Thursday, March 06, 2014 - Energy as Arsenal

Energy as Arsenal

by Sinclair Noe

DOW + 61 = 16,421
SPX + 3 = 1877
NAS – 5 = 4352
10 YR YLD + 4 = 2.74%
OIL + .45 = 101.90
GOLD + 13.60 = 1351.40
SILV + .28 = 21.54

The Standard & Poor's 500 index closed at another all-time high. The number of people who filed for unemployment benefits last week fell more than expected. That's a sign fewer workers are being laid off. Tomorrow we have the monthly jobs report and we’ll see.

Does a string of weak economic data in recent months represent a genuine slowdown in US economic growth, or is it just weather-related noise? The February jobs report might not provide much clarity because the reference week for the household survey coincided with a mid-February storm that dumped ice and snow (again) on much of the eastern US. Federal funding for extended unemployment benefits expired at the end of December, so we’ll be watching the jobs data to see what happens to people who have been out of work for more than six months.

Of course, the jobs number is hugely important because it supposedly plays into Federal Reserve monetary policy. Fed officials have signaled they’re on track to trim the central bank’s bond-buying program in $10 billion increments this year. The jobs report probably would need to very ugly to change their minds. Of course, the past two months of jobs numbers have been ugly but that was dismissed as weather related. Maybe the February report will be affected by weather as well. One bad report can be explained away, but three starts looking like a trend, despite the weather.

The situation in Ukraine is stable but escalating. Today, Crimea's parliament voted to join Russia and its Moscow-backed government set a referendum in 10 days' time. The EU condemned Russian actions in Crimea as illegal, voiced support for Ukraine's territorial integrity but took only minor steps suspending talks with Moscow on visas and a new investment pact while warning of tougher steps if there is no negotiated solution within a short period. President Obama announced plans to punish Russians and Ukrainians involved in what he called "threatening the sovereignty and territorial integrity of Ukraine".

The US and EU allies unveiled a coordinated set of sanctions to punish Russia for occupying the Crimean peninsula, imposing visa restrictions on individuals. The White House said its visa bans will affect an unspecified number of Russian and Ukrainian individuals immediately, with the threat of asset seizures and bans doing business in the US hanging as a deterrent against further escalation in Ukraine. The EU agreed to suspend visa and investment talks with Russia and held out the prospect of a full-blown trade and economic conflict with Russia unless there was a diplomatic breakthrough. Secretary of State John Kerry continued meetings with Russian foreign minister Sergei Lavrov in Rome.

Specifically, the sanctions would target people who undermine Ukraine's democracy and new government; threaten the country's peace, security, stability and sovereignty; are linked to misappropriations of government assets; and try to assert governmental authority over any part of Ukraine without the consent of Kiev. They would also prohibit US citizens from doing business with those who have been sanctioned. The sanctions plan, outlined in an executive order, lays the legal groundwork for the Treasury Department to impose financial penalties on offenders.

The EU and the US have struggled to coordinate a response to Russia’s military moves. EU-Russia trade volumes, including vast gas imports and engineering exports, are 15 times the level of US-Russia trade. Washington has far less to lose from a trade war, and has been talking tougher. The White House rejected criticism that sanctions risked escalating the crisis.

 President Obama said there is a way for Russia to defuse the situation:  “While we take these steps I want to be clear that there is also a way to resolve this crisis that respects the interests of the Russian as well as the Ukrainian people,” repeating calls for international monitors to be allowed into the Crimea and other parts of the Ukraine to ensure Russian interests are not threatened. But Obama’s rhetoric was more combative than of late and he accused Russia of not just “violating sovereignty and territorial integrity” of the Ukraine but of “stealing the assets of the Ukrainian people”.

While the Ukraine story plays out, the European Central Bank met today to determine monetary policy. The ECB left interest rates on hold and unveiled no other measures to bolster a euro zone recovery. The ECB left its main interest rate at 0.25% and held the deposit rate it pays banks for holding their money overnight at zero. ECB President Mario Draghi also described as "relatively limited" the benefits of one technical option for loosening lending conditions, suggesting the bank will either do nothing or else take bold policy action should the outlook deteriorate.

