7 October 2021
The chill of high energy prices
As energy prices break through highs, we analyse the implications for fixed income investors from this dramatic increase.
In recent months, gas prices have experienced a meteoric rise, reaching new all-time highs and pulling other energy prices higher. This has sparked shortage fears, resulting in increased demand and a shift in fuel usage from gas to oil. As energy prices initially started to rise in the second half of September, we expected that Opec+ (the Organization of Petroleum Exporting Countries and its partners) would be willing to lean on the market and use its spare capacity to increase supply in line with surging demand, which would halt any significant potential price appreciation. However, during its meeting earlier this week, the group did not change its plans despite the change in the demand picture. While there will be medium-term consequences of the Opec+ decision, which may be counterproductive, what is clear is that the immediate impact is different to what the market had previously envisaged. Heading into the end of the year, a spell of colder weather in Europe could further raise concerns about natural gas prices due to the region’s vulnerable position as a significant energy importer. Based on current market pricing, the eurozone’s strong current account surplus has been eliminated due to its dependence on imports of energy, particularly from Russia. This could have a follow through impact as we believe corporate profitability forecasts in Europe are currently overly optimistic, especially when compared to US corporates. A sustained surge in natural gas prices – coupled with already stretched supply chains – could increase input cost pressures for European corporates, lowering profit margins in this quarter’s earnings.
The seemingly exponential increase in European natural gas prices has required constant price readjustments for any investor following the natural gas market. During 2021 we have seen European natural gas prices rise nearly 450%, from EUR 19 per Megawatt hour (MWh) to EUR 104 per MWh. With these prices for natural gas, and with Brent oil at its highest level in three years, it becomes economical for the US to increase output; however, concerns remain over the sustainability of the recent price increases. As 2021 draws to a close, any significant increase in US production this year is unlikely; additional supply is more likely to occur in 2022 if prices remain at elevated levels
European gas prices have spiked to record highs
With the drastic price increases we have recently seen, it would be expected that the market positioning is currently long Brent oil. However, our proprietary indicators suggest market participants have not held a strong view of further appreciation or depreciation over recent weeks. Therefore, it is paramount to be watchful of changing market positioning as this could signal a continuation or correction of valuations. Furthermore, given energy markets’ correlation with other markets, a risk remains of a deterioration in energy prices based on weakness in other asset classes. Currently energy markets are rallying despite weakness in equity markets; however, if there is a capitulation in risk markets, energy prices may soon follow.
What does this mean for fixed income investors?
The downstream impact of higher energy prices to inflation could lead to higher yields. This would suggest that positioning portfolios with a short duration bias would appear optimal in the current environment. Separately, the spike in energy prices poses a significant risk to Europe as a considerable energy importer, while benefiting energy exporting nations. With 10-year inflation breakevens already at post-2008 highs in the UK, at 10-year highs in Germany and at the highest level since May in the US, investors should consider when the market will shift focus from increasing energy prices causing high inflation to inhibiting growth.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum