Economics 22/06/2009: All Quiet In Offaly Bogs & Apple

Hat tip to PMD: I was wrong. Irish economy is now on track to full recovery: read the details here.

In a nutshell, "workers at... bogs in Offaly, Westmeath and Longford" are back to "...harvesting process for peat delivered to power stations in Edenderry, Shannonbridge and Lanesborough."

The company - flagship of Ireland's knowledge economy is one of the largest peat producers in the world, with annual production second only to North Korea's 'Socialism = Electrification of Party Palaces' State-owned peat-fired rocket building enterprise. Bord na Mona's latest Annual Report (2007/2008) is available in English, Irish and Corporate-Social-Responsibilish on its website, showing

• Turnover of €371mln in 2007/2008 up 24.1% on 2006/2007 year;
• Profit after tax of €16.8mln - down 32.5% on 2006/2007
  
• Payroll costs €101mln (gross of employers’ pension costs) against €95mln in 2006/2007
• Average employment numbers 2,035 in 2007/2008 against 1,751 in 2006/2007.

So 'workers at bogs' were earning a tidy sum of €49,471 per annum on average in 2007/2008 - down from a whooping €54,037 per annum average for 2006/2007, making Bord na Mona one hell of a place to work for high wages and marking the company as one of the prime high-value added employers in Offaly.

A picture is worth a 1,000 words:So we have: more workers, less peat produced... lower profits...

Now, the company's latest Annual Report is loftily titled A New Contract with Nature. Of course, the State (aka taxpayers) is its shareholder and owner. Keeping in focus on contracts with nature (old and new ones), and keeping its unionised workers off the strikes lines, of course, does not distract Bord na Mona from delivering value to us, the taxpayers:
Hmmm... As I said above - all's good in Offaly bogs.


In the mean time, MarketWatch reports that Apple Inc. has sold "more than 1 million iPhone 3GS models through Sunday, just three days after the phone's launch". 6 million customers have downloaded the new iPhone 3.0 software in the first five days.

Spot the difference between RTE and the WSJ?

The next DofF Sales Brochure on Ireland Inc should, thus, contain a Yankees-only slide titled: "You have the iPhone, we have Bord na Mona's. Jealous?"

Economics 22/06/2009: Cutting public waste

Weekend papers had some rumors concerning the An Bord Snip Nua's forthcoming report with figures in the range of €4bn being quoted as the overall level of 'savage cuts' to be recommended. I have no specific information as to the exact figure that the body will recommend at this time, but I have expressed serious concerns previously that the An Board's cuts will be short of what is needed to restore balance to public spending.

Current official DfoF estimates put the need for 2010-2011 'cuts' in expenditure at €3bn in current expenditure and €1.75bn in capital expenditure. This, alongside with €2.5bn and €2.1bn in new tax revenue, is expected (by DofF) to deliver the Supplementary (April) Budget 2009 deficit targets. Clearly, these targets alone fully subsume the An Bord Snip's rumored levels of cuts. But wait, DofF's Fremowrk Programme published in April 2009 shows (Table 7) additional cost 'adjustments' of €4bn in 2012 and €3bn in 2013. Thus, the total for 2010-2013 in cost adjustments envisioned by DofF is €11.75bn.

In other words, should An Bord Snip deliver on €4bn in cuts, it will be €7.75bn behind the DofF targets for current spending cuts. If the DofF were to be serious in delivering on its own deficit targets, this means that additional tax measures between 2009 and 2013 will have to add up to the above number, or roughly, €1,800 per person in Ireland. Mad?

Now, let us do the magic for our An Bord Snip folks and look at the levels (not sources of cuts needed). Per Revised Estimates for Public Services 2009, we have:
Following these cuts for 2010, I will freeze spending at 2010 level for 2011 and 2012, generating the following 2010-2013 balance sheet:
Yes, cuts proposed above are savage indeed, but the benefit is that we will be running 7% deficit in 2010, 4% deficit in 2011 and 3% deficit in 2012, while generating €4.1bn, €3.6bn and €3.4bn in stimulus money at the same time. Translated into per-capita terms, we will have €2,636 per every man, woman and child in this country for tax cut between 2010 and 2012.

