Energy as Key Factor in Explaining Future Growth in Emerging and Developed Markets? By Erik L van Dijk (LMG Emerge) and Eloise Enanoria (LMG Emerge)1 LMG Emerge Oirschotlaan 19‐21 3704 HK Zeist, The Netherlands info@lmg‐emerge.com 1 Erik L van Dijk is principal at LMG Emerge (Zeist, The Netherlands). Eloise Enanoria is financial analyst Emerging Markets and Manager Selection at LMG. LMG is an institutional investment consultant with activities in the following three key areas: i) Asset Allocation, ii) Manager Selection and iii) Emerging Markets. LMG advises pension plans and other institutional investors with advisory assets under management of more than USD 20 billion (situation as of March 31, 2011) on their Emerging Markets and Energy investments.
1) Introduction Up until 2002 emerging markets as a group did not outperform developed markets. True, there were great periods for individual countries and even the MSCI Emerging Markets index had great periods (see for instance 1987‐1997 in Figure 1 below) but sooner or later negative surprises – in combination with excess volatility – would cause disappointments for investors. And that held not just for portfolio investments, but also for foreign direct investments. Things were of course directly related to the instability of the emerging countries: volatile, illiquid and relatively small stock markets; lack of a good institutional infrastructure and legal framework; corruption; weak currencies; unstable economies and large political risk. But Figure 1 seems to indicate that at least stock market investors do believe that things are different this time: the performance gap between emerging and developed markets grew over the last 10 years and it is now so large that it seems unlikely that it will be as easily closed as it always did up until 2003. Figure 1 MSCI EM versus MSCI World (in US$); 1988 ‐ 2011(5) In Table 1 we subdivide the period 1988 – May 2011 in 6 sub‐periods of 4 years each.2 The MSCI Emerging Markets outperformed the MSCI World in all sub‐periods with the exception of 1996‐ 1999, the period of the IT bubble (with initially positive effects for developed countries) and the Asian and Ruble crises (negative for emerging countries). The volatility gap between emerging and developed markets seems to be remarkably stable with values between 5‐6% and 9%, with only one exception: again the period 1996‐1999. As if (Western) investors translated the availability of a ‘new growth story’ at home (IT, Internet) into a decreased interest in and increased nervousness about emerging markets portfolio investments. 2 The last sub‐period is slightly shorter since we did not finish 2011 yet.
Table 1 MSCI EM versus MSCI World; 1988 ‐ May 2011; Analysis of Sub‐periods We also looked at the trend in systematic risk of Emerging Markets investments, using the MSCI World as our ‘market portfolio’. Since the mid‐1990s correlations between the two indices are gradually moving up and this is in line with ‘globalization’ tendencies. As a result of that the diversification value of Emerging Markets investments has decreased and with the leading emerging countries now maturing, one might interpret this as an indication that – unless one expects a fabulous global economic climate – the quest for new opportunities in frontier countries will be the next big thing.3 Since the beginning of this century things seem to be different, with the leading emerging economies, the so‐called BRIC nations (Brazil, Russia, India and China), developing into global growth catalysts. This has also positively affected growth in other emerging and frontier nations (compare for instance the so‐called Next‐11 concept as introduced by Goldman Sachs Asset Management in 2005).4 And indeed, when making the switch from stock market returns to real GDP growth rates, developments since 1980 indicate that the old adage that the higher growth rates in emerging countries don’t mean that much simply because they are related to a smaller economic base is not correct anymore. Excess growth over a long period of time will gradually but slowly lead to a situation in which the largest emerging economies will become noticeable as economic powerhouses. And that is what happened. In Table 2 we see that average real GDP growth per annum for all nations in the IMF database for the period 1980 ‐ 20165 is 3.69%. When looking at developed nations ‐ both the group as a whole and three sub‐groups (Eurozone, G7 and the USA) ‐ we see that they are at least about 100 basis points of growth less strong than this average. In other words: emerging nations do outperform substantially when it comes to growth. The average growth rate in emerging countries was 4.45% over the period studied. Frontier countries did less well, but their 3.56% is still about 100 basis points better than the developed nations.6 The BRIC nations are 3 This is a vision shared by some of the leading Scandinavian pension funds, the Norwegian Sovereign Wealth Fund (SWF) and several SWFs in the Middle East who have all increased their investments in smaller emerging and frontier markets to levels of 10 or more percent of their overall portfolio. 4 See http://en.wikipedia.org/wiki/Next_Eleven for more information about this concept. 5 We decided to include the IMF estimates for the period 2010‐2016 in our analysis, because future trends will play an important role in what we will have to say later in this paper. 6 When talking here about ‘Emerging Countries’ versus ‘Frontier Countries’, we used the MSCI Emerging Markets definition to distinguish the first category. The latter category consists of all countries in the IMF database (185 in total) not classified as ‘Developed’ or ‘Emerging’ market by MSCI.
