Global
Oil Prices -- Tight Markets plus Geopolitics Equals Upside Risks
Jan 17, 2006

Richard Berner (New York) and Eric Chaney (London)

The threat of an old-fashioned oil embargo resurfaced over the past couple of weeks, as escalating fears that Iran might cut off oil exports contributed to a jump in crude and refined product prices of $3-5/bbl.  Following two years of a voluntary suspension of nuclear research, Iran switched from negotiation to confrontation by preparing to re-start experiments at a nuclear enrichment plant.  As a result, market participants fear that if the United Nations Security Council threatens or decides to impose sanctions on Iran, the country could retaliate by curbing its 2.6 million barrels a day of exports to consuming countries. 

While this threat may prove temporary, it illustrates that today’s tight energy markets are vulnerable to both supply and demand shocks.  But there is an important distinction between these two types of shocks: Although reduced supply and higher demand will each raise energy quotes, supply shocks — such as embargoes or the loss of energy production from Gulf Coast hurricanes — will hurt global and US growth.  In contrast, higher energy prices resulting from stronger global demand — which has characterized the last four years — likely will have a modest impact on economic activity.

The threat of supply loss isn’t limited to Iran: For example, Nigerian oil production recently fell by about 225,000 barrels per day (10%) after the kidnapping of four foreign oil workers and an attack on a pipeline triggered supply cuts.   Nigeria is a key source of light, sweet crude needed for gasoline and other refined products.  But the loss of crude supply from Iran would represent a much bigger shock. 

Mind tighter market conditions for refined products

Crude supply disruptions aren’t the only factor threatening to hike energy prices in coming months.   In our view, refined product demand and supply have been and will remain the driving forces behind crude prices.  This year, refining margins could reach new highs, consistent with Morgan Stanley analyst Doug Terreson and the energy team’s long-standing “Golden Age of Refining” thesis (see “The Golden Age of Refining: Circa 2006 (Preview)” January 10, 2006).  Their view is straight out of Economics 101: The growth in demand for refined products likely will outstrip that of capacity, pulling up product prices, refining margins, and crude prices with them. 

Indeed, it appears that the blend of strong demand, heavy refinery maintenance, still-tight refinery capacity, and new environmental regulations for gasoline could drive US prices higher through the summer driving season.   In hindsight, 2005 was anomalous: Despite healthy global economic growth (4.2%), petroleum demand growth decelerated dramatically, courtesy of slower growth in China and a slight decline in US demand:  Growth in oil demand slowed to 1.2 mbbl/d from 2.5 in 2004.  We do not expect these circumstances to repeat this year.  Even with some conservation, product demand seems likely to grow moderately in 2006.  For example, the US Energy Information Administration projects that world oil demand growth will increase to 1.6 mbbl/d in 2006, as US demand recovers.  Our own estimate of 1.8 million bbl/d is slightly higher than the EIA’s projection, because we are more bullish on global GDP growth. 

Meanwhile, our energy team notes that refinery operators are likely to begin a seasonal maintenance period as much as 20% higher than in recent years, as companies finally catch up with downtime deferred after Hurricanes Katrina and Rita, and as they modify operations for new environmental regulations.  That will probably draw refined product inventories down to record lows in advance of the summer driving season.  And finally, in the US, the phase-in of Tier 2 gasoline requirements to cut sulfur content that began on January 1, the renewable fuels mandate, the introduction of ultra-low-sulfur diesel fuel starting in the summer of this year, and the phasing out of methyl tertiary butyl ether (MTBE) and increased use of ethanol may reduce supplies, snarl production at some refineries, and put upward pressure on pump prices.

The good news for consumers has been that temperatures in North America were unseasonably high in October and November, allowing a recovery in inventories following the loss of oil and gas production and refinery downtime in the wake of the hurricanes.  Even better, following a cold snap in early December, a period of balmy weather depressed demands for heating oil and natural gas.  That has been most evident in natural gas quotes, which soared during December’s deep freeze to $15/mcf, but plunged to $8.80 last week.  In the wake of that abnormality, it is striking that gasoline and heating oil prices either rose or were stable during that period.  Against the backdrop of still-tight supplies, we worry that a return to bitterly cold weather could promote sharp rebounds in petroleum product and natural gas prices. 