I guess, An Bord Snip can't be expected to worry about such minor numbers...


And while on the topic of Sunday papers: the report in the Sindo stated that the cornerstone of Brian Lenihan / Alan Ahearne's economic growth forecasts for 2011-2012 is their expectation that 150,000 people will leave Ireland in search of work elsewhere. If the Government and its adviser do indeed have such a 'policy' response in mind, I can chracterise it as:

1. Morally depraved and a sign of their abandoning any democratic and ethical responsibility. If Ireland is a mature democracy, Brian Cowen, as a Prime Minister of this country should immediately ask for both Lenihan's and Ahearne's explanation of the Sindo claim and, if it is confirmed, both should be forced to resign their posts.
2. Economically illiterate. Selection bias will ensure that the 150,000 who will leave will be above average in skills and superior in aptitude. With their departure, Ireland will lose a large number of young, more productive workers who also hold the greatest promise for this economy in the future. Equally damaging will be the fact that once the better skilled and younger workers leave this country, their success abroad will ensure that they will not be easily enticed to return to the Cowen-Lenihan-Coughlan & Ahearne Paradise in the future.

One part of the report in the Sindo - the part that cites senior DofF officials stating that Lenihan's strategy for dealing with this crisis is to tax his way out of fiscal insolvency - is true. I can confirm that my own 'birdie' from the Upper Merrion Street has chirped last Friday that senior Department officials 'are very concerned' that Brian Lenihan and Co are 'only interested in grabbing more tax revenue... with no regard for the effects their new taxes will have in the future' post-crisis. In particular, several tax areas currently under pressure have been mentioned as being the targets of such 'revenue grab': income tax, carbon tax, property tax, and employee PAYE.

Economics 22/06/2009: Unemployment & Social Welfare

For those of you who missed my Sunday Times article, here is an unedited version, along with more detailed explanation of my calculations on effective earnings for welfare recipients as compared against those for people engaged in lower-skills work across Irish sectors.


In 1987, after years of gradual decay, Ireland’s economy was scarred by 17% unemployment, of which 10.5% was long-term – of duration over 1 year. What got Ireland out of this quagmire was a combination of drastic currency adjustments, contractionary fiscal policies and a doze of realism when it came to real wages and welfare benefits.

In contrast, so far in the current crisis, 18 months into exponentially rising dole queues, our Government has reduced itself to repeating a handful of old and obsolete clichés.

The first one is to evoke an assumption that our demographic dividend – the term used to describe our younger than EU average labour force – is going to carry us out of the current mess to new heights of growth in years ahead. The second one is to claim that because the onset of unemployment was a sudden one, it is, therefore, temporary in nature. ‘All’s going to be fine, folks, once America starts growing’, says our Government. Will it?

Take the ‘demographic dividend’ argument. It is true that we have a strong younger labour force. However, it is dangerous to assume that these workers are always going to remain in Ireland. In demographics, like in everything else, there is no such thing as a free lunch.

In particular, young worker’s propensity to stay in this country is a function of several variables all of which are under threat from our current policies. Young and highly skilled workers require an environment in which their careers are less constrained by the incumbents. Given that Irish regulations favour the length of tenure over actual and potential productivity as criteria for promotion, layoffs and hiring, this is an area of serious concern. While October 2008 – April 2009 rate of increase in unemployment amongst all Irish workers was 64.5%, for 25-34 year-olds it was 77.5%. To keep young workers in this country, we need to give up some of the tenure-based job security that our trade unions enshrined in labour laws.

Likewise, given a choice between living in countries with much lower income inequalities and in those where pay is linked to individual and sectoral productivity differentials – vast majority of our younger and more able workers prefer to build their careers in the New York, London or Sydney, not in Stockholm or Helsinki.

