries – specifically China, South Korea, Taiwan, Hong Kong, and Saudi Arabia – have the means to resist Japan’s efforts to weaken the Yen. International capital reserves allow governments to manipulate exchange rates – either to provide their country with a more favourable economic environment or to buy domestic currency to protect their country from “hot money”. On the one hand, Japan has the second largest international capital reserves in the world at US$1,321,000 million. However, just considering China’s reserves alone, nearly double Japan’s at US$2,453,550 million, suggests the means to counter Japan’s Central Bank. In addition, Saudi Arabia have the fourth largest reserves (US$418,000 million), Taiwan have the sixth largest (US$360,230 million), South Korea have the eighth largest (US$316,000 million), and Hong Kong have the tenth largest (US$295,000 million). Combined, this is a potent arsenal to arrest Japan’s depreciating yen. My proposition is that they won’t let the repercussions of a weaker Yen last long and therefore a contrarian bet against the Japanese Yen is an attractive play.

The recent slight increase in the Yen’s value to 91.60 against the USD, from a low of 94.99, may just be a market correction. However, it may also signal testing of Japan’s strength and commitment to intervene to weaken the Yen. Once the Japanese Central Bank is installed with a governor conducive to Shinzo Abe’s vision of a weaker Yen and they begin a concerted campaign of unlimited quantitative easing, we may see a concerted effort from China, perhaps with implicit cooperation from other affected states such as South Korea, Hong Kong, Saudi Arabia and Taiwan, to combat their attempts. Although they may be unlikely allies, these countries could be united by a common cause – game theory suggests that cooperation would save them more of their individual capital reserves than if they acted alone. Therefore, be a surfer, watch the ocean, and figure out where the big waves are breaking. And adjust accordingly. 

Emerging Market Infrastructure: BTS Group Holdings

Bangkok Mass Transit Systems Plc (BTSC), the $1.3billion skytrain operator in Bangkok, is a subsidiary of BTS Group Holdings. BTS Group Holdings offers safe and excellent exposure to emerging market infrastructure. In fact, I would venture that, as the only privately owned mass train service worldwide, it offers unique exposure to megacity infrastructure.

BTSC has been in operation since 1999, and having paid down the majority of the debt that hampered its profitability in the first 9 years of operation, BTS Group Holdings has recorded profitability since 2009. In fact in 2012, BTS Group Holdings recorded a profit of approximately £42.1million. The company’s EBITDA represents roughly 60% of its total revenue and roughly THB5.5million per day. BTSC operates Bangkok’s skytrain under a concession awarded by the Bangkok Metropolitan Administration. This concession was extended by 13 years after the original concession expires in 2029. As of February 2013, the Skytrain serves around 650,000 passengers daily along a system consisting of 32 stations along two lines. Equally, BTSC has obtained excellent fixed assets from two companies with a proven track record of durable trains. German engineering powerhouse Siemens AG manufactures trains not only for the BTSC but also for Nuremberg, Melbourne, Shanghai, Oslo, Guangzhou and Vienna’s train systems. BTSC have also sourced trains from Chinese enterprise Changchun Railway Vehicles Company Ltd, a subsidiary of China CNR Corporation. Changchun’s clients include 11 major cities in Mainland China (Beijing, Shanghai, Guangzhou included), Sydney’s Cityrail, Tehran’s metro, Hong Kong’s MTR, Rio De Janeiro’s metro, Pyongyang’s metro, Mecca Metro, and Singapore’s downtown line.

BTS Group’s short-term future looks rosy. It has a solid foundation in terms of its popularity, fixed assets and profitability. Furthermore, it is considering raising fares for commuters from May 2013 in response to the increase of the minimum wage and the fuel charge tariff in Thailand. The company is looking to pass on the higher costs of labour ,electricity and maintenance onto commuters as these three operating costs account for approximately 75% of the company’s expenses. The need to make provisions for possible energy shortages in Thailand starting in April this year increases the likelihood of a fare rise. Moreover, a fare rise is not likely to meet much resistance as it would be the first since 2005. At the same time, BTSC projects 196million journeys on the skytrain this year, roughly a 8% increase on the previous year. With further investment in developing more stations to extend the skytrain lines as well as develop real estate surrounding stations, there is much going for the company. From March, BTS Group is seeking to offer an infrastructure fund aimed at raising THB50-60million and plans to hold roadshows in the USA, UK, Hong Kong and Singapore. Additionally, a subsidiary of BTSC, Bangkok Smart Card System Co, has jointly launched with Thailand’s biggest bank Bangkok Bank, the Smart Rabbit Card. This debit and credit card affords greater convenience by allowing cardholders to pay for goods and services as well as skytrain fares. Therefore, a fare rise combined with the likely success of BTS Group’s Mass Transit infrastructure fund, continued investment in development of more stations, and a more flexible Smart Rabbit Card contribute to a positive outlook for BTS Group’s share price and dividends. Being a major constituent of the SET, Bangkok’s stock exchange, the sixth fastest-growing stock exchange in the world in 2012 with a 50.21% growth rate, also doesn’t hurt.

