December 12, 2016

Revisiting our 5 surprises for 2016

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‘We are fairly confident of one thing.  2016 will not be a dull year.’

This was our concluding statement from an article published on the February 1st this year, setting out 5 potential market surprises for 2016.

It was hardly a prophetic statement.  Crude oil prices had already fallen 20% by the beginning of February to around 30 $/bbl.  European coal prices had slumped to 44 $/t.  German Calendar 2017 power prices were trading near 22 €/MWh.  Even after only a month, it was clear that 2016 was going to be an unusually volatile year in energy markets.

This is our last article for this year.  As 2016 draws to a close, we revisit the 5 surprises for a year end status check.

What do we mean by surprises?

Before we examine the 5 surprises, here is a little context on their genesis (taken from our 1st Feb article):

Over the last two years, we have published a number of bearish articles on commodity prices… Being bearish was a lonely argument in early 2014.  But now in 2016 we are hard pressed to find anyone with a positive outlook.

Such a strong market consensus for further commodity price weakness suggests to us it is time to take a more creative approach to considering what could happen next.  Markets are after all a discounting mechanism.  The near term fundamental drivers of the power, gas, oil and coal markets all point towards ongoing oversupply.  But the strength of market consensus suggests this is starting to be well reflected in market prices.

Periods of such strong consensus have historically tended to mark price inflection points.  So it strikes us in 2016 that it is time to look beyond a ‘bearish everything’ view, for some more interesting structural changes in market dynamics.

In today’s article we consider 5 potential surprises for 2016.  These are not forecasts or predictions; we have no better chance than anyone else of divining the future.  But they strike us as being plausible scenarios, not currently reflected in market pricing, but worthy of consideration when planning for 2016 and beyond.

With that context on board, let’s assess each of the surprises.

1. Oil prices form a multi-decade bottom:  Status: Surprise is now likely a reality.

Brent has roughly doubled in price since hitting 27 $/bbl in late Jan, its lowest level of the year.  This can be seen via the animation in Chart 1. Current market pricing for ‘out of the money’ put options suggests the crude market is placing a very low probability of Brent prices returning to those levels.  In other words it is likely that the Q1 low in oil prices was the bottom of this cycle.

That said, crude may run into some headwinds in 2017. The OPEC ‘freeze’ looks shaky at best. And continuing price rises will start to support renewed hedging and investment from US shale producers.  The evolution of global oil demand should also play a key role in determining how oil prices behave next year.


Chart 1: Animation of Brent crude spot price and forward curve

2. European gas market converges with Henry Hub  Status: No surprise in 2016, but risk remains for 2017.

We published an updated analysis of trans-Atlantic spreads two weeks ago.  The price differential between Henry Hub and NBP/TTF has remained in a fairly tight range this year (around the 2 $/mmbtu level), relative to the scale of the absolute price swings at these hubs.

In our view the trans-Atlantic spread can fall significantly further, for example to a 0.5-1.0 $/mmbtu range reflecting the non-sunk variable costs of moving gas from the US to Europe.  The rise in European LNG imports has been relatively modest in 2017.  But pressure is set to build on the trans-Atlantic price spreads as new liquefaction capacity continues to come online in 2017.

3. Major commodity market credit event Status: No surprise in 2016; looks less likely into 2017.

This surprise focused on a commodity price slump-induced credit event.  Back in Q1 this certainly looked plausible.  The market was pricing in substantial premiums to hedge the credit exposure to major commodity traders such as Glencore and Noble.

But as commodity prices have recovered, default risk has diminished.  As long as there is not a renewed plunge in commodity prices in 2017, the probability of a more systemic credit event appears to have receded.  What 2016 has shown though is that the balance sheets of large commodity traders are materially exposed to underlying commodity prices, despite the ‘structural hedge’ logic promoted by their PR departments.

4. Jump in European gas plant competitiveness Status: Surprise is now a reality.

Falling hub prices had already started to support UK gas plant load factors in January.  But a more structural shift in the competitiveness of CCGTs vs coal plants has taken place as the year has developed.  This has been driven by a sharp recovery in coal prices, while gas prices remain weighed down by strong supply.

The gas dominated UK and Italian power markets have led the recovery in load factors.  UK power sector gas burn has increased approximately 50% relative to 2015 levels.  But the recovery has extended across France, Spain, Belgium and the Netherlands.  Even Germany had positive baseload CCGT generation margins over the summer.  As long as coal prices remain elevated, this structural shift looks set to continue into 2017.

5. Continental power prices form a bottom Status: Surprise is now a reality.

The 2016 coal price rally has also played a key role in driving a recovery in Continental power markets. Baseload calendar 2017 German power prices fell to 21 €/MWh in Q1.  At these price levels it was doubtful whether any thermal plants in the German market were profitable.  But as coal prices recovered, German power prices surged 50% by October (although they have since given up some ground as coal prices have softened).

German power prices have a key influence across Continental European power markets, given high levels of interconnection.  Price rises in 2016 in France have been exacerbated by ongoing nuclear outage issues.  The price recovery may pause in 2017 if coal prices continue to retreat and French nuclear plants come back online.  But it is unlikely we see 21 €/MWh again.

What’s in store for 2017?

We leave you with two observations at the end of 2016:

  1. Cyclical bottom: It looks like energy prices have bottomed in 2016, marking the start of a cyclical recovery.
  2. Volatility: The events of 2016 suggest that after several years of more subdued conditions, energy market volatility is back.

Given the popularity of this year’s ‘5 surprises’, we have decided to make it a regular feature of the blog.  So what surprises lie ahead for 2017?  That was a topic of debate over an ale or two at the Timera Christmas party last week.  We’ll be back in early 2017 with further details.  In the meantime, all the best for the festive season.

Article written by David Stokes & Olly Spinks

Revisiting our 5 surprises for 2016