A corollary of this is that high minimum wage and social welfare rates, and rigid labour markets regulations act as a relative disincentive for highly skilled young workers to remain in Ireland. Higher minimum wage and social welfare benefits depress the premium to skills and aptitude that is collected by the young workers more than for older workers. Younger workers in Ireland already face lower tenure-linked wages, bringing their real consumption and wealth closer to those employed in low-skilled jobs and those who are not engaged in the labour force at all.

Table illustrates by taking an example of single parent in average and lower skills employment in Irish economy and comparing her against a person on social welfare. The current social welfare payments and benefits exceed lower grade workers’ earnings in all broad sectors of our economy, with the gap ranging between €1,423 per annum for production workers in industry overall to €2,006 per annum for lower grade workers in manufacturing.

See below for charts and explanations

There is an added external threat to our younger labour force. As an open economy, with wage premia for younger workers rise in increasingly geriatric Germany, Italy, Belgium and other advanced economies, Ireland will face a simple choice – let our demographic dividend slip to other locations or create a more rewarding and meritocratic home market.

On the net, it is hard to make a case that our demographic advantage over older EU15 economies will automatically yield significant economic or social dividend in the near future.


The second major issue with our labour market policies relates to the recent increases in unemployment. Irish commentators and policy makers often take a simplistic view that the current bout of unemployment was unpredictable, concentrated in the construction sector and is a temporary feature of our economic landscape. Once growth returns, the thinking goes, some 250,000-300,000 of the 402,100 currently in receipt of unemployment assistance will go back to work. Happy times are just around the corner, as our Taoiseach as been suggesting as of late.

This is not what the actual data tell us. While the early rise in unemployment was indeed attributable to the construction sector, since October 2008 a rising share of layoffs were coming from white-collar traded and domestic sectors: finance, legal, marketing, advertising and so on. And it is primarily the younger workers who are getting laid off first.

Just as with the ‘demographic dividend’ discussed above, the unemployment figures are influenced by our labour markets policies. According to the latest comparative data, Irish minim wages are the highest in the OECD when measured as a percentage of an average gross wage. Ditto when measured as a percentage of the average after-tax wage. Short of Luxembourg, we have the highest percentage of employees who earn minimum wage.

High minimum wages are generally an impediment to low skills and youth employment. Crucially, high minimum wages are a barrier to jobs creation in professions that require significant on-the-job training and long periods of skills acquisition. Their adverse impact on employment is further exacerbated by the combination of high labour taxes and low capital taxes. The latter effect is simply due to the less understood fact that lower skilled labour is an easier substitute for machinery than skilled workers. Given tax incentives for acquisition of physical capital and simultaneously staggeringly high costs of employing low skilled workers, any employer has strong incentives to reduce lower-skills workforce over time.

This, in turn, means that around 60% of the total new Live Register signatories since November 2007 (the month when the unemployment crisis really started to unfold) are candidates for becoming perpetually unemployed. In a year to April 2009, the number of those on the Live Register for 1 year or more has risen from 49,555 to 70,828 – an increase that can be broken down into a 13.3% rise in April-October 2008 and 26.2% rise in the subsequent 6 months to April 2009. Long-term unemployment is now accelerating, suggesting that by April 2010, long-term unemployment and withdrawals from labour force will affect some 250,000 Irish workers, brining our overall rate of long-term unemployment to over 11% or above that experienced in the dark hour of 1987.

At this point in time, we must face the reality of the labour markets. No amount of spending on FAS or any other up-skilling programmes will make a dent in the gruesome unemployment numbers. Only significant reforms of our labour markets and a reduction in the total cost of employment of younger and less skilled workers will create an environment in which new positions leading to significant on-the-job training can be added to this economy. Chief among these should be lowering our minimum wages, cutting excessively high welfare supports and using the savings generated to reduce employment-distorting taxes on businesses and workers.

