Currency wars and European energy portfolios
Foreign exchange market volatility has sprung to life over the Christmas break. Over the last two months the EUR has appreciated 7% against USD and nearly 10% against GBP. Sharp exchange rate moves characterised the first phase of the financial crisis. But these have been dampened over last two years by massive central bank intervention which has driven foreign exchange volatility levels towards historical lows.
However the global battle to gain a relative economic advantage via exchange rate depreciation, commonly referred to as currency wars, appears to be intensifying in 2013. The recent rapid appreciation of the EUR is a reminder of the significant impact FX risk can have on energy portfolio exposures in Europe.
Why is the EUR recovering?
Fundamental analysis of FX markets is an opaque concept. Genuine trade flows form only a small portion of the approximately $5 trillion daily FX market turnover. Instead the key drivers of FX movements are (i) flows of investment capital driven by interest rate differentials and (ii) central bank monetary policy.
The last 2 years has seen a rapid escalation in aggressive central bank intervention to defend export competitiveness by printing money to debase currencies. In the case of countries like the US, UK, Switzerland and Japan, monetary expansion has been a strategic decision. In a German dominated Euroland, expansion has been much more of a reactive measure to prevent the collapse of the European banking system.
As the Euroland takes a step back from the brink, some of the more extreme ECB monetary interventions (e.g. the LTRO) are expiring. As a result the ECB balance sheet is once again shrinking as shown in the left hand side of Chart 1. This comes at a time when the UK, US and Japanese central banks are still aggressively expanding their balance sheets. The relative moderation shown by the ECB, particularly at a time of renewed aggression from the Japanese, has driven a strong recovery in the EUR since December as illustrated in the right hand side of Chart 1.
Chart 1: ECB monetary stimulus wains and the EUR strengthens
Source: Wall Street Journal
European energy portfolio impact
European energy portfolios are characterised by a number of structural FX exposures. The following are three of the most significant effects that EUR exchange rate volatility has on energy portfolios:
- Oil-indexed gas contract formulas: The majority of gas imported into Europe is indexed to oil. This is predominantly crude indexation in the case of LNG contracts and oil product indexation in the case of pipeline contracts. In both cases oil-indexation results in a USD exposure where a rising EUR vs USD reduces the contract price index as we set out in detail here. The impact of exchange rate volatility is however typically dampened by averaging in contract price index formulas.
- Coal exposure: Coal contracts are priced in USD terms so USD weakness reduces EUR denominated coal prices. Exchange rate volatility therefore feeds through into dark spread volatility, with a higher EUR tending to strengthen coal plant generation margins.
- Relative gas hub pricing: Gas traded at the key North-West European gas hubs is denominated in different currencies, NBP in GBP and the Continental hubs in EUR. So the impact of exchange rate volatility feeds through into pricing and flows across European hubs. An appreciation of EUR against GBP will act to increase the value of gas at Zee/TTF vs NBP, although hub price differentials typically respond quickly to Norwegian delivery flexibility and gas flow across the IUK and BBL.
The last of these is a particularly important dynamic for companies that hedge Continental European gas hub exposures at the more liquid NBP. This results in a EUR-GBP position that has to be actively managed to retain a clean hedge.
Exchange rate volatility has been less of a threat over the last two years of the financial crisis as central bank intervention has suppressed FX volatility. But FX volatility may make a rapid comeback if the response and counter-response of intensifying global currency wars starts to destabilise exchange rates. It is times like these that residual FX risk in energy portfolios can cause nasty surprises as we explored in more detail in a previous article.