Trump victory threatens dollar safe-haven status
At 3:30 pm Singapore time (0739 GMT), January ICE Brent crude futures were down 64 cents/b (1.39%) from Tuesday's settle at \\$45.40/b, while the NYMEX December light sweet crude contract fell 59 cents/b (1.31%) to \\$44.39/b. The dollar fell across a basket of currencies as the Dollar Index lost 1.3% from Tuesday's close to 96.615 as of 0739 GMT Wednesday. In the 12 hours to 9 a.m. GMT, the dollar weakened markedly against both the euro and the Japanese yen in particular as capital took flight.
However, the drop has already been hauled back to some extent, but still leaves the dollar lower against both currencies, with the yen the primary beneficiary. Sterling initially gained against the dollar, but then gave up those gains, while also falling against the euro. Stock markets were also down heavily, the Nikkei plunging 5.36%, the Hang Seng Index down 2.39% and the Shanghai Composite Index edging lower by 0.62% at 0739 GMT. Gold, traditionally seen as a hedge against inflation, rose strongly, jumping 4% as the election results started to show the likelihood of a Trump win.
The Mexican peso went into free fall against the dollar, owing to concerns about Trump’s protectionist statements on economic policy made during the election campaign. Initial market reactions to the surprise result have been volatile, reflecting a result that went against the polling evidence and general expectations.
However, it will take time to gain perspective on the economic implications of a Trump presidency. Of most concern are Trump’s protectionist leanings and the potential risk of a trade war, which as S&P Chief Economist Beth Ann Bovino noted in a recent report, “would have dire economic consequences for the US and the world.”
Nonetheless, if sustained, a weaker dollar should improve the competitive position of US coal and LNG producers in international markets. It should also be good news for net energy commodity importers such as Europe and the major Asian economies, but it is bad news for non-US energy commodity exporters. For a fuller discussion on the implications of a Trump presidency on the dollar and energy commodity prices see the article below by Ross McCracken, S&P Global Platts Managing Editor of monthly newsletter Energy Economist.
The dollar is unequivocally the currency of international energy commodity trade. For both net energy commodity importing countries and net exporters, changes in the value of the dollar have major impacts; for the former on the relative value of their energy imports, and for the latter on the relative value of their revenues.
However, the dollar is no ordinary currency; it is the world’s reserve currency. If the global economic outlook is negative, investors tend to move into dollar assets as a safe haven. This creates an inverse correlation between the dollar and energy commodity prices. In other words, if the economic outlook is poor, the dollar tends to rise as commodity prices fall.
Conversely, in a more positive macroeconomic environment, in which demand for energy commodities increases, investors seek riskier, higher-yielding assets and the dollar tends to weaken at the same time that energy commodity prices increase.
But this is a correlation rather than causal effect. A crisis of confidence in the dollar, perhaps the result of the election of Donald Trump to the US presidency, could upset this relationship, just as the 2008/09 financial crisis wrecked then prevalent assumptions about the relative behavior of different asset classes — with systemic effects.
If the credit worthiness of the US government is called into question, the dollar becomes a riskier asset, raising the question of where funds would seek safe haven — Asia or Europe? The answer to this would determine relative buying power and thus impact global trade flows in energy commodities between the Atlantic and Pacific basins.
Analysis continues below...
For the US, the failure of the inverse correlation would mean that non-US producers could no longer hide behind currency depreciation as a means of offsetting the effects of lower commodity prices. US energy exports would become more internationally competitive. Ironically, although Trump may have no formal plan for fulfilling his promise to save the US coal industry, a weak dollar would certainly help.
The offset effect
The inverse correlation between the dollar and commodity prices provides an offsetting effect both for net energy commodity importers and exporters. A break down in the inverse correlation represents the loss of this offset effect and more extreme pressures —a double positive or a double negative instead of countervailing influences.
If dollar weakness is accompanied by falling energy commodity prices, net energy importing countries receive the double positive. Not only are energy commodity prices cheaper overall, but the relative buying power of domestic currencies rises. The impact on trade flows then becomes more heavily influenced by the euro/yen rate, in terms of which appreciates more against the weak dollar. To put it another way, it depends on whether European or Asian currencies are seen as the safer haven.
However, for a petro-economy, such as Saudi Arabia, a weaker dollar does not reduce the country’s dollar revenues, but it does diminish its buying power in Europe and Asia. It will cost more barrels of exported oil for Riyadh to maintain its current level of European and Asian imports of goods and services.
Moreover, energy commodity exporters’ own currencies are closely tied to the price of energy commodities. If the oil price falls, oil exporters’ revenues decrease and their currencies generally weaken. This has the effect of a competitive depreciation, reducing local costs versus dollar revenues.
