Crash Or Correction? SocGen Answers
Following last week's crude drubbing brought about by correlations gone wild, following the 5 sequential margin hike-inspired collapse in silver, many are wondering if the silver correction is over, or if the crash is just starting. Here is Soc Gen joining in a very schizophrenic Goldman (a month ago: sell; yesterday: buy) telling clients the coast may be clear now that all the weakest hands have been purged (following SLV 88% share turnover on Thursday any latent mania elements have been exorcised).
Oil prices experienced a huge sell-off this week, plunging by $12 /b on Thursday (11% over the week). Other energy prices followed but the extent of the move was much less limited (between –0.6% and -3.5% over the week). This can be explained by a number of reasons – most of all it seems market participants were finally convinced by the economic newsflow that downside risk have become dominant and it was time to take profit. The question now is obviously if - after the usual technical rebound - this will continue next week and translate into a crash, energy markets in Europe following oil with a lag. Or if prices will stabilize close to present levels, in what should then be considered as the correction of excesses. Our view is that the correction, a violent one, could be over as overall fundamentals remain sound. Hence some prices will stabilize (coal and power), at least temporarily. Further drop for gas is however expected, coming from the continuing seasonal adjustment for which gas is late as compared to the other components of the power complex. Carbon should suffer from this gas movement, with limited downside risk.
Energy prices collapsed this week. Brent month ahead contract dropped by a staggering 11%, moving from $125.89 /b to 112 /b, of which almost $12 /b in a single session (Thursday), a rare fact. Following this dynamics but with a much lower amplitude, gas prices (NBP month ahead) lost £p2 /th and closed on Friday at £p55.8 /th (-3.5%). For coal, power and carbon prices, the pattern was slightly different. They started the week with an increase. German baseload Cal12 and CIF ARA Cal12 reached €59.82 /MWh and $133.25 /t respectively on Monday and Tuesday, continuing on previous week’s momentum. Then they followed the oil prices and strongly retraced from Wednesday to Friday. On the whole, German baseload Cal12 and CIF ARA Cal12 lost €0.9 /MWh and $3.75 /t, closing today at €58.2 /MWh and $129 /t. For carbon, the early week increase was strong with Dec11 EUA closing on a new high €17.42 /t on Monday, at a level not seen since November 2008. The contract fell only by 0.6% over the week and finished
today at €17.04 /t.
So the energy markets brutally turned eventually. This comes after two quiet weeks marked by long breaks and holidays across Europe, delaying decisions – which might partly explain the brutality. Last week had finished on a rather bullish note, encouraging our view for this week that prices would still hold to high levels, and even increase for some of them (coal in particular). Fundamentals indeed had turned more supportive for prices, but sentiment made it all in the last four days.
What happened? The market had become nervous over the recent weeks on concerns that the emerging countries would see their growth reduced in H211 due to the difficult fight against inflation, which is leading some of them to tighten their monetary policy. China has been in a tightening cycle for months – without much success on inflation readings so far. When India surprised this week by raising interest rates by 50 bps instead of the expected 25 bps, the concerns heightened. As the most liquid commodities (oil, precious metals) have largely become a macroeconomic play, and an EM play in particular, these concerns had lead investors to consider commodities as increasingly risky assets, whose potential for appreciation had turned quite limited in the short run. The good Q1 corporate results in the US and in Europe, very often beating analysts’ expectations, had temporarily appeased these fears as they sent equity indices up to levels unseen since mid-2008 (for the US stocks at least). The enthusiasm over, operators have started to take into consideration the bad news again. And realized the dark cloud has been getting darker and bigger over the recent weeks.
Western economies remain fragile. In Europe the lingering risk of the sovereign debt crisis is in the news again, through the Portugal bailout and the talks of Greek debt restructuring. In the US, the debt rating downgrade is still in the memories and the end of QE2 in June leaves the market wonder if this means the end of ever more cheap liquidity around, hence the end of the golden period for risky assets. The rising topic of oil demand destruction due to high prices, the bad unemployment figures yesterday in the US (jobless claims increased to an 8-month high while they were widely expected to drop) and the bad German factory order figures exacerbated the worries on the state of the developed economies.
At the same time the threat of inflation is also getting more precise in the US and Europe, which eventually is no good for growth either, as it will lead to rate hikes. For oil, the bearish inventory report mid-week (see our US Petroleum Report dated 4 May) showing unusual stock builds even as the Driving Season is coming near, combined to news OPEC was considering raising formal output limits when it meets in June, pushed in the same direction.