indeed real growth champions with annualized growth rates of 5.74% on average over the period 1980‐2016. Table 2 Real GDP Growth Rates over the period 1980 ‐ 2016(E) We also looked at the standard deviation of GDP growth rates in Table 2. The reason is that a lot of portfolio and (foreign) direct investors refrained from emerging and frontier markets investments because they believed that good average growth numbers would hide the risk of huge potential disappointments in individual cases. In other words: they believed that volatility of growth was much higher. The volatility gap is remarkably low and the ratio of GDP growth to GDP volatility gives far better scores in emerging and frontier markets than in developed nations. Of course, the developed, emerging and frontier groups (and the sub‐groups we presented) are themselves like small portfolios and it is therefore possible that this would hide the fact that individual countries within them are far less volatile within the developed segment with its more diversified economies. A closer analysis of the 185 countries in the IMF database confirms that this is actually true. However, with the individual economies of emerging and frontier countries also still being much smaller, portfolio and direct investors should not simply compare the ‘average’ developed country with the ‘average’ emerging or frontier country. When having let’s say an investment budget of $X million they could consider spreading this over n smaller projects in emerging or frontier economies, something that would be more difficult in the richer and more expensive developed economies. In this way, excess volatility and risk at the individual country level is compensated for in a way demonstrated in Table 2. In Figure 2 we present the data in more detail, looking to the annual growth rates from year to year over the period 1980‐2016. When looking at the extremes, we see indeed that – if anything – the BRIC category is visible as ‘growth champion’. Also remarkable: this is clearly not something new. Already during the period 1980‐2002 BRIC has qualified as fastest growth area on several occasions. Just as surprising: with the exception of the 1997‐1998 period – characterized by the Asian and Ruble Crisis – we do not really see emerging or frontier markets as the negative outlier over the time period. The United States (1982), Eurozone (1991‐1993 and 2008‐2009) are more prominent in this respect, and that is not exactly what one would expect based on the reputation of emerging and frontier economies.
Figure 2 Annual Real GDP Growth Rates; 1980 ‐ 2016(E) When looking at the availability of production factors within developed and emerging countries we can detect a pattern that makes it understandable why things are ‘different this time’ and that emerging market growth is a structural phenomenon now. Figure 3 shows in a simplified, schematic way how a deterioration of relative production factor availability in developed nations went hand‐in‐hand with improvements in the emerging world. Figure 3 Global Availability of Production Factors: Period until (Before) and since (Now) 2000 The main scarcities are now to be found in developed nations. As we will show in the remainder of this contribution, changes in supply‐demand patterns and reserve positions within primary energy markets are key when it comes to the analysis of future trends within emerging countries on the one hand and the differential development between emerging and developed nations on the other. In chapter 2 we will first look at the new balance of power that has developed in international capital markets as a result of the differential growth in emerging and developed nations. In chapter 3 we will analyze what this will imply for international money flows, with the growing importance of wealth funds that are based on commodity exports as a first indication of the pivotal role of the energy sector. In chapters 4 and 5 we will look in more detail to trends in the various primary energy
sub‐sectors, both physically (chapter 4) as well as financially (chapter 5; stock market developments). Both return and risk considerations will be discussed in chapter 4 and 5. Chapter 6 concludes. 2) A New Balance of Power in International Capital Markets When looking at the stock market and GDP growth trends described in chapter one, the world is changing, with developed markets losing influence vis‐à‐vis emerging and frontier ones. As shown in Table 1 above, correlations between the MSCI World and MSCI Emerging Markets have gone up substantially from levels of 0.3‐0.5 up until 1995 to current levels of 0.8‐0.9. ‘Segregation’ of economic development in emerging countries has been replaced by ‘Globalization’. Emerging countries’ dependence on foreign government and bank loans has diminished with international portfolio and direct investors generating substantial money flows into the emerging growth markets. Positive effect for emerging countries: these capital flows are far less volatile than loans, with the latter often drying up whenever the host country was in the biggest need of a capital injection. A shifting focus away from ‘Aid’ towards ‘Economic Support’ and ‘Micro Finance’ has also contributed to a better competitive position for those emerging and frontier nations who showed progress in economic and political development on the one hand, and improvements in governance, financial and institutional infrastructure, legal system and prevention of corruption on the other. The work of Zambian economist Dambisa Moyo7 and Nobel Prize Laureate Mohamad Yunus8 has played an important role in explaining this trend. Developments in financial markets are lagging when it comes to the embracement of this ‘Changing World’ concept. True, institutional and private investors are now investing far more in emerging countries than they did before, but allocations to emerging markets do normally reach 5‐15% of the overall portfolio. When we compare that to the global GDP‐based weight of these countries – about 30% in 2010 – there is still a long way to go before the underweights to fast‐growing emerging markets have been washed away. Table 3 indicates that the GDP weight of emerging and frontier countries combined was approximately 15% in 1980. In 2016 it is expected to reach 35% and growth will continue. Cheng et al. (2007) estimate that its share will reach 50% by 2050 and there are even scholars and practitioners who believe that this level might be reached sooner. 7 See Moyo (2009). 8 See Yunus (2003).
Table 3 World Distribution of GDP; 1980 ‐ 2016 Although beyond the scope of this contribution, it is not totally coincidental that the last 10 years were one of the worst decades in terms of investor performance, since the information above suggests a dramatic underweight to markets with the best growth record and potential! Until recently investors could defend themselves by referring to the shaky financial positions of emerging countries. Financial crises in Latin America (1994) and Russia and Asia (1997‐1998) showed that in a dramatic way. And political risks are also a major factor (e.g. Middle East). But when looking at the financial situation things have totally changed. Twelve of the 20 richest countries in the world ‐ when it comes to gold and foreign currency reserves ‐ are now emerging markets! Of course, it is not only about gold and currency reserves, but when we add external debt to the equation the overall picture is more than confirmed: all top‐20 debtor nations in the world are ‘developed’! Emerging countries as a group do now have far lower External Debt / GDP ratios and faster growing economies. 3) International Money Flows: What to Expect? With institutional investors now adjusting their strategic investment policies to the new reality of a ‘Changing World’ in which emerging nations are here to stay, longer‐term money flows are reasonably predictable: from developed countries into emerging ones. But in a globalized world in which market liquidity of emerging markets has gone up and transaction costs have come down while volatility remains relatively high, tactical withdrawals and re‐entries will ensure a confusing short‐term pattern, not to the least because the more or less stable volatility gap between the MSCI Emerging Markets and the MSCI World (see Figure 4 below) translates into a relatively higher beta when comparing it with the substantial increase in correlation between the two indices. This helps explain why emerging countries were hit hard in 2008‐09 even though – when taking a closer look at the reasons of the Global Financial Crisis – it was clear that negative developments in the United States, Europe and some other developed markets were at the heart of the GFC.