But in a weak dollar, weak energy commodity price environment, net energy exporters get hit by the double negative that is the reverse side of the net importers’ double positive. Net energy commodity exporters see the relative value of their dollar revenues fall, but also experience higher domestic input costs.
For countries heavily dependent on oil and other energy commodity exports this represents a real threat because they are already close to breaking point. The recent sustained period of low oil prices has created huge budget deficits, reduced foreign reserves and prompted heavy cuts in state spending, reducing domestic economic activity. Without the shield of competitive currency depreciation they would become even more exposed to default and financial crisis.
But what of the US itself?
The US’s position is, like the dollar, unique. The US is an overall importer of goods and services, but the dollar’s role as the global reserve currency, and as the primary medium of exchange in internationally-traded energy commodities, means is does not benefit from the double positive on a macroeconomic level. Instead, a weaker dollar implies inflationary pressures as imports become more expensive.
Higher inflation as a result of more expensive imports implies upward pressure on interest rates and thus capital borrowing costs. This would have serious implications for debt-exposed US shale oil and gas producers because it would create the perfect storm: rising capital costs in a period of weak oil and gas prices. Although their access to capital has already been severely restricted by the fall in oil prices since mid-2014, US oil and gas producers have at least been able to weather the storm in an environment of relatively cheap capital.
Conversely, for the euro area, yen and other major currencies, a weaker dollar implies disinflationary pressures and lower interest rates for longer. However, the US energy sector would see one key benefit. The net energy commodity exporters hit by the double negative are also the United States’ competitors in both LNG and international coal markets. Higher production costs for its competitors would make US energy commodity exports more internationally competitive.
Coal markets
Although they have recently shown a marked recovery, seaborne thermal coal prices have sustained a long period of weak pricing. Over the same period, all the currencies of the major coal exporters —South Africa, Australia, Colombia, Indonesia and Russia —fell heavily in value against the dollar. Other factors aside, a stronger dollar has severely reduced the competitiveness of US coal exports, which fell in volume by 17% in 2014, by 24% in 2015 and a further 32% year-on-year in first-half 2016.
The immediate future of the US coal industry hangs on the fortunes of President Barack Obama’s Clean Coal Plan. Trump says he would abolish the plan, while Democratic Party candidate Hilary Clinton is expected to support it. The CPP, through the imposition of tougher emissions measures, is likely to see a further shift in the US electricity generation mix from coal to natural gas and renewables.
As a result, the US coal industry looked to exports for salvation only to find themselves priced out of the market by the competitive depreciations of foreign producers.
Paradoxically, while Trump has not published a formal plan to save the US coal industry, a crisis of confidence in his economic leadership, should he be elected, leading to a sustained depreciation of the dollar, would put in place one of the key conditions for the revival of US coal exports.
Oil markets
The Russian ruble dropped 55% in value against the dollar between January 1, 2014 and January 1, 2016. This meant that although the dollar-denominated crude price fell by more than half in this period, the price per barrel of exported Urals crude in rubles fell much less —by just under a third.
For a Russian crude producer using predominantly Russian oil field services, the fall in international oil prices was to some extent cushioned by ruble depreciation, a cushion not enjoyed by the Russian producer’s US counterpart working on a US shale play.
Without the offset of currency depreciation, the cost of non-US oil production will rise relative to the dollar revenue earned from exports. In a relatively low oil price environment, this will subject non-US oil producers to more of a price squeeze. In effect, the currency depreciation shield will have been removed, exposing them more fully to a weak oil market.
This suggests the oil market rebalancing process will start to fall more harshly on non-US producers. If oil prices continue to firm they may escape the worst; if oil prices trend down again, they will be more exposed than ever. In effect, US crude producers’ cost base will become relatively more competitive as domestic currency costs rise for competing producers, while the dollar value of exports falls.
Gas and power
Like oil and coal, international natural gas trade tends to be denominated in US dollars, whether it is pipeline gas sold by Russia to Germany or LNG transported from Australia to Japan. This is in part because oil trades in dollars and oil-indexed gas contracts still predominate outside of North West Europe and the US. Gas price risk can thus be hedged to some extent through dollar-denominated oil futures and other contracts.
However, local gas markets are less well connected than oil markets, despite the increase in LNG trade. In addition, with the exception of Japan and South Korea, which are almost entirely dependent on imported LNG, most national and regional gas markets have some domestic production. In North West Europe this combines net exporters, such as the Netherlands and Denmark, with net importers, such as Germany, France and the UK, the latter having a substantial proportion of its own production, as well as non-EU external suppliers Norway and Russia.