Much has been made about the impact of Bin Laden’s death. While it might reduce terrorist risk, it is not completely clear why this would lead to lower risk of oil cuts in the Middle East – for this, the less commented demise of one of the Libyan leader’s son over the same week-end could actually bear more impact. The big “Abbottabad news” was for us used more as a pretext to the first profit-taking, which was actually short-lived on Monday. But the date will for sure be remembered as the turning point for the oil market, even if the real fall in oil actually trailed losses in precious metals later in the week. The bearish reaction was compounded by the ECB’s press conference yesterday, during which Mr. Trichet dampened the expectations for a rate hike in June. This sent the Euro rapidly down, EUR/USD retracing from 1.48 (up to now seen as a pause before 1.50) to 1.45, which is also bearish commodities.
It is to be noted however that the astounding drop in oil prices fails to be reflected into other energy commodities, which fell only by 2% to 5% so far. This for us stems from two main reasons: barring oil, energy commodities are little invested by non-commercial players, whose behavior is evidently fuelling the movement for oil; and the stronger fundamentals for thermal coal or power in Europe also helped limit the downside compared to oil.
Seen in retrospect – as usual – we can see the energy prices had to go down! What was doubtful before becomes so clear afterwards… Hence, the real interesting question for next week is: will prices stabilize and rebound, or continue falling? Was this a correction, or is this the beginning of a crash, the explosion of a “bubble” that will take off the classic 30% off the (oil) prices? In each case, which levels will the prices reach?
Our view as a team was that a correction was to be expected but that Brent prices should for now remain in the $110 /b - $125 /b range. See for instance our Commodity Strategy - Brent 1x2 Put Spread at zero cost to benefit from tactical correction dated 4 May, where the following paragraph appears: “In conclusion, there seem several reasons to expect a correction lower in Brent prices over coming weeks. The key question is then how deep and long lasting such a correction is likely to be? We believe that any correction is unlikely to drop below $110 and any drop below $115 is likely to be short-lived.” We also think that solid fundamentals do not warrant a full-fledged crash (the -30% guy who would take oil back down to $85 /b), and that energy prices had not reached a “bubble-like” level. Hence the room for downside exists but is not massive. Economic fundamental first, are not that bad. H211 will be weaker, which is what the market is rapidly pricing now. However according to SG Economic team central scenario the theme of double-dip is behind us and the economies are recovering for good.
More precisely, on the energy commodities we follow two views are possible. Either the more inert, less investor-driven coal, gas, carbon and power markets will more heavily come down next week, after a 2-day lag. Or they are close to finishing their correction, even if it can seem limited. In this case they would stabilize next week. Actually our view is that they have probably finished the part in their consolidation that corresponds to the unavoidable sympathy with oil prices. But that they have not finished their seasonal adjustment, at various levels. Hence some of them will stabilize next week (maybe temporarily as there is still some time for the season to play before summer), while other will continue coming down due to a higher gap with what seasonal conditions would justify.
For coal, prices are undergoing the spring adjustment we have been expecting, but could be supported in the short run by continuing Chinese buying. Low inventories and Chinese domestic prices come closer to international ones are the main reasons behind this resurgence. For gas on the contrary, the market (wrongly we argued in our 19 April European Gas Special: five reasons for NBP gas price to go down this summer) thought lots of LNG would be diverted from UK to Japan to make up lost nuclear supplies but on Thursday the UK was in fact receiving more LNG than could fit in the pipelines at MilfordHaven, home of SouthHook and Dragon LNG. Dragon and South Hook were together flowing over 70 mcm /day into the national transmission system, about the maximum combined flowrate that has been seen in recent months. The high LNG supplies should continue to compensate for any other problems that could arise in Norway. Please refer to our equity Statoil note explaining that Statoil production in Q1 11 has been lower than Q1 10 and that Q2 and Q3 11e should also be below 2010 levels. We remain bearish for next week, especially in light of the rising temperatures. For carbon, our view is that the drift of gas prices lower will weigh downward, and that prices could suffer a bit. However there is little in the present price dynamics that could herald a significant departure from the €17 /t – its new average. For power, we think that coal prices are still price-makers in the German system, so that power prices will be relatively supported. However we think that NewC will be more resilient than CIF ARA (see our Thermal Coal trading idea dated 5 May Long NewC /Short CIF ARA) so we see risks more biased to the downside.
Overall, we expect coal (CIF ARA Cal12) and German baseload Cal12 to remain above $128 /t and €57.7 /MWh. On the contrary, gas (NBP month ahead) should continue its consolidation to £p54 /th. Finally, carbon should to be traded in a range €16.7 /t - €17.2 /t. Given this configuration and without strong downward move of the EUR/USD, German dark spread should remain stable while German spark spread will continue increasing (see our European Gas and Power Strategy dated 3 May Long German Spark Spread). We anticipate slight steepening of the CIF ARA forward curve with Next Quarter – Next Year spread decreasing to $-4 /t. For the NBP forward curve, the seasonal adjustment will weigh on the shortterm maturity contract and timespread will accentuate their drop.
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