Calculations for the Social Welfare Wage Gap:
First, let us start with assumptions on benefits.
Converting the above into the rates of earning, hourly equivalent):

Comparing the above welfare hourly earnings against the latest CSO data on hourly earnings ex-bonuses etc:
Note that above we have welfare hourly equivalent rate of €18.18 per hour exceeding all hourly earnings in lower skilled production workers and manual labour categories for all sub-sectors, except our semi-states dominated Electricity sector. In other words, on per-hourly basis, if you are a lower-skilled worker in the sectors marked with red in the above table, you are better off on welfare than on the job. And this before we adjust for taxes, which we do here:
Just as above, once we factor in the work efforts across different sectors, and net out taxes, we have social welfare recipients coming out better off than lower-skilled employees in all but one broadly defined sectors. Three sectors (marked in blue) are also under threat of being only marginally better off for an average worker (not a low-skilled one, but an average one!).

Lastly, consider recognizing the fact that welfare recipients have virtually unlimited 'vacation' time, while people with jobs have to sweat for their severely restricted R&R allowances. Table below takes this into account by adding the value of 1 month vacation time to the social welfare recipient's benefits...
Bright red now marks new categories of employees who fall below the effective after-tax earnings and benefits of our average welfare recipient.

Lastly, it is worth noting that a person on minimum wage is currently twice worse off working than sitting on a permanent dole.

Economics 19/06/2009: IMF on NAMA and Construction Data

Per Reuters report (here), IMF is about to publish long over-due Consultation Paper on Ireland.

IMF, allegedly, will recommend Ireland "retain the option of including additional types of loans, such as residential mortgages, in its "bad bank" scheme for housing bad debts".

This if proven correct will open NAMA to an additional downside of some €30-40bn in stressed residential property loans, which cannot be foreclosed or enforced for political reason. A costliest form of rescuing the ordinary homeowners, as compared with directly repairing their balancesheets via cash/assets injection. It will completely politicize NAMA. Hence, I will be revising my NAMA cost estimates upward in days to come.

The Indo reports that the IMF had calculated that Ireland's "structural deficit", which excludes the impact of economic fluctuations on revenues and spending, could be as much as 10 percent of Gross Domestic Product (GDP), or 18 billion euros ($25 billion). Brilliant. If proven right, IMF will be bang-on with my estimates from December 2008 and full 1.8 percentage points ahead of DofF numbers.

"It (the IMF) will endorse the widespread view that most of the correction must now come on the spending side, rather than through more tax rises," the Irish Independent wrote. Now, recall that Brian Lenihan and his adviser, Alan Ahearne, told us that no serious analyst was sugegsting, at the time of the Mini-Budget of April 2009 that the Government should focus more heavily on spending cuts, and thus, per Lenihan, huge tax increases in April budget were justified. Of course, many analysts, ncluding myself, replied that this was a lie back at the time. Now, IMF is falling behind our view.

Now, two things worth mentioning before the report is out.

First, a birdie told me that the IMF was 'convinced' by the Government to delay publication of its report until after the local elections.

Second, another birdie told me that the report was less watered down than usual, because the usual 'consultative' process where by the Governments get to vet some of the IMF's recommendations and analysis in rounds of bargaining broke early in April/May.

I am looking forward to this report...

CSO data on Production in Construction and Building sector:
When a picture is worth a 1,000 words...
No signs of 'bottoming out' or 'Green Shoots' above Q1-Q2 2009 are dire and getting worse for the private building sectors. But what about the so-much touted 'Fiscal Stimulus' on our Brian-Brian-Mary 'Public Investment' side?
None! all is dead on Civil Engineering growth side, courtesy of a lie that is our public investment stimulus.
And things are getting much worse with time across the entire Residential and Non-Residential Building sectors.
But do spot an odd one out...

Economics 16/05/2009: NAMA delayed

Retail sales... Per CSO today: "The volume of retail sales (i.e. excluding price effects) decreased by 17.0% in April 2009 compared to April 2008. There was a monthly increase of 2.3%. The large year on year retail sales decrease in April 2009 is primarily due to the large decrease in the motor trades sector. In April 2009 motor trades decreased 50.1% on the same period last year. If Motor Trades are excluded the volume of retail sales decreased by 7.1% in April 2009 compared to April 2008 and the monthly change was +0.5%. The value of retail sales decreased by 20.5% in April 2009 compared to April 2008 and increased by 2.0% in the month. However, if Motor Trades are excluded, the annual decrease was 11.2% and the monthly change was-1.2%Published by the Central Statistics Office, Ireland."