In these regional markets, local currency risk becomes much more important. In Europe, for example, the oil-indexed component of long-term gas contracts can be denominated in euros for the price of the refined oil products that compete with natural gas. In addition, UK National Balancing Point gas futures are traded on the InterContinental Exchange (ICE) predominantly in ?/therm, but there is also a €/MWh contract, providing a hedging tool for trade between the UK and continental Europe, which are connected by a number of gas interconnectors.
As positions can balance on the NBP by cashing out, as oppose to physical balancing at the connected continental hubs at Zeebrugge in Belgium and the TTF in the Netherlands, and because the NBP contracts are more liquid than their continental counterparts, traders use the NBP to balance gas positions on the continent, thus exposing them to the sterling/euro rate. If sterling weakens against the euro, continental gas prices tend to fall because of the dominance of NBP forward market liquidity in driving pricing at continental European hubs.
Brexit impact
However, the pound has become a risky asset. In the week following the June 23 referendum on the UK’s membership of the EU, sterling lost 9.6% of its value against the dollar and fell 7.6% against the euro. Continuing uncertainty about how the Brexit process will be managed, and what it will mean for the UK economy, had, by early November, left the pound 17% weaker against the euro and 16% against the dollar compared with the start of the year, when the UK’s EU membership seemed secure.
Although a weak pound is clearly good news for UK exports in general, the UK as a whole is a net importer of goods and services, including energy commodities. The expectation is that the higher cost of imported goods, including oil, gas and coal, will feed through into higher inflation.
This, in turn, will eventually prompt the Bank of England to raise interest rates, and improving returns on sterling holdings should cause the pound to strengthen again. In the meantime, companies have to deal for better or worse with the new terms of trade. However, Brexit means that sterling is now seen as a risky bet. In other words, its safe haven status has been severely diminished.
The pound is thus less likely than other currencies to be the beneficiary of any flight from the dollar. While sterling might regain some value against the dollar, euro appreciation against the pound could still be pronounced, which will impact European gas and power prices through the agency of the NBP.
Moreover, while a crisis of confidence in the dollar points to disinflationary impacts in the euro-area, the outlook for the UK is inflationary. Uncertainty over the pound and the UK’s broader relationship with the EU, may prompt questions over its influence on European gas pricing.
Electricity generation
For electricity generators in Europe, the currency equation become more complex still. They are looking for positive generation margins which are often determined by the marginal role played in wholesale electricity price formation by coal and gas-fired generation plant.
This generating margin is composed of the difference between wholesale power prices in local currency, compared with fuel costs, which might be denominated in local currency, but the base price of which is determined by imports denominated in dollars. To this they have to add the carbon price denominated in euros, or in some cases in euros plus an additional national carbon tax in domestic currency.
European electricity generators should stand to benefit from a weaker dollar as the relative value of their revenues in domestic markets will rise in comparison with the dollar costs of imported feedstock.
However, their search for positive generating margins is based on the relative price of each component —fuel cost, electricity price and carbon price —rather than absolute prices. An additional factor is that changes in European exchange rates impact the spread between power prices across interconnectors between different regions within Europe.
LNG
Unlike regional gas trade in Europe, trade in LNG is international and takes place predominantly in dollars. For most Asian importers of LNG, the impact of a fall in the value of the dollar is little different to that of importing oil; it will increase their relative buying power.
LNG cargoes have a wide and increasing range of potential destinations and are not restricted by pipeline infrastructure. On the spot market, they can be bid for by a South Korean buyer as easily as a Spanish one, the dollar being the common medium of competition.
Moreover, the continued predominance (albeit declining) use of oil-indexation in gas contracts means that dollar-denomination makes sense in terms of the use of liquid financial instruments for hedging and optimization.
There are two primary geographic markets; the Atlantic basin —Europe and the Middle East —and the Pacific basin —North Asia and Latin America. Arbitrage between the two depends on the relative price of competing fuels in each market and more specifically on the price of NBP gas in the UK versus spot LNG in Asia-Pacific and long-term contract LNG, which, in turn, is largely determined by the price of oil with a six to nine-month time lag.
As such, while a weaker dollar plays into the hands of importers, to which importers it plays best will depend on the relative weakness of the dollar against individual currencies. This returns to the question of where the safe haven is seen to lie when the dollar is viewed as a risky bet —the euro or the Swiss franc (sterling can be discounted because of Brexit) —or Asian currencies, such as the yen?
But, as for coal, dollar depreciation is a bonus for US LNG producers because it removes the currency depreciation shield from non-US producers. The relative cost base of US LNG production becomes more competitive versus, for example, Australia, just as the US enters the international LNG market in earnest and as Australia emerges as the largest LNG exporter in the world.
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