Figure 4 36‐months volatility; the MSCI EM versus the MSCI World (1990‐2011(5)) But there is more. Whereas big institutional investors from developed nations still dominate global financial markets with total assets under management (AUM) of approximately USD 15 trillion9, Sovereign Wealth Funds (SWFs) are of growing importance. As of December 2010 their combined wealth has grown to USD 4.2 trillion10, less than 25% of the combined wealth of pension plans but of growing importance due to faster growth. Asian and Middle Eastern emerging countries dominate the SWF investment pool as Figure 5 below illustrates: 9 Data based on LMG Emerge database and OECD figures 10 Sovereign Wealth Fund Institute, 2011
Figure 5 Wealth of SWFs as of Dec 2010 ‐ Regional Distribution When digging deeper (see Table 4), we can derive that about 60% of SWF wealth is oil‐ and/or gas‐related, with excess economic growth (China, Singapore, Korea) playing an important role within the remaining 40 %. And when looking at tensions in the Middle East – and their impact on global energy prices – on the one hand and Western nervousness when big Middle Eastern investors (SWF or private) want to invest within their countries on the other, it is clear that the energy sector will play an important role over the next 10 years if we want to explain not just financial market return and risk prospects but also geopolitical trends and risks. Table 4 The largest Sovereign Wealth Funds; Dec 2010
When looking at the situation in international financial markets, the world has moved into a three‐bloc structure (USA, Eurozone, Emerging Markets) with the EM‐bloc clearly led by the BRIC nations and with developed nations outside the USA or Eurozone opting for a linkage with one of the blocs in a more flexible way than ever before. The structural, longer‐term money flow will be an inflow of portfolio investment capital into emerging and frontier countries, but it will remain a volatile one that – whenever the global or individual country market climate turns from positive to negative – could easily be interrupted by substantial periods of withdrawal back into more mature markets albeit that the availability of less‐risky asset classes in emerging and frontier countries (money market securities, emerging market debt; the latter both hard and local currency) will gradually reduce the size of these moves. The money flow related to foreign direct investment (FDI) capital will also imply disinvesting in mature economies, with internationally‐operating firms adding new investments in emerging and frontier countries so as to share in the excess growth and favorable economic conditions of these countries. However, the FDI related inflow will be less volatile and far more sticky instead: instead of large withdrawals in bearish periods, we will now see a substantial reduction of the inflow at best. But these patterns will – when combining them with increased wealth in emerging and frontier nations at both the government/SWF‐level as well as privately – translate into growing tensions when investors based in these nations will try to buy themselves a bigger stake in developed economies. First indications are that developed nations do normally make big pleas for free capital flows and liberal financial systems as long as it is about investments in emerging and frontier markets, whereas they define far more investment cases as ‘strategic’ (and therefore not investable for outside investors from these nations) in their home market. This might translate into increased geopolitical tensions, especially when Middle Eastern or Russian investors are involved. Within emerging and frontier nations there will be substantial changes as well. Changing competitive advantages and scarcities will have an impact on money flows, with energy and other commodity producers in a good position to benefit from growth in China and other leading emerging countries. 4) The Pivotal Role of the Energy Sector Table 5 tells us that traditional fossil fuels – oil, gas and coal – are still playing a dominant role within our global energy consumption. Interest in renewable energy is growing, but at a speed that cannot in the near future reduce the tensions within markets for fossil fuels. And this will automatically translate into expected price increases that will benefit producer nations and hurt consumers.
Table 5 Global Consumption of Primary Energy Sources; 2009 A regional comparison of the energy reserve position for the three most important primary energy sources with the intra‐regional consumption needs does clearly indicate the energy problems of the developed blocs. The Middle East, Russia and Sub‐Saharan Africa are the only regions capable of covering their own consumption needs for hundred years or more from their own reserves (see Table 6). Table 6 Intra‐regional Comparison of Primary Energy Consumption and Reserves But of course: countries with shortages can import from countries with surpluses; and when comparing consumption with production and reserve developments at the global, inter‐regional level the situation is seemingly not so bad. Consumption growth was slightly higher than production growth, but this was compensated by an increase in reserves. And growth rates of both consumption and production went down tremendously during the period 1989‐2009 when comparing it with 1969‐1988. But the real problem for the next 20 years is that so far the bulk of growth was eaten away by ‘just’ the developed nations. Now, as a result of growth in emerging markets new reserves and gains due to increased energy efficiency will by no means be sufficient to capture future global consumption growth. This will result in price increases for oil, gas and coal. Price increases will of course make new exploration profitable, but it will not be enough. Not to the
least, because there are also environmental pressures that work against increased exploration of new oil and coal fields (especially in developed nations).11 And if we add the fact that reserves are depletable, this will translate into an increased focus on renewable energy, but will it be enough? The answer is most likely: No. Especially now that there are huge setbacks due to the March 2011 nuclear drama in Japan, with nuclear energy being the only primary energy source with sufficient shorter‐term growth capacity to help offset supply‐ demand imbalances for the three traditional fossil fuels in a meaningful manner. And that will make a country’s sensitivity to energy risk one of the most important themes of the next 10‐20 years when analyzing its economic and investment potential. When looking at crude oil price developments since 1861 (Figure 6) we see a more alarming story, albeit one that is not totally new when translating spot prices into real prices adjusted for inflation. Figure 6 Crude Oil Price Development: 1861 ‐ 201112 When looking at nominal price developments we see that oil prices started to move up since 1973, albeit in a volatile way. Shorter‐term Economic and political factors have played a tremendous role in explaining this pattern, but the longer‐term trend is clear as well. But from the literature that 11 See BP Statistical Review (2010). 12 Average Annual Prices (except 2010/2011 EOP)
studied the relationship between energy price changes (especially oil) and exchange rates, we do know that it is important to correct for exchange rates effects, especially the ones related to changes in the value of the US Dollar.13 In real terms – when looking at constant dollar prices ‐ it is even more obvious that the rise of emerging markets and their excess economic growth rates will translate into more price increases. Figure 7 Gas and Oil Prices Compared; 1984 ‐ 2011(1) In Figure 7 we compare the trend in gas prices with the one in oil, and ‐ although it is clear that things look better there (from the perspective of gas consuming nations) – we can only conclude that since 2003 oil and gas prices are moving up more or less in synch due to increased emerging markets growth, albeit that oil prices are more volatile. In Figure 8 we include coal in our analysis. Conclusion: things look better there at first glance, but ‐ when incorporating the fact that there is a strong environmental lobby working against increased coal production in the developed nations and some emerging ones as well – it seems unlikely that this price advantage will translate easily into a ‘rediscovery’ of coal. But there are exceptions, mostly in the bigger less‐densely populated emerging nations, with the USA (relatively large reliance on coal) as a remarkable exception to the rule. In chapter 5 we will dig deeper into the balance between consumption, production and reserves per individual primary energy source. 13 See for instance Akram (2009).