Of course, if you are a retailer in Ireland, it is the value that you care about. The rise in core (ex-Motor) sales in April (+0.5%) was the first m-o-m increase since September 2008. But in terms of value, m-o-m rates were:Is this a 'dead cat bounce' or a real sign of stabilization? My gut feeling that May-June figures might come in with a moderately positive rebound (weather and recession-fatigue effects will drive people into shops), but the real test will be September-October. Notice, however core value rates staying below the waterline - signaling continued jobs pressure in the sector into the summer months.

Also telling - a look at the actual indices of activity:
Core value index still heading South and a mixed picture in other measures... Again - wait and see...


NAMA delay - predictable stuff of governance... So Brian Cowen (June 17th, Dail comments) thinks that the vote on NAMA might happen as late as in September and other decision-makers (e.g DofF) are indicating that even that might be an optimistic deadline. And, of course, going by the Government record on decision-making - the latter are right:

• Unemployment increases onset - November 2007. Problem acknowledged - July 2008. Policy solutions proposed - still waiting;
• Fiscal deficit onset - Fall 2007. Problem acknowledged - July 2008. First steps taken to raise taxes - October 2008. First (real) steps taken to reduce public spending costs - February 2009;
• Currency crisis onset - on exports side - January 2007. First acknowledged - Summer 2008. First steps taken to address - still waiting;
  
• Competitiveness (using HCI) crisis onset - around 2002. First acknowledged - around 2004. First (real) steps taken to rectify - still waiting;
• Cost of public services crisis onset - around 2002. First acknowledged - still waiting;
• It took the Government less than 3 months to draft and implement sweeping tax cull of our incomes (July-October 2008), but it took the same Government the same 3 months (since April 23rd) to reduce redundant Ministerial/TD pensions by a miserly 25%. It will now take at least 3 years before we can see a real change in the way our politicians pay themselves.
  

In this environment, why do the markets still listen to our political leaders? They promised NAMA to be in place for July vote. After all, in the case of NAMA delays there are real risks to the equity markets:

• banks, absent NAMA clarity, are constrained in raising own capital;
• banks might be facing much higher rates of interest in raising funding in the latter months;
• political risk of the Government bailing out (partially or wholly) of NAMA has now risen as well;
• political risks are now amplified by the fact that NAMA costs are going to play-out coincident with 2010 Budget;
• development projects and investments are now placed under a new round of uncertainty;
• banks valuations are now being impacted by the post-August detailing of the NAMA exposures; and so on.
  

These and other are real costs to the stock market prices and thus to the real risk-adjusted returns to investors.

And on related issue: Davy's note today contains an interesting discussion of Minister Lenihan's statement in the Dail on banks capital. Quoting from the note: "Regarding the suggestion that there was a danger in raising capital ratios, the UK raised them to give confidence to markets in respect of the banks. We did not follow suit, keeping with the minimum capital ratios. I do not propose to change that because I agree ... that if one raises capital ratios too high we will inhibit lending. We must have a minimum and that must be adhered to'.

Davy's analysis: "This would seem to confirm our suspicion that the Irish government is not planning on setting the capital bar particularly high for the Irish banks post-NAMA. Instead it
plans to let the preference shares help offset a slightly lower level of equity tier 1 (maybe 5%+) versus UK peers. In Ireland, the minimum capital requirement is a core tier 1 of 4% whereas in the UK the new FSA requirement is 4% but after a severe stress test. The market will of course make up its own mind on this but it is inevitable that ALBK and BKIR are going to need to do rights issues at some point if they are (a) going to pay back the government preference shares, and (b) want to lend again rather than be focused on reserve building."

