Digital assets: ‘the government’ is not going to ban them2022 has seen a number of major public policy shifts for digital assets in the United States, United (UK) Kingdom and the European Union (EU). Far from banning digital assets, the new announcements are overt and positive signs that digital assets are being integrated into existing regulatory and legislative frameworks in different parts of the world. Now that the scale and benefits of digital assets are too great to ignore, governments in these countries are now playing catch-up with Switzerland and Singapore. The latter now serve as home to thriving digital asset industry clusters due to the clear regulatory and legislative positions established years ago.
The digital asset ecosystem is not the wild west that it once was. It is maturing, becoming safer and more could benefit as it becomes more regulated. This is the same process that many technologies go through as they become ‘part of the furniture’1. Using these networks will become second nature just as many don’t think twice anymore when using Global Positioning System (GPS) to navigate a city they’ve never been in before.
Scale that has become impossible to ignore
The digital asset ecosystem reached an all-time high of over USD$3 trillion in market capitalisation in November 20212. The benefits that this new technology brings – such as increased speed, accessibility and transparency – are becoming too great to ignore. At the same time the potential risks – particularly related to cybersecurity and criminal activity – are now well known.
The first major announcement came out of the United States of America (USA). In March, the Biden Administration announced the “Executive Order for the Responsible Development of Digital Assets”3. This is a finely-worded policy document that clearly lays out potential benefits and risks from digital assets then tasks various federal agencies to investigate and provide recommendations on how the USA can continue to be, “a global leader, growing development and adoption of digital assets and related innovations”, and, “defend against certain key risks, necessitate an evolution and alignment of the United States Government approach to digital assets.”
Not wanting to be left behind, the United Kingdom’s Treasury announced their intention to make the UK the ‘global crypto hub’4. While details are scant, some initial initiatives include, “legislating for a ‘financial market infrastructure sandbox’ to help firms innovate, a 2-day Financial Conduct Authority (FCA)-led ‘CryptoSprint’ event in May 2022, working with the Royal Mint on a Non Fungible Token (NFT) and an engagement group to work more closely with industry.”
Finally, the Markets in Crypto Assets (MiCA) proposal is snaking its way through various working groups in the European Parliament5. While the actual wording of this proposal is under constant review, if it continues to progress it will eventually be reviewed by Parliament, the European Commission and Council of Europe en route to providing the EU with a unified framework for regulating digital assets.
Governments deal with new technology in different ways
Each government will take a slightly different approach based on their own domestic political structure, how developed the digital assets industry is in their jurisdiction and other policy imperatives. The approach can take time to develop and can also evolve over time. This is no different to previous waves of technological change. Railroads went through a round of legislative efforts in the United Kingdom during the 1840s to raise safety standards of train carriages and lines6. So too did car safety in the United States due in part to the work of Ralph Nader in the 1960s7.
The most recent major technology wave, the Internet, is still playing out. One facet of internet governance, data protection and privacy, is handled very differently in the United States. Where there is no federal digital privacy legislation, to the European Union and its General Data Protection Regulation and Directive (GDPR). This didn’t happen overnight - it took two decades for the GDPR to be developed and implemented. Another example can be seen in the way that speech is regulated online. Section 230 of the US Communications Decency Act has provided online service providers with a safe haven for the liability linked to the conduct of their users on their platform. This was put in place in the 1990s and is part of the reason so many social media companies are US based. Contrast this with the EU Digital Services Act8, which is a relatively new initiative that will only make its way out of the EU apparatus in 2024 – around 30 years since the commercial internet arrived.
There can be many homes for the digital assets industry
For years a recurring question about digital assets has been “what happens if ‘the government’ bans it?”. It turns out that there are many governments – no single one chooses how new technology will be used worldwide. This is particularly the case for open source software in an internet connected world. Far from banning digital assets, many governments are now competing to be ‘the home’ of the businesses that use this technology. The governments who manage to strike the right balance of measures will be home to a new wave of technological change – including the jobs, tax revenue and well-being that come with it.
Sources
1 www.collinsdictionary.com
2 www.coingecko.com
3 www.whitehouse.gov
4 www.gov.uk
5 www.europarl.europa.eu
6 www.orr.gov.uk
7 www.nytimes.com
8 digital-strategy.ec.europa.eu
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
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Where Can We Store Carbon Dioxide?The concept of physically removing carbon dioxide (CO2) directly from the air has gained momentum in the midst of significant, sustained global focus on climate change. We see in Figure 1 that projects focused on carbon capture, utilisation and storage that are either in ‘advanced development’ or ‘early and announced’ phases jumped dramatically in 2021. Notably, the number of ‘Operating’ facilities has been fairly stable in recent years.
Eighteen plants are currently operational globally and are located in Canada, Europe and the United States. Two technology approaches are currently used to remove the CO2 from the air1:
1. Solid ‘Direct-Air-Capture’ technology makes use of solid filters that chemically bind with CO2. When the filters are heated, they release concentrated CO2 that can then be used.
2. Liquid ‘Direct-Air-Capture’ technology pass air through chemical solutions which removes the CO2 while returning the rest of the air to the environment.
The cost of removing CO2 from the air depends on many factors, and the current research recognises that there are not large numbers of plants operating at massive scale. As more facilities are built and capacities for removal are increased, the true cost of removing carbon from the air will become more and more accurate.
But, the question then becomes, once the CO2 is removed from the air—what do you do with it?
Rocks ?
A company, Climeworks, is running the Orca device, the world’s largest commercial direct air capture device. The machine is located roughly 20 miles outside of Reykjavik in Iceland.
Fans, powered by geothermal electricity, suck in air. Carbon Dioxide (CO2) bonds with a sand-like filtering substance. Once heat is applied, the CO2 is released and mixed with water by an Icelandic company called Carbfix2.
Carbfix has discovered that this CO2 mix will react chemically with basalt and turn to rock in just 2 to 3 years, as opposed to the centuries that the mineralisation process was believed to take. The notable factor here is that this represents a permanent solution3.
The Orca machine can remove 4,000 metric tonnes of CO2 annually. However, this quantity is only about three seconds of humanity’s annual global emissions, which are closer to 40 billion metric tonnes4.
Clearly, the question is not whether it is possible to suck CO2 out of the air, but rather whether it can be done at a scale that would have a meaningful impact on climate change. However, this is actually a classic question5:
Humanity was likely saying something similar in 1980 about the world’s first commercial wind farm, which consisted of 20 turbines and an output of 600,000 watts.
Forty years later in 2020, the world’s installed wind capacity was 1.23 million times larger, at 740 gigawatts.
If Orca’s removal capacity was increased at the same rate, it would yield CO2 removal capacity of 5 billion metric tonnes by around 2060.
Fuel?
LanzaTech traps carbon that would be emitted during industrial processes and uses bacteria to convert the waste gas into sustainable chemicals. Companies, like the Chinese steelmaker Shougang Group Co. add LanzaTech’s technology to their manufacturing process6.
One process being utilised actually creates fuel, with the possibility to generate hundreds of billions of gallons per year. Acetogenic microbes are used in a fermentation process that can be set up to use the CO2 coming from 1) industrial waste gas 2) agricultural processes 3) solid waste 4) biomass, just to name a few potential sources. The principle is based on the fact that any liquid fuel must contain carbon—the microbes are able to take it from the air (CO2) and convert it to a chemical format that can be useful as fuel7.
In fact, early efforts to develop synthetic aviation fuels using air-captured CO2 and hydrogen have begun. In the Net Zero Emissions by 2050 Scenario, roughly one-third of aviation fuel demand is met with these synthetic fuels. Currently, the cost is too high—about five times the conventional options. As innovations drive costs down, these processes become more and more interesting8.
Conclusion: Carbon Capture, Utilisation and Storage Represents an Important Arrow in the Quiver to Combat Climate Change
2022 represents an interesting time in many technologies. Success and scalability, while not assured, is beginning to look more and more possible. Directly removing CO2 from the air will not be a panacea—we will still have to make progress on other fronts in the battle against climate change. Still, we believe it will represent an important component of the mix in getting the world to net zero by 2050.
Source:
1 Source: “Direct Air Capture: A Key Technology for Net Zero.” IEA. April 2022.
2 Source: Wilson, Peter. “Is Carbon Capture Here?” The New York Times. 31 October 2021.
3 Source: Wilson, 2021.
4 Source: Wilson, 2021.
5 Source: Wilson, 2021.
6 Source: Ramkumar, Amrith. “Carbon-Transformation Start-up LanzaTech is Going Public in $2.2 Billion SPAC Deal.” Wall Street Journal. 8 March 2022.