Supply-side shocks matter for the global economy

Financial market participants seem blasé about energy shocks.  Small wonder: Last year’s solid global economic growth in the face of surging energy prices seemed to demonstrate a new resilience in the global economy.  However, as Hurricanes Katrina and Rita demonstrate, a significant supply shock, if it lasts, will have serious economic consequences.  The model-based rules of thumb that have worked reasonably well over the recent years — i.e., that a 10% rise in oil prices typically cuts 0.1 to 0.2 percentage points from global GDP growth — might underestimate the real impact of another price spike if product prices increase significantly more than crude prices, as happened last August-September.  Our revised baseline for 2006 is 10% higher than in our previous projection.  Other things being equal, the downside risk to our global GDP growth forecasts associated with that higher trajectory is probably around 0.2 pp.  But supply shocks that triggered still-higher prices would weaken growth more significantly.

The case for lower oil prices in 2007 is intact

Looking forward, we continue to think that market conditions will be different in 2007, as more refinery capacity is added to the global supply chain.   With GDP growth expected to slow to 3.8%, demand for crude oil should increase by less than in 2006 (by 1.6 mbbl/d, down from 1.8 this year on our estimate), and the markets for both crude and products should be well supplied.  Accordingly, we stick to our longstanding call, i.e., that the price of crude, Brent for instance, should decrease significantly in 2007.  This is not the view currently embedded in future markets, but futures are not reliable predictors of actual prices, as a recent research note from the Federal Reserve Bank of San Francisco confirmed (See “Do Oil Futures Prices Help Predict Future Oil Prices?”, Tao Wu and Andrew McCallum, FRBSF Economic Letter, December 30, 2005). 

However, we concede that risks remain on the upside: The standoff over Iran is unresolved and could drag on, and refinery outages could disrupt supply.  Also, since exceptionally warm winter weather in North America has capped heating oil and natural prices, a return to normal or colder weather might push prices higher.  After all, American folklore has it that if the groundhog sees his shadow on February 2, there will still be six more weeks of winter.  Punxsutawney Phil, we have a date at Gobbler’s Knob on February 2!

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Spain
Challenging Four Mainstream Views (Part II)
Jan 17, 2006

Vincenzo Guzzo (London) and Javier Rodriguez (London)

This the  second  part of an excerpt from a joint report with Morgan Stanley analysts Pablo Beldarrain Santos and Davide Serra.  Part I  was published the January 13 edition of the Global Economic Forum.

I.  The Housing Market

Higher interest rates will help the economy, not kill it

The usual mantra is the Spanish success story is all about construction.  Historically low interest rates and sizeable transfers from the EU budget have led to a boom in the construction sector, which in turn is driving the current phase of economic expansion.  With the ECB now moving to a tightening cycle and the EU structural funds fading away, the construction sector will fall and strong economic growth will evaporate, the story goes.  Even this point looks exaggerated to us.  Let us look at the housing market first and then tackle the issue of the EU structural funds in the following section.

Strong income growth supports affordability …

There is little doubt about the case for overvaluation in the Spanish housing market.  House price inflation has been in double-digit territory for four straight years.  After peaking at 19% in late 2003, it barely decelerated and only recently eased to around 13%.  Nevertheless, several factors suggest that the current dynamics are still consistent with a gradual adjustment.  First, nominal disposable income is currently expanding at an annual rate in excess of 6%, whereas it goes up by just above 2% in the euro area.  Strong income growth has helped contain any downward pressure on affordability during years of large price increases.  It will play an even more important role at times of rising rates.  Courtesy of healthy income gains, the economy should be able to absorb the just-injected 25bp of rate hike without major consequences.  Moreover, even if the ECB were to go for another 100bp of tightening, as anticipated in our forecast profile, debt service costs as a percentage of disposable income would go up by just above 5%, we estimate.  In addition, financial institutions would probably react to an aggressive tightening cycle by extending the average maturity of mortgages and thus relieving some short-term pressure on debt holders.

… and puts a floor under spending

Second, if house prices were to correct significantly, robust income creation would play a second important role by containing the risk of a negative wealth effect on consumption.  While the lack of mortgage equity withdrawal reduces the scope for a proper wealth effect, housing turnover as well as a positive impact on confidence have certainly been factors beyond strong private spending in the recent past.  In 2004–05, real consumer spending exceeded real disposable income by more than a percentage point a year.  We believe that a sudden correction in house prices would probably erase this gap.  However, the recent solid 3% growth rate in real income puts a floor under spending and prevents the risk of a larger adjustment.