Figure 8 Coal Price Development (1987‐2011); Comparison with Oil and Gas 5) Macro Sensitivities to Energy Risk Factors Chapter 5 consists of two paragraphs. In 5.1 we focus on the physical market and take a closer look at the balance between consumption, production and reserves for individual primary energy sources at the country level. In 5.2 we focus on the financial market situation and present a multi‐factor approach in which we link excess returns on equity markets to several risk factors, including a set of risk factors directly related to the energy market. 5.1 Primary energy sources and the physical balance between consumption, production and reserves; a country analysis Summarizing chapter 4 we can say that oil prices of USD 100 or more per barrel are therefore here to stay. Although in a somewhat less volatile way, prices of gas have followed oil price trends, so consumer nations do not really gain much by trying to move from one fossil fuel to the next. Coal might be an option, but this is exactly the primary energy source that is confronted with the largest environmentalist lobby in the developed world. Within emerging countries we do however see a growing interest in coal consumption and production. Using the BP Statistical Review (2010) we ranked the top‐50 nations in terms of consumption, production and reserve positions. Using a data set containing the situation in 1989, 1999 and 2009 we are also able to see trends. The larger the production and reserve position compared to its consumption, the better‐off a nation is. Large consumption without sufficient internal production and reserves would translate into dependence on energy imports and that will be a big risk in a future characterized by rising prices for the main primary energy sources and
relatively inelastic demand for these resources. We will now proceed by analyzing the situation for each of the five primary energy sources (oil, gas, coal, nuclear energy and hydro energy) separately. We will start with coal. 5.1.1. The Coal Market When looking at the consumption of coal in Table 7, it is clear that the USA and Japan are the only two densely‐populated developed nations that resist environmentalist pressures to such an extent that they make it into the top‐tertile of coal consumers. Table 7 Coal Consumption 1981 – 2009 Other than that, coal consumption seems to be an emerging countries’ thing, with energy‐hungry Asia‐Pacific being by far the largest consumer with a 65.6% share of global consumption. South & Central America and the Middle East don’t have much coal reserves and this translates into low production and low consumption figures. Table 8 Coal Production 1981 – 2009
When we compare the production situation in Table 8 with coal consumption in Table 7, we can deduct that top‐tertile consumer Japan is also a huge importer notwithstanding potential environmental problems. This is indicative of the energy shortage faced by Japan. The nuclear catastrophe in Fukushima in March 2011 will probably translate into a growing interest in renewable energy and – since this will not have sufficient impact in the short run – ongoing strong dependence on coal, oil and gas imports. Taking into account expected energy price trends this will provide the Japanese economy with a huge burden when trying to re‐ignite its economic growth, making a continuation of a sluggish economic growth path a more likely outcome. Remarkable: economic tigers Turkey and Vietnam are depleting their coal reserves rapidly so as to benefit from relatively low coal prices (vis‐à‐vis oil and gas). Table 9 Coal Reserves; situation as of 2009 An analysis of the coal reserve situation per 2009 (see Table 9) in combination with production and consumption trends tells us that the USA is still the largest player in this market, but how long will the government be able to resist environmentalist pressures? We believe that it is not unlikely that the USA will use these pressures to make a case for a growing production and consumption of nuclear energy albeit that the Fukushima nuclear debacle will temporarily postpone this move. Coal reserves are definitely a huge asset for countries like Russia, Kazakhstan, Ukraine, South Africa and Australia. China and India are big users and producers today, but they are also densely‐populated countries with substantial wealth increases for the middle classes. It is not unlikely that this might translate into lobbyist pressures that will stop them from exploiting this primary energy resource to the fullest, i.e. a pattern similar to what we have seen in the 1950s and 1960s in (developed) Europe. Increased imports from the aforementioned countries would then be a logical choice.