7 Source: www.energy.gov
8 Source: “Direct Air Capture: A Key Technology for Net Zero.” IEA. April 2022.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
It is time to find out which companies have been swimming naked- Pierre Debru, Head of Quantitative Research & Multi Asset Solutions, WisdomTree Europe
A little bit over a year ago, President Biden was elected, and the cyclical recovery rally kicked into gear. Low-quality stocks (lower profitability, higher debt) that had particularly suffered earlier in 2020, benefitted the most and outperformed all other parts of the market. However, the Federal Reserve (Fed) may soon be starting to taper and has hinted at a more hawkish stand, and with increasing fear of a rebound of the coronavirus this winter, investors may start to be more selective with their investments. Such mid-cycle behaviours tend to favour high-quality stocks (high profitability, low debt). After a period where they took a backseat to their lower quality counterparts, such stocks could now benefit from their high pricing power and stronger balance sheets to help them face rising costs and compressing margins and help them potentially outperform.
Market timing the all-weather factor
At WisdomTree, we believe that quality stocks could be the cornerstone of an equity portfolio. We have often described quality as the all-weather factor that can help investors build wealth over the long term and weather the inevitable storms along the way:
- Since quality companies generate high revenues, they can grow and compound wealth in the future.
- Thanks to their solid business models and financial strength, they can withstand unexpected events such as an economic downturn or a pandemic.
Of course, no factor strategy is perfect and outperforms every day and in all market environments. Quality stands out among all factors because its periods of underperformance are relatively easy to identify and because this underperformance tends to remain pretty contained. Most factors can post double-digit underperformance in a short period of time, which has been less the case historically for quality.
Figure 1 shows the relative performance of the 30% most profitable US equities compared to the full US equity universe. Market drawdowns (in red) are periods of consistent, large outperformance. The relative outperformance line (in blue) increases, highlighting that quality stocks are performing better than the market as a whole. However, during the subsequent market recoveries (in green), low-quality stocks tended to recover faster than high-quality stocks, leading to some underperformance for the quality factor. The blue line goes down, meaning that the market is outperforming quality stocks. Outside of early recoveries and drawdowns, quality also outperforms quite nicely (the blue line creeps up), even if more slowly and usually towards the middle to the end of the business cycle.
A statistical analysis of the returns over the same period highlights the same pattern. High-quality stocks outperform:
- 56% of business days during market drawdowns
- 45% of the time in the first 12 months of the recovery (i.e. the 12 months following the bear market low)
When investors get picky, quality companies benefit
“Rising tide lifts all boats” is a famous aphorism that applies very well to the market behaviour in the first month of the economic expansion. Following a recession and a market drawdown, fiscal and monetary policy end up pretty loose, and liquidity flows to all corners of the economy. This pushes the prices of all companies up, in particular those of the companies that suffered the most in the crisis. This phenomenon usually leads to a low-quality rally at the beginning of the expansion cycle.
However, at some point, central banks turn hawkish, liquidity dries up, volatility starts to reappear, and investors start to get pickier when it comes to their investment. Investors start to look for solid companies with solid earnings and safe business models. High-quality stocks tend to benefit and see their price rise with increased demand at that point of the cycle.
Figure 2 exhibits the average annualised outperformance of high-quality stocks (defined as the top 30% by operating profitability in the US equity universe) versus the market over four distinct parts of the cycle. The National Bureau of Economic Research defines recession and expansion periods. Then each of those periods is split into two halves of equal duration. The quality factor’s outperformance is the largest during recessions. However, its outperformance in late expansion is also very strong, significantly better than in early expansion.
The latest two years fits that pattern to the T. Quality performed very strongly at the end of the previous cycle, i.e. in 2019 and in the early part of the Covid crisis in early 2020. Since the election of President Biden and the rollout of the vaccine, the low-quality rally has kicked into gear, and high-quality stocks have taken a bit of a back seat to the rest of the market. However, as we approach the first anniversary of the Biden presidency and with the Fed starting to taper and hinting at a more hawkish stand, it appears that the early recovery phase may be ending, especially in the US.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Broad Commodities, not just another cyclical asset- Pierre Debru, Head of Quantitative Research & Multi Asset Solutions, WisdomTree Europe
Since the beginning of the covid-19 pandemic, broad commodities have benefitted from a new lease of life. The Bloomberg commodity index is up almost 60%2 from its nadir, and investments, tactical or strategic in nature, are flowing once again to the asset class. However, unrelated to their recent performance, broad commodities can be an additive to a multi-asset portfolio. In our previous blog, we focused on commodities’ diversification superpowers. In this blog, we want to look at the behaviour of commodities across the business cycle.