My analysis, in addition to agreeing with Davy's: Minister Lenihan is consciously trying to alter the issue of post-NAMA capital adequacy of the banks by not imposing strict test-linked capital bounds. The whole exercise has nothing to do with actually freeing banks funds for increased lending in the economy, as, per Davy analysis, the banks will still face constraints in paying (a). Instead, it is about reducing, artificially, the demand for government recapitalization funding post-NAMA and making it palatable for the banks to accept slightly higher discount rates for assets transferred to NAMA. Investors will have to face a choice in this case:
Option 1: banks accepting the deal and running with lower capital reserves, exposing themselves to the downstream risk of emergency recapitalization should financial conditions deteriorate further in Fall 2008-Winter 2009;
Option 2: banks raising adequate by international standards capital outside state recapitalization scheme, undermining future profitability, but compensating for the above risk.

Good luck to anyone pricing the difference in two Options...


Minimum Wages... ETUI Policy Brief Issue 2/2009 titled "European Economic and Employment Policy Minimum wages in Europe: new debates against the background of economic crisis" provides an inetresting set of comparative charts and tables on minimum wages in Europe. Here they are:
In the above, don't let Luxembourg's numbers deceive you - Lux is a country where national accounting produces vast distortions in per capita incomes and earnings that make it irrelevant for comparisons with other EU states.
In the above, PPS adjustments in Lux and Belgium are distorted by large shares of external transfers into the economy, while the UK PPS-adjusted wage is adversely impacted by the strength of Sterling in 2007. Another issue not reflected above is the tax impact on minimum wage earners.It is worth mentioning here that while the levels of minimum wages are a problem for Ireland, the rate of growth in minimum wages over 2000-2008 is relatively modest, especially once we control for purchasing power.

Economics 16/06/2009: Oil & Gas and NTMA's auction

For a longer post with my thoughts on oil and gas prices, scroll down.


NTMA's gamble... per NTMA release today:

On Tuesday 16 June, NTMA offered two bonds in the auction,

• the 3.9% Treasury Bond 2012 and
  
• the 4.6% Treasury Bond 2016.

Actual results are below:
"Total bids were received for €2.397 billion and it was decided to issue a total of €1 billion [as planned]. An amount of €500 million of the 4.6% Treasury Bond 2016 was issued where the total bids received were 2.5 times the amount allocated, while €500 million of the 3.9% Treasury Bond 2012 was also issued where the total bids received were 2.2 times the amount allocated. The 2016 bond was sold at an average yield of 4.755% while the 2012 bond was sold at an average yield of 3.056%."

If you look at the table above, NTMA always preferred issuing €300mln in shorter maturity bonds and €700mln in longer maturity bonds - a 30:70 split. This time around, it appears it had to borrow heavier in shorter maturity range, hence 50:50 split. And this is for 2016 bond as opposed to 2019 bond earlier. Ouch...

Price spreads min-max were also relatively heavy on shorter maturity. Compare the following two screen shots:
June 16th auction: spreads of 19bps on 2016 bond (2.375 pa ) and 16bps on 2012 bond (5.33 pa)
May 119th auction: spreads of 37bps on 2019 bond (3.7 pa) and 5bps on 2014 bond (1 pa).

Again, NTMA are doing excellent work here, but it is a tough job...



Natural Gas - upward?

Natural-gas prices have been lagging oil prices over the recent months despite the fact that gas drilling and production are on decline worldwide. This has been noted by some Irish analysts, most notably – Davy, whose June 15 quick daily note must be credited for spotting the trend first in the Irish market.

Per Davy note (Caren Crowley): “The ratio of the US oil price to gas price is reaching record highs. A reversion to more normal levels requires the oil price to pull back or the gas price to rally. With the oil price looking unstoppable, it is all up to the gas price, but it is an uphill battle.” There is not much of a real in-depth analysis in the Davy note, so here are some of my thoughts on the issue.

First some short-term facts:

US gas prices have fallen 34% in 6 months to June 2009 and 72% off 2008 peak. In part, this is driven by demand declines. But, as Davy note states, supply capacity has been catching up on downward trajectory: “the number of rigs exploring for, and producing, gas has fallen 56% since September 2008 when it peaked at 1,606, and is at its lowest level since 2002.” This is yet to translate into actual supply cuts as “US gas inventories are abnormally high and are 22% above their five-year average.”