5.1.2 The Market for Nuclear Energy Table 10 shows that two players dominate the nuclear energy market: France and the USA with the first of the two countries treating it as an important export market as well.14 South Korea and Canada are definitely ‘rising stars’ within the industry. So was Japan but the consumption in 2009 (in million tons of oil equivalents) was already substantially lower than in 1999, and the Fukushima accident will further suppress Japanese nuclear efforts. Table 10 Nuclear Energy Consumption across the World; 1999‐2009 The Middle East, Africa and Latin America are negligible players and when taking this into account it remains to be seen if Iranian claims that its nuclear program is commercial and not military is that illogical. Middle Eastern providers of the two dominating primary energy resources oil and gas will have to start thinking about what will happen when reserves are depleted. Iran does have the money to invest long‐term in alternatives that might help to diversify the economy. Recent growth in Brazil can be explained by similar motives. 5.1.3 The Market for Hydro Energy The market for hydro energy is slightly more important (still) than the nuclear one. In 2009 total consumption in million tons of oil equivalents was 740.2 versus 610.4 for nuclear energy. However, the growth rates are totally different. Over the period 1969‐2009 the annual growth rate of nuclear energy consumption was 9.9% per annum versus 2.7% for hydro energy. Most people are excited about this relatively ‘clean’ primary energy source, but unfortunately the possibilities for expansion are smaller and more directly linked to geographical/natural opportunities. Brazil and China are 14 When looking at the nuclear sector in the USA substantial export activities are mainly limited to technology and facility providers like for instance Westinghouse. In France it is both technology & facility services and the energy provision itself. Germany’s recent move away from expanding its nuclear activities as a result of Fukushima might further strengthen French nuclear energy exports.
expanding and both do still have ample opportunities to do so. That is far less clear for other giants like Canada, Russia, India, Norway and Venezuela. Table 11 Consumption of Hydro Energy; 1969 ‐ 2009 5.1.4 The Oil Market Table 5 indicated that oil and gas are still the dominant primary energy sources. Almost 60 percent of global energy consumption is directly linked to these two sources. Oil is still the most important fossil fuel. Energy‐hungry Europe and Asia‐Pacific are full of users who need the resource for their economic engines, with these users not having sufficient productive capabilities or reserves themselves (see Table 12; gray‐shaded countries). Table 12 Oil; Consumption 1969 ‐ 2009
The USA is still by far the largest consumer, but China and other EM powerhouses are catching up quickly. On the production side Russia and the Middle East dominate (see Table 13). Can the rest of the world catch up when price increases will make the search for new reserves worthwhile? Table 13 Oil ‐ Production Development 1969 – 2009 The USA is still a large productive power when looking at its output, albeit that it is now some 33.5 percent lower than in 1969. Demand is simply too big, irrespective of gains in energy efficiency. This will sooner or later lead to the removal of the USA from the list of prime oil producers. A quick look at the proved oil reserves (Table 14) confirms that the USA is becoming more dependent on the production of other energy sources and/or imports of oil and other energy sources. The size of its reserves has gone down over the last 20 years, notwithstanding the fact that the world total has risen by about 30 percent over the same time period. Table 14 Proved Oil Reserves 1989‐2009
Reserve positions indicate that the main players in the years to come will be Saudi Arabia, Iran, Iraq, Kuwait, Venezuela and Russia, with Africa having the potential to become an important supplier. 5.1.5 The Gas Market Gas is the second‐most important fossil fuel, just behind oil. Its consumption is reasonably dispersed (see Table 15) over the various regions. To what extent can it fill the gap that will inevitably arise when oil reserves will be depleted? Table 15 Gas Consumption 1970 – 2009 Table 16 presents the production figures over the period 1970‐2009. The USA and Russia are still the dominant producers. Canada, Norway and Iran are other major league providers and a set of ‘rising EM stars’ is getting more important: Uzbekistan, Qatar, Saudi Arabia, Algeria, China and Indonesia. Table 16 Gas Production 1970 – 2009
When combining the production and consumption figures with available reserve positions, we see that Russia and the Middle East are once again – just like in the case of oil – the countries with the best position (see Table 17). Venezuela, Indonesia and Nigeria are runners‐up that will have a bright future based on a comparison of these numbers. Table 17 Proved Gas Reserves 1989 – 2009 That Qatar has made it to the spot of one of the richest – if not the richest – countries on earth is no surprise when looking at the tremendous growth in gas production and reserves in combination with increasing gas prices and a relatively small population.15 5.1.6 Combined Analysis of Production, Consumption and Reserve Positions (All five primary energy sources combined) In Table 18 we translated the analysis presented in paragraphs 5.1.1 to 5.1.5 into a quintile classification. Energy Winners have higher production (relative to consumption) and larger reserve positions, whereas Energy Losers deplete reserves rapidly through excess consumption, or even worse: do not have substantial local reserves and production in the first place. We looked at the absolute situation as of 2009, as well as the trend between 1989 and 2009. 15 According to The CIA Factbook (2010) average GDP per capita in US Dollars has reached a level of 179,000 in Qatar. Taking into account the average family size this would imply that a millionaire household is the standard in the small Gulf state! Of course we are aware of the fact that this description triggers the imagination with respect to Qatari wealth, but that it is somewhat simplistic in that it does not take into account income inequalities and the translation of GDP into net income at the personal level. But taking into account reasonable price levels and very low tax rates – when comparing things with other nations – it is clear that energy market developments have made Qatari citizens very well‐off.