New jobs are not only in construction

As income plays such an important role, then some may wonder whether a weak housing market could have a meaningful impact on income itself.  This is unlikely, we think.  The construction sector currently generates 12% of total disposable income and contributes to 24% of its annual growth rate.  Should activity in construction come to a complete halt, an event we do not anticipate over our forecasting horizon, income would still grow at an annual rate of 5%, twice as fast as in the euro area and sufficient to keep consumption on a moderate upward trend.  The truth of the matter is that higher interest rates will help support economic expansion, not kill it.  A gradual normalization will rein in excess liquidity from the system and lead to a rebalance within the various components of domestic demand, we think.

II.  The EU Structural Funds

2007 will not be a watershed

The last but not least mainstream view is that the current Spanish supercycle is a byproduct of large positive net transfers from the EU.  With the just-approved EU budget now foreseeing a sizeable cutback in this source of funding from 2007 onwards, the economy is bound to shift into a lower gear, this analysis concludes.  We disagree.  No doubt, these subsidies will go through a major reduction, but the idea that GDP growth will experience a large discrete step in 2007 is exaggerated, in our view.  To assess appropriately the impact of these changes let us first take a closer look at the functioning of the EU budget.

Into the structural fund world

According to data from the Regional Policy Directorate of the European Commission, in 2000–06, around €257 billion or 37% of the budget of the Union went into regional development and economic and social cohesion through a number of funds.  Spain was by far the main recipient with €62 billion, more than a quarter of the total, a wide margin ahead of Germany and Italy, both getting €32 billion.  During this period, 79.2% of the Spanish population lived in assisted areas: 58.4% were in regions with less than 75% of the EU per capita GDP average; the other 20.8% lived in less disadvantaged regions, but still lagged behind in terms of regional development and thus benefited from financial aid.

Lower population coverage …

Under the new Regional Aid Guidelines, the total population coverage will drop by nearly 20 percentage points to 59.6%: 36.2% still in the most disadvantaged areas and 17.7% in the second category.  A residual 5.8% will benefit from the special status of ‘statistical effect regions’.  These areas now have a per capita GDP of more than 75% of the EU25 average, but this is simply a statistical effect of the enlargement of the Union.  On an EU-15 basis, they would still fall short of the 75% threshold.  On this ground, financial aid will still be available to them at a reduced rate.  Finally, an additional 12.4% of the population will benefit from a two-year transition period in 2007–08. 

…and lower aid intensity

In addition to reduced population coverage, the new regime will affect Spain through a second important dimension.  Aid intensity coefficients, i.e. the ratios between discounted values of aid over discounted values of eligible costs, will also decline.  In 2000–06, the least developed regions of Extremadura and Andalucia, as well as the Canary Islands, have had access to financial aid of up to 50% of their eligible project costs.  Aid intensity coefficients of 40% were applicable to all other regions below the 75% per capita GDP threshold.  From 2007 onwards, on average these measures would be between five and 10 percentage points lower than under previous guidelines: from 40–50% to 30–40% for the most disadvantaged regions and the Canary Islands and from 20% to 15% for the others.

Still a net receiver …

Once we also account for agricultural transfers, Spain is still a net receiver of EU funds, but transfers will go down substantially from the 2000–06 period.  Government estimates that have appeared in the press in the past few days point to €74 billion of spending versus revenue worth €90 billion, adding to a net positive balance of around €16 billion.  On our accounts, that is probably less than a third of what was observed over the previous period.  As described above, regional aid will gradually phase out for those areas where per capita GDP now exceeds 75% of the EU average.  In addition, the country will have access to an additional €3 billion of Cohesion Funds, but this number was as high as €11 billion previously.

… and decline will spread over time

The key point, however, is that, while these subsidies will go through a major reduction, any decline is set to spread over a number of years rather than being a one-off drop.  In fact, we would stress that transfers have already been on a downward trend since 2003, with no obvious effect on the economy.  As time goes by, Spain will lose the second-round productivity-enhancement that these funds have guaranteed over the past few years, but the idea that GDP growth would experience a large discrete step in 2007 is exaggerated.  And do not forget that Spain probably ran a sizeable budget surplus in 2005.

