Pour Oil on Troubled Waters

There is no reason to think the oil prices will not go down further given the current state of affairs. We are entering unchartered territory and, looking at our estimates, it is very likely that the price of crude will bottom out at $40. Indeed, most commentators point squarely at supply (or over supply) rather than demand deficiency as a main driver for the spiralling prices.

Whilst the US remains the largest producer (and consumer) of crude, in terms of international trade, Saudi Arabia was the largest exporter of crude in 2014 and is forecast to reign at the top spot in 2015. Delta Economics forecasts world crude exports to take a hit in 2015 with a -1.28% reduction in exports on the previous year (2014). As global demand continues to dampen because of weak economic activity, oil exporters such as Saudi Arabia are responding by slashing prices to the EU and US yet increasing them to Asia. This is understandable given the inelastic nature of crude. Indeed it seems Saudi Arabia is more willing (and able) to absorb potential losses because it accumulated a generous buffer when prices were high. Qatar and Kuwait, too, are better poised than producers such as Venezuela, Iran and Russia, all of whom are experiencing budgetary strains – some small (Russia), some large (Iran), with one, Venezuela, facing imminent default unless China, the largest crude importer, steps in to negotiate some kind of agreement. OPEC nations agreed last month to maintain production at their usual level, whilst non-OPEC producing nations have stoked up their capabilities, which helps drive down the price of crude even further.

The Shale Revolution on the other hand is helping the US wean itself off its dependency on international crude. However, as reports have shown, the extraction of Shale is only viable if oil prices remain high: lower prices are only adding pressure to Shale producers’ business model. But let’s not forget that lower oil prices are also great news for the largest importers of oil such as US, India, China and the EU, all of whom are experiencing an unintended windfall that is likely to be passed on to the consumer in the months to come.

 

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Figure 1
 |  Pour Oil on Troubled Waters
Source  |  DeltaMetrics 2015

 

Pour Oil on Troubled Waters  |  Author  |  Shefali Enaker  |  Economist

Running out of energy

Why Europe needs Germany to sort out its energy policy  |  The last thing Europe needs right now is a crisis. With the ECB’s decision to take interest rates into negative territory last week, it rekindled the spectre of disinflation turning into deflation in the Eurozone. If this wasn’t enough, fears about Europe’s dependency on Russian oil as the crisis in Ukraine continues appeared to be abated slightly as Germany appeared to open up the potential for shale gas production and then shut it again saying that the exploratory work would stop well short of allowing fracking to resume.

This matters because Germany’s trade is 98% correlated with its imports of mineral fuels, including shale [Figure 1].

 

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Figure 1  |   USDm value of Germany total exports and its imports of mineral fuels June 2001-Dec 2014
Source  |  DeltaMetrics 2014

 

Germany is undeniable the export engine of Europe and its energy consumption (measured through imports) is so tightly related to the value of its exports that its energy policy becomes vital, not just to the country itself but also to the rest of Europe. Eight of Germany’s 17 reactors were closed after the Fukushima disaster and a commitment to close the remainder by 2022 was made, leaving Germany without a major source of internally generated energy and a need to rapidly find an alternative. In addition, much of Germany’s energy is produced in its own coal and lignite mines making it arguably increasingly dependent on one of the most polluting types of fossil fuel, despite its reputation for being at the leading edge of environmental technologies.

So are there signs in Germany’s trade that it is becoming either more green in terms of its energy production or consumption or that it is reducing its dependence on Russia for oil?

The short answer to this is not really as Figures 2a and 2b show.

 

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2014-06-09_runningOutOfEnergy_fig02b

Figure 2a (top) and Figure 2b (bottom)  |
German imports or exports of mineral fuel products as a proportion of all mineral fuel imports or exports, 2014
Source  |  DeltaMetrics 2014

 

Although imports of crude oil are forecast to decline by 2014, imports of refined oil are set to increase by a similar amount. Imports of electrical energy, which is all energy produced from non fossil fuel sources and so includes nuclear and alternative sources of energy are forecast to increase slightly.