Table 18 Energy Winners versus Energy Losers; Ranking Analysis using 1989 ‐ 2009 data Some interesting conclusions can be drawn from Table 18, especially when taking into account expected price developments of fossil fuels and the current financial and economic positions of the various countries. First of all, it is clear that sometimes heard suggestions that Russia should be removed from the BRIC group do totally forget the energy situation. If anything, we will have to worry first about Brazil – a favorite of many Emerging Markets asset managers – when it comes to longer‐term prospects. Table 18 also indicates that developed nations in Europe and Japan are most endangered as far as their energy position is concerned. On average we can say that energy risk is far less of a problem for emerging nations as a group than it is for developed nations. However, energy‐poor emerging countries without a diversified economy to cope with expected energy price disappointments are a clear exception. Their only chance is diversification into an export‐oriented focus on industries consuming relatively low amounts of energy and the use of cheap labor, but that is easier said than done. 5.2 Linking financial markets to energy markets: a multi‐factor approach Basher & Sadorsky (2006) link the oil market to financial markets in emerging and developed countries. With oil still being the most important of the primary energy sources, their work provides a good starting point when analyzing trends in the energy market (and their impact on real economic variables) as a whole. They do so by linking the excess returns on stock markets – defined as the difference between the relevant stock market index return and the risk‐free rate – to sets of risk variables, with the latter including variables related to the oil market. Basher, Haug & Sadorsky (2010) expand this work by paying special attention to the linkage between oil prices, stock market returns and exchange rates. Up until then there was a lot of literature focusing separately on the
linkage between oil prices and stock market returns on the one hand and oil prices and exchange rates on the other. Huang, Masulis & Stoll (1996) derive that energy price developments can affect stock prices in several ways. Stock prices at any point in time reflect the expected future cash flows, discounted using a required rate of return incorporating the appropriate risk premium. Energy prices can have an impact on stock prices via their direct influence on expected future cash flows on the one hand and/or their link with risk premiums in the discount rate on the other. With energy being an important resource / production factor, price increases will normally translate into lower stock prices for the bulk of companies affected. Energy producers – who might benefit from positive cash flow effects – could be an exception, although they too will have to be prepared for negative counter effects resulting from increased cost issues in combination with negative demand effects in other sectors. With the energy sector (producers, suppliers to the industry) being ‘just one of the many sectors’ in the average economy, one could deduct that the normal relationship between energy price increases and stock prices will be a negative one. But in a globalized world in which investment capital can flow relatively freely from one country or industry to another, we cannot exclude the possibility that specific events will change the relative position / performance of stock markets based on their sensitivity to and dependence on energy consumption and/or differential prices / cost effects vis‐à‐vis the global market price for energy. Basher & Sadorsky (2006) and Basher, Haug & Sadorsky (2010) analyze this in a more detailed fashion for the countries in the MSCI World and MSCI Emerging Markets indices. In Table 19 we present general information concerning the Basher & Sadorsky (2006) dataset for the period 1992 to 2005 (10). We added a tertile analysis to the data for every individual variable, with the ‘best’ (i.e. most favorable) eight outcomes receiving a value of +1 (cells in green), the ‘worst’ (i.e. least favorable) eight outcomes receiving a value of ‐1 (cells in red) and the medium group a value of 0. Variables analyzed are the excess return on the stock market (Ri‐Rf), stock market volatility (Sigma), skewness (Skew) and kurtosis (Kurt), the correlation between the excess return on a country’s stock market and the excess return on the MSCI World index (CorMRKT, with high values indicating lower diversification potential and vice versa), the correlation with the excess return on the West Texas Intermediate oil price (CorOIL, with high values indicating positive oil price sensitivity and low values a potentially large risk taking into account our expectations about future oil price increases). We also incorporated two systematic risk variables, or betas: one with the MSCI World as explanatory variable (BetaMRKT) and one with the West Texas Intermediate (BetaOIL). Higher beta’s for the linkage between Ri‐Rf and the West Texas Intermediate are treated as ‘positive’ news (and lower values as risk), assuming that the longer‐term, structural trend for oil prices will be up. Notwithstanding the fact that longer term stock market returns for the MSCI World will also be positive, our analysis in chapters 1‐3 has indicated that short‐term volatility and cycles might have quite an unpredictable impact. And let us not forget the relatively long, disappointing equity return series that was produced during the first decade of the 21st century. We therefore decided to classify the market beta variable BetaMRKT somewhat differently. The highest score (+1) was assigned to the four highest and four lowest betas. Idea: when global markets would go through
boom and bust periods, these markets would present investors with interesting opportunities to benefit from this either through ‘long’ or ‘short’ positions. The next four highest and lowest betas were awarded a score of 0, with the remaining eight countries receiving the lowest value of ‐1. We then proceeded by adding scores horizontally. The cumulative results are reported immediately after the country abbreviation.16 Table 19 Oil Price Risk and Emerging Stock Markets ‐ Base Data and Analysis The overall picture in Table 19 is not immediately clear. The highest positive value (+5) is scored by OIL, but – and that is quite remarkable – the lowest one (‐5) is for Venezuela. This is surprising, because Venezuela is one of the energy‐rich nations classified as potential Energy Winner in Table 18 in paragraph 5.1.6. When taking a closer look, things are not that surprising anymore. Stock markets are – even in energy‐rich countries – about more than just the availability of energy resources. In Venezuela the political factor has played an important role as well, since the tensions between the government – especially in the Chavez‐period – and the United States has cost them their position as big exporter to the latter country. And that does also explain the +4 for Colombia who benefited from the USA’s search for an alternative for Venezuelan oil imports on the one hand and large money flows from the USA to help stop growth of the Colombian narcotics sector on the other. The MSCI World itself did rather well, when comparing things with the individual EM country indices. The WORLD score is +3, one of the highest cumulative scores in the table. But there are a few things that we should take into account before jumping to conclusions. One is that the period under study, 1992‐2005, was one in which EM countries were showing above‐average growth albeit at a still very low level that made the countries not yet attractive for foreign investors. Governance, corruption problems and poor financial and legal infrastructure explained the rest. And when looking at oil price developments in Figure 6 in chapter 4, we can add to this the fact that the period studied in Basher & Sadorsky (2006) was also not yet the one with the biggest upward pressure on energy prices: the growth period of EM nations as energy consumer was yet to come. Another 16 Oil is traded in US Dollar prices. This introduces exchange rate risk. As a result, Basher & Sadorsky (2006) did add a trade‐weighted exchange rate variable (TWEX) to their analysis. We treated this variable as a separate asset class ‘Emerging Markets Currencies’ and incorporated it in the analyses described above.