In early April, US natural gas inventories stood at 1,650bn cubic feet in the week ended and steady, equivalent to 300 bn cf above 5 year average and 400bn above year before. Chart 1 below (courtesy of Energy Information Administration) shows that this abnormal situation has gone worse since then with gas inventories breaching the 5-year min-max range for the first time since May 2007.
Now, 25%-30% of US gas production comes from relatively young wells (drilled in the last 12 months). A significant cull of drilling rigs operating today will, therefore, translate into higher demand for imports in winter 2009-2010. The number of running (producing) rigs was down to 1,039 in the week of April 1, 2009, according to Baker Hughes (BHI) - down 49% from the 2,031 level seen in mid-September 2008 -- the highest since 1980.

Chart 2 shows the same over the longer period, with clear signs of seasonality and a rising trend in inventories over time.
One noticeable feature here is that volatility below the trend has been declining throughout the April 2003-April 2006. Afterward, the maximal depletions of gas reserves have steadily increased through April 2008, before once again starting to decline in late 2008 through April 2009. The rate of the later decline has been so far consistent with the rate of decline in 2003-2006 period. This is exactly identical to the 4 years falling, 3 years rising and 1 year falling cycle in 1996-2002.

Another feature is the lack of similar cyclicality at the maximum surplus inventories level, in other words – in peaks above the trend (dashed line). In fact, the trend here is identical (in slope) to the average trend line. Furthermore, when it comes to surplus inventories deviations, current historically high levels (for November 2008) are actually below the maximal inventories trend.

The two facts together suggest that high inventories are not being driven by excessively high supply of gas (which would be consistent with abnormally low minimal inventories in around April trough and abnormally high maximal inventories in and around late Autumn).

Yet another interesting feature of the data is captured in Chart 3, which clearly shows that in recent months, weekly growth rate in inventories has not fallen substantially for positive growth rates, while the rate of natural gas inventories depletion (the negative range) has declined.


Given that this already accounts for seasonality and the weather effects have not been dramatically out of line, what’s going on? The answer is: twin effects of demand changes and equity markets trends are driving prices of oil, while only demand changes have been instrumental in determining the price of natural gas to date. And this is about to change...

On the demand side, power gen accounts for 58% of all US gas demand and this has been falling – 6-8% down so far in 2009. It is also important to note that gas-based electricity generation in the US is concentrated in the Western Pacific states and Northern Atlantic Board states – all of which have seen serious economic pressures on demand side.

But these fundamentals do not really explain the historic trend in gas prices. Futures prices for natural gas have now hit their lowest levels since 2002. Recent pricing below $4 per million British-thermal-unit on the NYMEX, down from $9 mbtu in Q1 2008.

Again, supply-demand analysis does not explain this. Fundamentals analysis focuses on abnormally cold weather in early 2008, which pushed spot prices up and resulted in higher levels of exploration activity. Production capacity increased, but demand collapsed. Fine theory, except, recall prices are down more than 50%, although US Energy Department expects natural-gas consumption to decline by only 1.3% in 2009.

And US gas prices are linked to global gas prices – which are facing significant pressure on the Russian supply side. How? In two ways:

Short-term pressure is rising due to delays in pumping annual storage reserves in Ukraine – a technical issue that can derail gas supplies to Europe. Basically, the principle here is a simple one. To run gas pipe between Russia and Western Europe (the pipe transiting Ukraine), Soviets built a pressure maintenance system that requires intermediate storage facilities (positioned on Ukraine’s territory out of the Soviets’ consideration for ‘balanced regional development’ and owned by Ukraine) to be filled to capacity. This ensures that if Ukraine’s own gas purchases start depleting the pipe flow, the flow can be topped up with reserves of gas. Ukraine is broke and has no cash to pay for this gas – which it will own once it is pumped into storage. Russians are telling Ukrainians that they can’t give them a $2bn loan for gas and are offering to split the loan between Russia and the EU. EU is refusing. So we have stalemate. Now things are getting even more complicated because Ukraine also owes Russians further $3bn worth of cash for gas supplied to the Ukrainian consumers. In short – if gas is not pumped into storage tanks within the next 2 months, there will be serious risk of disruption of gas supplies to Europe in fall/winter 2009-2010. This in turn will lead to price increases for gas globally.