Draghi said the latest economic information suggested recovery was on track and needed no extra push for now. The biggest concern right now for the ECB is inflation, or rather the lack thereof. The ECB’s primary goal is to maintain inflation at just below a target of 2%. But inflation has run at less than half of the target rate for some time, raising fears that the euro zone could tip into Japan style deflation. Draghi has said that inflation under 1% is in the “danger zone”. In 2016, the ECB reckons inflation will average 1.5%, or roughly double the current rate; and GDP growth was upgraded to 1.2% for this year; so, according to Draghi, everything is on track.  

According to the ECB’s forecast, the euro zone economy is in pretty good shape, all things considered. Although growth is weak and inflation is lower than the ECB would like, the bank believes that these indicators will continue to drift in the right direction. After each of the three rate-setting meetings so far this year, Draghi has said that the bank stands ready “to take further decisive action if required.” Based on his reading of the economy, he hasn’t yet seen the need to change course.

The situation in the Ukraine could change all that. Despite a few improvements, both European economic prospects and credit markets are showing signs of another slide. Unemployment remains high, financial indicators are moving south, and the likelihood of another interruption in Russian natural gas is hardly encouraging for either the residential or industrial end user.

This is anything but an abstract concern. Think of Ukraine as Russia’s fuel tank, or at the very least Russia’s pipeline to Europe. During the last Russian-Ukrainian spat, back in January 2009, during one of the continent's coldest snaps in recent history, a disagreement broke out between Gazprom and the Ukrainian national gas company Naftogaz Ukrainy. Before that, the Russians shut natural gas supplies in 2008 and 2006, resulting in a complete halt of the Russian gas pass-through across Ukraine, and some very cold folks further west.

Russia has always used gas as an instrument of influence. The more you owe Gazprom, the more they think they can turn the screws. Prices of some LNG cargos to Europe jumped above $30 per million British thermal units as a result of the disruption in 2009. Curtailing supplies now would be less disruptive to the market than in past years because a mild winter has kept Europe’s gas inventories 11% higher than at the same time last year.

The crisis has escalated a State Department initiative to use a new boom in American natural gas supplies as a lever against Russia, which supplies 60 percent of Ukraine’s natural gas. Europe, in turn, depends on Russia for 40% of its imported fuel. The administration’s strategy is to move aggressively to deploy the advantages of its new resources to undercut Russian natural gas sales to Ukraine and Europe, weakening such moves by Putin in future years. Although Russia is still the world’s biggest exporter of natural gas, the United States recently surpassed it to become the world’s largest natural gas producer.

The United States does not yet export its natural gas. But the Energy Department has begun to issue permits to American companies to export natural gas starting in 2015. American companies have submitted 21 applications to build port facilities in the United States to export liquefied natural gas by tanker. The agency has approved six of the applications. Even if the Energy Department approves all the pending permits from companies seeking to export natural gas, the fuel could not begin flowing overseas for at least a few years. Most American natural gas export terminals are in the early stages of construction.

In 2011, the Secretary of State Hillary Clinton created the State Department’s Bureau of Energy Resources for the purpose of channeling the domestic energy boom into a geopolitical tool to advance American interests around the world. It has been working, helping to lower Ukraine’s dependence on Russia for natural gas supplies to 60%, down from 90%. Now, there is a renewed push to allow nat gas exports.

This is not the first time energy resources have been used to gain geopolitical advantage. In 2012, in response to Iran’s nuclear program, the United States urged the Europeans to impose financial sanctions that greatly limited Iran’s ability to sell oil on the world market. Other countries feared that the move would raise prices, but officials assured other nations that a surge in American oil production would keep prices stable.

If you’re looking for companies involved in nat gas exporting, start with Cheniere Energy (LNG), Kinder Morgan (KMI) and Sempra Energy (SRE); but don’t forget other energy providers, especially in the renewable or green energy arena, for example the Solar energy ETF (TAN). These are not recommendations, only ideas for research.

Even after taking into account all the transportation, infrastructure, and storage costs, U.S. natural gas can easily compete with Russia's in terms of price. EU countries would probably be willing to pay a slight premium for US natural gas if it ensures energy security. It also serves American geopolitical interests.

The world is changing and energy runs the world.