The picture for exports sheds some more light on why there is no real change in Germany’s energy consumption. Although imports of refined oil are set to increase, its exports are set to decrease suggesting that Germany will become more, not less, dependent on outside of its borders for refined oil. Even though exports of electrical energy are set to increase by nearly 3% between 2014 and 2020, suggesting greater production from non-nuclear and renewable sources, it is still insufficient to offset Germany’s greater demand for refined oil.

However, although the Netherlands is by far and away Germany’s largest import partner of refined oil, its oil comes from Belgium, the UK and Russia in almost equal proportions; Belgium gets its oil from the Netherlands, Russia and the UK. Figure 3 shows, the dependency of Germany on Russian oil is substantial.

 

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Figure 3  |  Running out of energy suppliers;
Why Germany is likely to be dependent on Russian oil for some time to come
Source  |  DeltaMetrics 2014

 

Countries like the UAE, Mexico, Angola and Iraq are all fast-growing suppliers of crude oil into Germany. However, adding up the total import values for each of the five fastest growing economies yields a total of USD 1.7 billion which is just one seventeenth of the total value of Russian imports of crude oil into Germany alone. More than this, Russian imports of both crude and refined oil are more highly correlated with German trade that imports from the UK, the Netherlands (refined) or Norway (crude). While oil imports from the UK are highly correlated with German trade, they are also forecast to remain static in the case of UK imports of refined oil and to fall by over 6% in the case of UK imports of crude oil.

There is still a long way to go; renewable energy alone will not reduce the dependency that Germany, and therefore Europe, has on Russia. Figure 4 shows how, despite a brief drop in imports into Germany during 2014, as a consequence of the current geopolitical uncertainty, Russia’s imports into Germany will continue to grow into 2015 and 2016 in current prices.

 

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Figure 4  |  USDm value of Germany’s crude oil imports from its top three import partners, June 2001-Dec 2015
Source  |  DeltaMetrics 2014

 

It is likely that the Netherlands will pick up the slack as imports drop from Russia during 2014 but as it is similarly reliant on Russian oil this simply shifts the fulcrum temporarily rather than generating a real change.

Over and above everything else this is important because Germany’s trade is 87% correlated with the value of the Euro against the dollar and 76% correlated with the value of the FTSE. Given the even higher correlation at the moment of Germany’s trade with oil, this renders the concerns over its energy security not just understandable but actually critical if Europe is to avoid an economic crisis caused by geo-political uncertainty.

This brings us back to the opening statement. What Europe needs least is another crisis. There is evidence of growth in demand and the Delta Economics forecast for trade, although flat, is a considerable improvement on the negative outlook of six months ago. Yet a closer examination of Figure 1 shows something worrying: in current prices, Germany’s trade growth is relatively flat too. In other words, the slow growth in value terms of trade over the past few years and into the next two years, is not just because of slow global demand conditions, especially in Asia. It is also because there is downward, disinflationary pressure on prices which is flattening the real value of trade as shown in Figure 5 which looks at German exports against gold prices.

 

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Figure 5  |  German exports, USDm value June 2001-May 2015 versus Gold Spot, Last Price Monthly, June 2001-May 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

The correlation between German exports and the Gold Spot price is high at 0.79 (compared to 0.78 and 0.77 for the EU 28 and the Eurozone exports respectively). Gold is a hedge against deflation and we are beginning to see strong disinflationary tendencies if not deflation itself. At present that correlation remains positive because deflation has been on the horizon for a while, so markets are pricing it in at present.

However, if the Ukraine crisis deepens and Russian oil to Europe is shut off, then this will have a profound effect on German trade, pushing its real current value down and, hence, adding to deflationary tendencies. There is a real danger that the European recovery may be threatened by Germany’s trade, quite literally, running out of energy.