Long-term pressure is also rising due to Russian gas production now shifting to the Eastern Siberian plains. Completion of the new pipeline to service China and Japan is a sign of this. The problem here is that unlike Western Siberian plains, Eastern Siberian plains have smaller gas fields, fewer developed fields and geology that is much more challenging (shale, smaller reservoirs, more complex folds and more broken folds) that the near-perfect sands of Western Siberia. Again, this signals an upside to gas prices in the longer term (I will write about this in few days in more details).

So in the nutshell, future supply constraints are daunting. And these should be working in both short term and long term in the future... Again, supply is not the main driver for the abnormal situation of falling gas prices and rising inventories.


So what is? One word answer is ‘oil and gas price correlations with equity markets’. In my view, it is a speculative buying of oil as a hedge against inflation and the ‘blue chip’ low risk commodity that is driving a wedge between oil prices and gas prices and simultaneously driving closer oil prices and equity prices.

A series of charts below illustrate this point.



Chart above shows relatively coincident long-run trends in DJIA and Oil prices that are not replicated in gas prices. This is confirmed in the scatter plot below. Here, strong correlations in oil and gas prices against DJIA occur over significantly different slope relations. If 100 points increase in DJIA index leads to a $1.4 increase in the price of oil, the same change in DJIA index is associated with a $0.16 rise in the price of gas. While at parity this appears to be a movement in favour of oil, given current conditions in the market (the extremely high negative correlation between price of oil and price of gas and extremely low price of natural gas) any changes in the stock markets valuations should, based on fundamentals, drive prices of gas closer to the price of oil. Expressed in current price percentage terms, table 1 below the chart shows these historically-justified price responses.

Chart below illustrates what I mean by extreme correlations
Notice that current correlation is:
(a) within the range of -0.75-1;
(b) the change in correlation between peak of June 2008 (+99.3) to today (-88.1) is the highest on record for downward adjustment.
Chart above shows the replay of the oil and gas prices correlation in line with the broad equity markets. Here, while correlation between DJIA and oil prices stands at +0.78 and remains in the positive territory since September 2008, the correlation between DJIA and gas prices is at -0.57 and has moved into negative territory in May 2009.

This is interesting, because the structure of gas prices to date contrasts the findings of the recent research on links between oil and gas prices. Jose A. Villar (Energy Information Administration) and Frederick L. Joutz (Department of Economics, The George Washington University) paper The Relationship Between Crude Oil and Natural Gas Prices, prepared for Energy Information Administration, Office of Oil and Gas in October 2006, shows that there exist “a cointegrating relationship relating [natural gas] prices [and] the WTI and trend capturing the relative demand and supply effects over the 1989-through-2005 period. The dynamics of the relationship suggest a 1-month temporary shock to the WTI of 20 percent has a 5-percent contemporaneous impact on natural gas prices, but is dissipated to 2 percent in 2 months. A permanent shock of 20 percent in the WTI leads to a 16 percent increase in the [gas] price 1 year out all else equal.”

So the lags structure implies that a temporary shock to oil price should be followed by a delayed shock to gas prices 12 months after and that the magnitude of changes in gas prices is roughly 80% of the magnitude of shock to oil price.

Clearly, as table above and charts illustrate, this relationship is currently being reversed, suggesting two emerging short- and medium-term trends:

1. fundamentals (firming demand/falling supply) trends indicating significant room for gas prices increases in the range closely linked, but shallower (at 70-80%) than those in oil prices. This implies trend price for gas of ca $8-8.25 per thousand cubic feet of gas;
2. short-run dynamics trends, indicating a ca 6% upside to gas price relative to oil price in the next 3-6 months, implying a price range of $6.8-6.9 per thousand cubic feet.

Short of a W-shaped global recession risk, there is little downside pressure on gas prices in the medium term in my view.