Sky high earnings

Outlook for the next 5-10 years is also bright. All current skytrain station platforms are built to accommodate trains of six cars, but currently only trains of three or four cars are in operation. There is therefore potential to increase the number of passengers on trains, perhaps partially during peak times. In addition, Western Bangkok is devoid of any train system and further development in this tourist hotspot (Wat Pho, Royal Palace, Wat Arun, among others are located here) could be a key growth area for BTS Group. The major hindrance to such development is regulatory consent. Although with an estimated net worth of $800million, founder and CEO Keeree Kanjanapas’ influence with various elements of Thai government and Hong Kong connections are good indicators that he would be able to push through such a development.

BTS Group’s current share price stands at THB8.15. To take advantage of the short-term developments, look to buy at THB8.00 and sell around the end of June where the summer season higher passenger totals and greater international awareness of BTS Group should see the price surge to around THB11.40. For the longer term, the outlook is positive and the dividends aren’t bad either – the dividend yield is 3.3%. 

Buying into Securitisations

Securitisations are making a comeback and presenting an excellent investment opportunity along the way. With the EU examining ways to recover from the financial crisis and banks (such as Societe Generale) looking at novel methods to decrease their counterparty risk, securitisations are looking attractive to buy for investors due to the low yield environment driven by excessive quantitative easing in Europe, USA and Japan.

2008: bankers handling CDS² 

This interest may be at odds with the negative sentiment culminating in the financial crisis of 2008 when the US mortgage market exposed the dangers of packaging and reselling large volumes of dodgy Alt-A (borrowers with patchy record of repayment) and sub-prime (borrowers with No Income No Jobs or Assets) loans.

However there is an added factor that makes securitisations attractive, besides obtaining a higher interest for buying into the new raft of securitisations. It is looking likely that the European Central Bank will guarantee, at least implicitly, certain securitisations. Having initiated the Outright Monetary Transactions (OMT) scheme to successfully support the periphery Eurozone countries and given €1,019billion in low-interest loans to banks across the EU, the ECB  has demonstrated its commitment to finding a long-lasting solution to the economic depression in Southern Europe. Therefore, a commitment from the ECB to guarantee, in some way, securitisations would add to their appeal.

Traditionally in continental Europe banks are the providers of credit to European business. Yet the financial crisis resulted in banks withdrawing lending to European businesses and households, with amplified effects in eurozone periphery countries like Spain, Italy and Greece. For example, by December 2012 outstanding bank loans to Spanish businesses had dropped by 25% from January 2009. The void created by European banks unwilling to lend is already partly being filled by European corporate debt markets, which remain underdeveloped by USA standards. In the USA it is capital markets, not banks, which are the major sources of credit for American businesses. However there is a divergence in European capital markets, with companies raising funds from them being predominantly from Northern Eurozone countries such as Germany, France, and the Netherlands. For these countries, they not only can obtain cheap bank loans but the yields on their corporate bonds are low. Conversely, companies from Southern Eurozone countries face much higher bank interest rates and only the largest companies can access capital markets.

This divergence has led to discussions among EU policy officials about using securitisation as a method to get credit flowing again in the Eurozone by packaging loans to small and medium-sized enterprises in the periphery and selling them to global investors. The ECB want to effectively play the role of banks in supplying funding for SMEs as well as the role of markets in providing the mechanisms for sufficient liquidity in the securitisation asset class.