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Asia/Pacific
The Reversal of the US's and Asia's Relative Monetary Conditions
Jan 17, 2006

Andy Xie (Hong Kong)

*****The spreads of the real and nominal interest rates between Asia and the US have reversed.  The spread of the real interest rate between Asia ex-Japan and the US has fallen from the high of 187 bps in 2003 to -75 bps now.  The lower US nominal and real interest rates drove capital flow into Asia.  The reversal could trigger hot money to leave Asia.

*****Asian central banks are not catching up with the Fed: Asian inflationary pressure is tolerable in general.  Growth rates are decelerating.  Asian central banks would be slow in catching up with the Fed.  The US’s real interest rate is likely to rise faster than Asia’s in coming months.

*****The sentiment bubble on China revaluation could burst in six months: The funds flow into China has waned but remains strong.  There is a huge sentiment bubble on the China revaluation story.  There is also a sentiment bubble on the Japan growth story.  These twin bubbles sustain faith in Asia assets despite receding global liquidity.  The bubbles could burst in six months, in our view.

Summary & Conclusions

The US’s real interest rate dropped below Asia’s in 2002, which triggered capital flow into Asia.  The negative spread widened and remained large in 2003 and 2004 and the period was accompanied by unprecedented capital flow into the region.  The US’s real interest rate has risen above Asia’s in recent months.  It could slow down or even reverse the capital flow into Asia, we believe.

Further, Asian central banks are in no hurry to catch up with the Fed.  Asia’s inflationary pressure is tolerable and growth slowing.  The positive spread in real interest rate between the US and Asia could widen in the coming months, which may cause the hot money in the region to leave.

The beginning of 2006 saw another wave of capital flow into Asia.  We believe that this reflects the momentum of the past three years and that it goes against the headwind of the interest rate trends.  While the momentum can still carry the day for a few more weeks, relative monetary conditions will ultimately reverse the tide, we believe.

Monetary Conditions Reverse Between Asia and US

The current monetary cycle began with the Fed rate cuts in response to the tech burst.  The US real interest rate was 164 bps above Asia’s but dropped to 187 bps below in 2003.  The 351 bps turnaround made the returns on capital in Asia much more attractive than before.

The situation has reversed in the past few months.  The US real interest rate is now 75 bps above Asia’s.  The reversal in real interest rates appears to have caused slowdown in liquidity flow into Asia.  The best indicator for Asia’s liquidity is the region’s forex reserves.  The total for the region ex-China/Japan has barely changed since August 2005.  The situation was about the same in December.

The reserves may have increased in January 2006, as there was an asset allocation in favor of Asia in the past two weeks.  This asset decision, I believe, reflects the momentum of the past three years.  The big funds were making allocation based on the past relative performance in asset markets.  This force can carry the day for now, but the relative monetary condition between Asia and the US is a more powerful force, and the liquidity into Asia will reflect that.

Peaking Fed Funds Rate Cannot Reverse Liquidity Flow

The market is excited about the peaking of the Fed funds rate and its potential to rejuvenate fund flow into Asia.  I do not share that view.  Asian central banks are not in a hurry to catch up with the Fed.  The region’s inflation rate is below 2.3%.  With waning energy prices and overcapacity in China, the inflationary pressure should remain tame in 2006.  In addition, the region is losing growth momentum due to decelerating export momentum.  The region’s central banks are likely to take their time in raising interest rates.

The Fed will likely increase the interest rate by 25 bps on 31 January 2006, and may hike one to two more times in the rest of the year.  The region may raise interest rates by half as much as the Fed this year.  There is reversal coming in the relative monetary conditions between Asia and the US.

In addition, there is a lag between relative interest rates and capital flow.  The lag appears to be one year on the way down in terms of interest rates in this cycle.  If the same lag holds on the way up, Asia will suffer capital outflow this year.

China Is Not an Exception

China’s foreign exchange reserves have performed much stronger than the region as a whole.   China’s forex reserves rose by 62.5% in 2004, 17.7% in 1H05, and 14% in 2H05 (including the injections into the state banks), compared to 18.9%, 2.8%, and 1.1% for the rest of Asia.  While China’s forex reserves follow the same pattern as the rest of the region, the growth rate is still high.

