The Weekly Report: Energy in 2012 | Beware the Ides of March

6 February 2012


In this, our last instalment on Energy in 2012, we will examine the risks that Europe’s sovereign debt crisis pose to global energy markets, using a little imagery from the movie “300” and other Greek history or mythology. Europe’s situation is more likely to impact on global energy prices than Iran: the sovereign debt crisis there is a fact, while military conflict with Iran is still quite removed from inevitability.

While the news of the European fiscal compact is certainly encouraging (ignoring the fact it only took them 16 meetings in 2 years), there are still a number of scenarios that could rattle energy markets in the short term, including further sovereign downgrades as well as defaults. The markets are focusing on the fiscal compact, but eventually will have to refocus its attention on the Greek debt negotiations, which aren’t going so well.

Greece is the country most likely to default—in fact, it is almost a certainty. It isn’t a question of if, but when, and how. Greece has proven to be a veritable Trojan Horse for the European Union, and particularly its currency and collective creditworthiness.

While nominally a ‘developed’ country (albeit a very minor one), the economy in Greece was structured very much like a non-industrialized developing nation: inefficient tax collection, high levels of government or government-affiliated employment, wealth concentration, and inefficient labour and production systems. Adding to the similarities with developing nations, particularly before the commodity boom of the 2000s which brought them large fiscal surpluses, Greece has a crushing debt load which it has no hope of repaying without massive and disruptive economic reforms. In essence, Greece is a Trojan Horse because they were allowed within the EU’s walls under certain assumptions and pretenses, but they turned out to be something completely different – and potentially catastrophic.

The country and its leaders have yet to formulate a real, long term economic growth strategy, and even if they had, they may not be able to implement it as they have been forced into an austerity regime that has proven far more damaging than helpful thus far – increasing unemployment and decreasing consumption.

Because Greece, unlike for example Italy or Japan, has a high level of indebtedness to international private sector creditors such as banks and investment funds, the restructuring process is all the more complicated because those bondholders are far less willing to be flexible, particularly on taking haircuts on the value of the debt. It is not inconceivable that we end up with a scenario where the negotiations are inconclusive, or worse, an outright failure.

We could see a Greek default as soon as March 20th, five days after the ominous Ides of March when Julius Caesar was assassinated (yes, he was Roman, not Greek but still). The real question is, will it be an orderly default or a chaotic one—the difference being intervention of some sort by the ECB or IMF, as well as advance notice, in the former. In case of an ‘orderly’ default, the impact on the market could be quite severe, but short-lived, with a $6 to $10 drop in crude prices in less than 4 days, before it starts a slower creep back up to somewhere around $100. Eventually, once the market is sure that the Troika is willing to step in somehow to minimize volatility, the markets will normalize.

However, if there is no reassurance of an ‘orderly’ default, we could easily see prices fall between $12 and $20, and remain at those levels for several months. A disorderly default would also mean higher risk of contagion (particularly for Portugal, as well as Spain and Italy, in that order) and subsequently, further sovereign downgrades for both core and periphery. Lastly, Greece may be forced to leave the European Union and or the European Monetary Union, which may work to its advantage because it could then devalue its currency aggressively and take other measures to stimulate growth.

Nevertheless, even if the Greek debt negotiations go well, their debt is simply unsustainable at 339 billion Euros. Core countries such as Germany will end up having to fork over more funds. Regardless of how much noise is made by the likes of Germany, it is too late to turn its back on the Union—ultimately, it is in Germany’s self-interest to preserve the EU, and more costly to abandon it than to bail it out. Therefore, the likelihood of a catastrophic split or mass exodus from the EU is quite low.

Economists across all major investment banks as well as multilateral organizations such as the IMF and World Bank also acknowledge that regardless of the debt picture, there is likely to be a recession this year in Europe. This will add some resistance to oil prices, meaning that there may be some sort of ceiling level that prices will not be able to stay above for any extended period (barring conflict in the Gulf). We may well have reached that resistance level already, with oil floating around the $100 range lately. However, oil could continue to go up to levels between $105 and $110, particularly if U.S. economic statistics continue to improve.

The real headwinds in Europe are far scarier and less fixable: dwindling populations, aging and unfavourable demographics, and regulatory regimes that often discourage entrepreneurship and innovation—or at the very least, do not encourage it or make it blossom the way it does in China, the U.S. or even Latin America. In the end, these will be the real undoing of Europe, unless it takes drastic action, something which they have shown scant ability to do.

Firstline’s call to action is a defensive one. Investors should always have a diversified portfolio to protect against the impact of events that could disproportionately affect certain companies, industries, or regions. Luckily, as Trinbagonian investors, we have access to Unit Trust’s TT$ investment funds, which can provide an excellent shelter should Europe suffer major credit events this year. UTC’s TT$ returns are based primarily on local debt and equity securities, which have minimal direct exposure to the E.U., thereby presenting an excellent diversification option.

UTC aside, we are happy to assist and advise you on how to avoid exposure to the turmoil in Europe. Send me an email at michael.cooper@nullfirstlinesecurities.com to find out more.

Michael J. Cooper
Trading & Strategy Consultant

Comments are closed.