There are several reasons to invest in these SME loan securitisations:

1. Higher interest rate than other asset classes;

2. Supported by the ECB;

3. Before the financial crisis, Europe had a burgeoning market for SME loan securitisations. For example, in 2006 there were 34 issues worth €46billion in total, with 15 issues originating from Spain. Therefore there is a track record of success in this asset class;

4. Global regulators in the USA and EU have approved residential mortgage-backed securities as a product banks can utilize when constructing liquidity buffers, which is a sign of support for securitisations;

5. SME loan-backed securitisations have a low default record; and

6. The ECB has launched the European DataWarehouse to bring transparency to the pools of loans underpinning asset-backed securities and restore confidence in the market. A second initiative aimed at increasing transparency in the securitisation market is the Prime Collateralised Securities initiative, which awards kitemarks to high quality asset-backed securities (including SME loan-backed securitisations). These initiatives should address some of the issues with SME loan-backed securitisations, such as problems standardising these small business loans and worries about the ease of buying and selling such securities.

A Bet Against the Kiwi

If one believes in the theory of purchasing power parity, then we should sell the New Zealand dollar with a view to realizing gains in Q3 2013. The NZD is significantly overvalued compared with its economic fundamentals, as was confirmed by the New Zealand Central Bank Governor Graeme Wheeler last week. Having surged since the beginning of 2013 due to reports of a healthy New Zealand economy and a change in its trade balance from a deficit of around NZ$500million to a surplus of NZ$500million, the NZD is at a potential cross-roads. With the NZD trading at 0.8397 to the USD at last sight, several factors suggest that it is time to sell the Kiwi with a view to realizing gains in Q3 2013.

1.The rising value of the NZD has made New Zealand’s exports less competitive, which should prove unhelpful for the NZD. Expect New Zealand’s terms of trade to deteriorate in the coming months.

2. US, EU and Japanese central banks have effectively printed money, lowering their exchange rates in a bid to stimulate their economies through an increase in exports. This has resulted in a surge in the NZD so far this year. The announcement that the US Federal Reserve is uncertain about continuing its unlimited quantitative easing program slightly decreased the NZD. However the impending statement from US Federal Reserve Chairman Ben Bernanke will offer greater clarity as to the strength of the division in the Fed Committee concerning the scale of quantitative easing that was highlighted in the FOMC minutes released last week. This will have a knock-on effect on global currencies due to the risk-on risk-off effect, with an ambiguous statement from Bernanke increasing the strength of the USD and being counterproductive to the NZD.

3. Strength in the AUD supported by demand among sovereign wealth funds for its bonds as well as continued FDI flow into the Australian mining industry will draw funds away from the NZD into the ‘hotter’ AUD.

4. This week sees the result of the Italian election, which may not be a clear-cut result and therefore would dampen the outlook for EU recovery and result in a retreat to haven currencies such as the USD and away from risk-appetite linked currencies such as the NZD.

5. NZD has advanced against the Yen as reports suggest that Asian Development Bank chief Haruhiko Kuroda is Prime Minister Shinzo Abe’s preference to be Governor of the Bank of Japan as he shares his desire to stimulate the economy through weakening the JPY.

6. There is a substantial amount of speculative longs in the NZD/USD, which confronted with this week’s event risk, may result in a sharp sell-off of NZD vis-à-vis other currencies.

7. NZ Central Bank Governor Wheeler has provided clarity on the conditions where the Central Bank would intervene to artificially bring down the NZD. His criteria for intervention stated last week were:

1. Is the exchange rate at an exceptional level?

2. Is this exceptional level justified?

3. Would intervention be consistent with the current monetary policy?

4. Is intervention likely to succeed?

Markets reacted to news that the Central Bank was not considering intervening by selling the NZD in the immediate aftermath of his statement. This is a signal that markets feel the NZD is currently overvalued, but a fix will have to wait for stimulus from market forces.

However, New Zealand’s size and limited funds confers special constraints on its ability to quickly influence its currency. Other developed countries with significant size can cut interest rates or directly intervene in its currency markets. New Zealand’s only options are longer-term, which is not necessarily a bad thing. Traders should look out for New Zealand government action to improve productivity, reduce foreign borrowing, cut fiscal imbalances as currently NZ Government’s future expenditures do not match their future revenue streams, and clarify distortions in their citizen’s saving and investment incentives. If such action is forthcoming, a long term view on the NZD’s depreciation would be favourable.