The ‘China exception’ theory is unlikely to work, in our view.  There is a massive bubble in the expectation of Chinese currency revaluation.  While the global liquidity boom is at its tail end, its firepower is increasingly concentrated in China-related concepts.  But, such sentiment is against the tide.  This is a liquidity reallocation rather ‘a rising tide lifting all the boats’ story.

This sentiment bubble could burst when the Japan sentiment bubble bursts.  I have not met a single investor in the past three months who is bearish on Japan.  On China, there are still many doubters.  Even though Japan’s economic data have disappointed for the past two months, the market has shrugged it off and believes that the data will come through in the next month.  The sentiment bubble around Japan is even more fragile than that around China.  When this bubble bursts, the yen will depreciate significantly.

When the yen depreciates substantially, it will take down the yuan revaluation expectation.  These twin sentiment bubbles sustain the liquidity into Asia despite the declining tide.  These sentiment bubbles could burst in six months, we believe.

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Israel
Internalising Price Stability
Jan 17, 2006

Serhan Cevik (from New York)

Moving from hyperinflation to deflation, Israel is now internalising price stability. In the early 1980s, the Israeli economy was devastated by the consequences of hyperinflation that fortunately became the trigger for a comprehensive stabilisation attempt lasting for over a decade. Inflation, measured by the consumer price index, declined from the peak of 453.6% in 1985 to 21.1% by the end of 1989 and then averaged 11.3% in the 1990s. In our view, the breakthrough came in the latter years of the 1990s. Accompanied by the ‘peace dividend’ of the Oslo Accords, reasonable fiscal policies, an influx of human capital and increasing integration with the world economy, the Bank of Israel’s restrictive policy stance pushed inflation to 1.4% at the end of 1999 and nil in 2000. If it had not been for a policy mistake at the end of 2001 resulting in a sharp depreciation of the shekel, Israel was steadily moving into deflation. Nevertheless, after a temporary spike to 6.9% in 2002, inflation rapidly turned into deflation, declining to -1.9% at the end of 2003 and -2.7% in March 2004. And only through an aggressive monetary easing campaign and the shekel’s weakening, did the central bank prevent a deflationary spiral in Israel.

Inflation settled within the official target range of 1-3% last year. After years of under- and over-shooting official inflation targets, the CPI posted a month-on-month drop of 0.2% in December that brought the year-on-year inflation rate to 2.4% last year. In our opinion, the rise in inflation (from 1.2% at the end of 2004) has largely been driven by higher energy quotes and the shekel’s depreciation against the dollar. Housing prices in the CPI basket are still strangely linked to the dollar and thereby worsen the volatility of the headline figure. As a matter of fact, excluding the housing component that increased by 6.5%, the CPI recorded an annual rise of 1.3% last year, down from 2.3% at the end of 2004. Having said that, core price indices may have so far behaved in line with the central bank’s multi-year inflation targets, but there is a growing body of evidence in favour of removing expansionary policy accommodation in order to maintain price stability in the coming years.

Above-trend growth in the business sector is narrowing down the output gap. Without a doubt, surging prices in the global petroleum market and the pass-through effect from a weaker exchange rate have been the dominant factors in the inflation process. However, overlooking a number of fundamental issues that, we believe, will have a greater influence on domestic cost pressures and pricing leverage would be another costly mistake. First, the pace of real GDP growth accelerated well beyond its long-term trend, reaching 5.2%, as output expansion in the business sector surged to 6.6% last year. Second, the growth rate of labour productivity in the private sector declined abruptly from 5.6% in 2004 to 2.8% last year, putting upward pressure on unit labour costs. Accordingly, our computations show that the current pace of growth is narrowing down the output gap and therefore not consistent with long-term price stability.

With lagging investment growth, the Israeli economy may experience capacity constraints. Even though export growth is still the leading engine of output expansion and the labour market, albeit improving in recent months, it remains depressed.  The Israeli economy may nonetheless experience inflation-inducing capacity constraints in the future. Fixed investment spending, rising by a mere 1% last year, has lagged behind the recovery in real GDP. Even if we exclude buildings, the increase in capital expenditures on machinery and equipment lingered — at 3.2% — well below the pace of output growth in the business sector. These developments, in our view, signal an inflationary build-up on the supply side of the economy. However, given that both short- and long-term inflation expectations are within the official target range, the Bank of Israel is in a comfortable position to gradually push short-term interest rates towards the neutrality zone.

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