problem with the dataset used, is that a group of Energy Winners – as derived in Table 18 in paragraph 5.1.6 – is not even included in the analysis. The bulk of Middle Eastern countries is not part of the MSCI EM and the Russian dataset was not yet complete when taking 1992 as the base year. Basher & Sadorsky (2006) proceed by moving from a descriptive analysis at the individual variable level to a multi‐factor approach, hoping that this will lead to stronger conclusions. The authors did run their multi‐factor analysis in both an unconditional and conditional format. The conditionalities are related to returns on the MSCI World and the West Texas Intermediate Oil Price respectively. Dummy variables D1 and D2 are given a value of +1 when returns on these two indicators are positive and 0 when they are not. They also decided to perform the analysis for developed and emerging countries separately. Table 20 Multi‐factor Emerging Markets Regressions of Ri‐Rf on several variable sets: 1992‐2005 The results in Table 20 (Emerging Markets) and Table 21 (Developed Markets) indicate that the conditional approach works. Explanatory powers of the models go up substantially in all cases.
Table 21 Multi‐factor Developed Market Regressions of Ri‐Rf on several variable sets: 1992‐2005 When comparing the regressions in Table 20 with those in Table 21, we see that the regression constant in the Emerging Markets regressions is positive and statistically‐significant in all cases, contrary to those in Developed Markets. There is a positive linkage between oil price increases and Emerging Markets stock returns and this linkage is statistically‐significant at the 10 percent level. When digging deeper, we can see in the conditional regression frameworks that the positive net impact of oil prices is the result of a positive effect in periods of oil price increases with stock market prices not falling back in a more or less symmetrical fashion when volatile oil prices drop later (see Table 20). On the contrary, the impact of oil prices on Developed Markets stock returns was not very strong nor significant. This corroborates the physical analysis in Chapter 4: the big test has gradually but slowly developed since 2002/03 with net demand for energy sources from emerging countries now being an important factor. Last but not least, the linkage between oil price developments and stock market returns seems to be a non‐linear one. When we include a squared beta term in our regressions in Tables 20 and 21 it appears to be negative and statistically‐significant, especially in emerging countries although the effect is present in the developed country regressions as well. In other words: more extreme oil price sensitivity and price movements work against stock market excess returns in both developed and emerging countries, thereby diminishing the positive impact somewhat (emerging countries) or leaving markets with a net burden (developed countries).17 Market volatility turns out to be a positive factor when the conditional climate is ‘bullish’, but beware of it when markets switch into a ‘bearish’ mode. In the latter case it shifts into being a negative (emerging countries) or insignificant (developed countries) factor. The Basher & Sadorsky (2006) paper leaves us with a few interesting conclusions, but also with the problem that the period studied (1992‐2005) was one in which we knew already more or less upfront that the real challenge of rising energy prices and shortages wasn’t there yet. The physical analysis in Chapter 4 and our GDP‐based analysis in Chapter 1 and 2 indicates that it is only since 2002 that we witness the growing impact of emerging countries (either through their role as net 17 See the columns for model 3 in Table 20 and Table 21.
energy provider or as rapidly growing consumer nations). When we add to this the fact that leading BRIC nations like Russia and China were not incorporated in the Basher & Sadorsky study, it will be of interest to analyze stock market performance over the last 10 years for all markets in the MSCI World (developed nations), MSCI Emerging Markets and MSCI Frontier Markets indices. The results are presented in Tables 22, 23 and 24 below.1819 In Tables 22, 23 and 24 we added a column with the Energy Classification from Table 18, using a quintile ranking with a 1 indicating an ‘Energy Winner’ and 5 the lowest category for ‘Energy Losers’. Both developed and emerging nations (MSCI World and MSCI EM) are expected to suffer some energy‐related return issues in the future when looking at their equally‐weighted average Energy Score of 3.8 and 3.7 respectively. In the case of developed nations this has already contributed to the fact that the last 10 years were a poor period when looking at the average annualized gross return of 5.6%. In the case of emerging markets the energy position was not yet a problematic factor, with gross returns of 18.7% for the average constituent over the last 10 years. Interestingly, Frontier Markets have the best Energy Score (2.9) which is not that surprising when taking into account that the major Middle Eastern markets are part of this index. Over the last 10 years Frontier Markets posted an average return of 17.2%, but we should keep in mind that just four of the FM countries do have that long a history in the MSCI already (Argentina, Jordan, Sri Lanka and Pakistan). Table 22 MSCI World Constituents ‐ Stock Market Returns over the 10‐year period ending Jan 28, 2011 18 We decided to opt for a simple, descriptive presentation of materials. The period under study (10 years) left us with 120 monthly observations. Taking into account the fact that quite a large group of countries (almost all Frontier Markets) did not even have 10 or sometimes even 5 years of data, we felt that the sample size was insufficient for a full‐fledged regression analysis. 19 Although the Basher, Haug & Sadorsky (2010) data set is an updated one (data until 2008), the authors concentrated on another research question in that paper, with the data set being a more generalist, macro one that focused less on comparisons between individual countries.
When we take a closer look at the individual index constituents and compare their performance with their Energy Ranking we can deduct more information. Energy‐strong nations Canada, Norway and Australia are among the better performing developed nations (see Table 22). Singapore, Hong Kong, Denmark and Sweden are success stories that are not directly energy‐related, but it is most likely not a coincidence that they are among the nations that made the largest progress when it comes to increased energy efficiency and/or the use of renewable energy. Table 23 MSCI EM Constituents ‐ Stock Market Returns over the 10‐year period ending Jan 28, 2011 Table 23 provides a somewhat more blurred picture. It is clear that GDP growth in combination with the discovery of Emerging Markets by western institutional investors explained stock market returns as least as much (if not more) than the energy situation. However, Energy‐strong nations like Russia, Colombia, Indonesia and to a lesser extent Malaysia did post good returns.
Table 24 MSCI FM Constituents ‐ Stock Market Returns over the 10‐year period ending Jan 28, 2011 Table 24 does not really tell us yet if the Energy Winners in the MSCI Frontier Markets index will be the future outperformers. So far the picture is blurred. And the fact that quite a few of the MSCI FM country indices exist 5 years or even less, doesn’t help either. However, when combining our physical market information from chapter 4 with the GDP growth rate information from chapters 1 and 2, and when we incorporate the fact that due to an increased allocation to ‘new economies’ by Western institutional investors frontier markets are now being ‘discovered’, the most likely scenario will be one in which the ‘fundamental strength’ (read availability of natural resources) of energy‐rich frontier markets will make them the most likely growth candidates. Krugman (1983) deducts a direct link between current account balances of nations, the impact of primary energy surpluses or shortages on them and the value of the US dollar vis‐à‐vis other exchange rates taking into account that an important fraction of primary energy sources (e.g. oil) is dollar‐denominated. With net energy demand in developed nations more or less stabilizing, the combination of excess GDP growth in emerging countries ‐ in combination with their increasing share of the world’s GDP ‐ and their rapidly increasing demand for energy will translate into larger surpluses for the energy producing nations and an appreciation of their currencies vis‐à‐vis the US dollar. This will provide investors from these nations (both private and SWFs) with a more favorable opportunity set, which will further strengthen their fundamental economic strength. The other way round, when taking into account mean‐reversion tendencies in financial markets it is not unlikely that energy‐poor constituents of the MSCI EM and MSCI FM will face tougher times. More in general, a closer look at the Energy Losers indicates that their returns are far more volatile and dispersed than those of Energy Winners. And this is true for all three indices presented here.
6) Evaluation Energy positions of countries will play a pivotal role in explaining their future growth potential. This is especially true for emerging and frontier markets. The energy‐rich countries within this group will be able to translate this resource into improved wealth. And this implies that the world will have to accept a new geopolitical order in which investors from these nations will now acquire strategic interests in firms domiciled in developed nations at a far larger scale than we are used to (or willing to accept) nowadays. A continued quest for increased energy efficiency and a focus on sectors and industries that consume less energy will be an important point on the strategic agenda of many developed and emerging nations as well. It is good to know that over the period 1969‐2009 improved energy efficiency did indeed help avoid huge demand‐supply imbalances, but the next four decades will be ‘another ball game’ because growing energy consumption in emerging countries that benefit from above‐average economic growth and wealth increases will translate into increased pressure on demand‐supply situations. Energy‐poor countries – especially in emerging and frontier markets – can be considered the ones faced with serious risks. They will need to specialize in directions that help them cope with their poor resource positions. One way to do that could be to provide services to energy‐rich nations. The growth track record of energy‐poor Turkey over the last decade is a nice illustration of an – until now – reasonably successful effort to do so. Turkey focuses on playing an intermediary position between energy producers Russia, Ukraine, Azerbaijan, Kazakhstan and Iran on the one hand and the large European market on the other. Renewable and nuclear energy in combination with technological innovation might mitigate things in the longer run. However, we have to incorporate that the Japan catastrophe will translate into setbacks for nuclear energy. And we should also be realistic about renewable energy: growth from a low base level takes a long time of high growth before it becomes visible in overall energy production and consumption figures. A substantially increased interest in the MSCI Frontier Markets index is also a logical consequence of our analysis, with the likelihood of its fundamentally‐strong, energy‐rich constituents a) attracting larger money inflows from foreign investors and b) being considered for incorporation in the MSCI Emerging Markets index going up dramatically. The latter does of course immediately translate into an even stronger inflow of foreign investment money into these markets.20 At the same token, these trends – in combination with underlying fundamentals – indicate that the financial markets of Saudi Arabia and Iran, both not even part of the MSCI Frontier Markets yet, 20 As of June 21, 2011 MSCI looked at the position of Qatar and UAE already, considering to promote them from the FM Index into the EM index. This would be the case if South Korea and Taiwan were to be promoted into the MSCI World. The latter did not happen and the indices weren’t changed. But it is clear that the likelihood of ‘change’ that will work out positively for Middle Eastern Frontier Markets states is only growing. Geopolitical problems in the region provide only a temporary set‐back.
might be the real gemstones for investors in the years to come. Obviously, both countries need to make changes to their financial and legal infrastructure to make this possible, with an end to the international embargo being an extra complication in the Iran case. However: we believe that the world energy situation is such that the alternative option (‘continuation of current international policies’) is simply not a viable one. And in a slightly similar fashion, we would also not be surprised if the fundamentally‐strong position of energy producers in the Middle East will trigger a growing interest in Islamic Finance even among non‐Islamic Western investors who should not be surprised to see growing activity by the leading Middle Eastern financial institutions in their home countries based on strong balance sheets and growing wealth in the Middle Eastern markets. The most likely pattern will be one of i) growing interest in these products by Muslim minorities who struggle in their relationships with Western banks now that the latter are licking their wounds after the GFC (tighter policies); ii) a gradually‐ growing niche interest by the largest and most advanced institutional investors who look objectively to all solid asset classes in an effort to achieve diversification in a globalized world.
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