Analyses show that broad commodities, while cyclical, complement other cyclical assets like equities very well across the business cycle:
- Broad commodities tend to resist pretty well in the early phase of a recession, a period where equities suffer the most.
- They also tend to do well in the late part of an economic expansion when equities usually fail to find their second wind.
Commodities benefit from economic expansions
Intuitively, it feels like commodities should benefit from a positive economic environment. When the economy grows, it needs base materials to do so. Metals are required to build new homes, new factories, new infrastructure, new cars etc. More energy is consumed to move goods and people around. So overall, there is a logic to commodities behaving like a cyclical asset.
To fully assess the relationship of commodities with the business cycle, we turn to the National Bureau of Economic Research (NBER) Business Cycle Dating Committee, which maintains a chronology of US business cycles. The chronology identifies the dates of peaks and troughs that frame economic recessions and expansions. By comparing the performance of different assets in those recession and expansion periods, it is possible to assess their cyclicality. Figure 1 shows that equities have gained on average 0.86% per month in periods of expansion. This is the largest performance among the asset classes tested. They are followed by commodities (+0.80%), high yield bonds (+0.56%) and then corporate bonds (+0.35%). In periods of recession, high yield bonds (+0.15%) and equities (+0.36%) have performed less strongly. On the other side of the spectrum, US Treasuries and corporate bonds performed strongly (0.88% and 0.87%, respectively). Equities, commodities and high yield bonds are cyclical assets, with equities and commodities being the strongest.
A surprisingly robust asset in early recessions
While logical, this cyclicality may seem difficult to reconcile with the low correlation between commodities and equities, as discussed in Broad Commodities, the portfolio’s super diversifier? Equities are also very cyclical, so how can two cyclical assets be so uncorrelated?
On average, in all the months since the 1960s where US equities have lost more than -5%, commodities have lost -0.65%3. In all the months where US equities gained more than 5%, commodities gained 1.13%1. So while commodities are cyclical, i.e. they tend to lose and gain broadly at the same time as equities, the amplitude of such gains is significantly more muted. This supports our decorrelation hypothesis. It appears that while commodities and equities tend to gain during the expansion phase of the business cycle, they may not gain at the same time, i.e. during the same part of the cycle.
- They suffer the most from the early recession part of the cycle but rebound the strongest in the later part of that recession.
- While they benefit from the expansion part of the cycle, they rise faster in the earlier part of that expansion.
On the contrary, commodities:
- Tend to hold up well in the early phase of a recession, posting on average a positive performance of 0.54% (vs -1.3% for equities).
- Suffer more in the later phase of a recession and trail both equities and high yield bonds.
- Perform better in the second half of the expansion period, contrary to equities that prefer the first half. Commodities are the strongest performers among all the asset classes in that late part of the expansion cycle.
So overall, while commodities are a cyclical asset, their behaviour is very decorrelated to equities or high yield bonds. They offer great diversification in early recession and late expansion phases when other cyclical assets (equities, high yield bonds) struggle.
Late recoveries are commodities’ best friend
Commodities tend to perform the best in late recoveries, with an average performance of 1.25% in this phase. Judging by recent Composite Lead Indicator (CLI) prints4, we are in the latter stages of the current economic expansion. The United States, Japan, Germany and the United Kingdom are nearing economic peak, and in the Euro area, there are signs of moderating growth5. If history is any guide, this could be an environment for commodity outperformance. We also take the view that there are some unique tailwinds behind certain segments of commodities that could propel them for years to come. For example, the energy transition to lower-carbon energy sources will likely be very metal positive (given their use in developing renewable and electrification infrastructure and battery technology). Also, a renewed interest in building infrastructure in the US and Europe could benefit commodity demand.
An excellent diversifier and a strong complement to equities across the business cycle are only two of the potential advantages broad commodities could bring to a portfolio. The next item to consider will be whether broad commodities could act as a powerful inflation hedge.
Sources
1 Bloomberg, WisdomTree, 27th April 2020 to 7 Dec 2021
2 Bloomberg, WisdomTree, 27th April 2020 to 7 Dec 2021
3 Source: WisdomTree, Bloomberg, S&P. From January 1960 to August 2021. Calculations are based on monthly returns in USD. Broad commodities (Bloomberg commodity total return index) and US Equities (S&P 500 gross total return index) data started in Jan 1960. Historical performance is not an indication of future performance and any investments may go down in value.
4 The OECD system of Composite Leading Indicators (CLIs) is designed to provide early signals of turning points in business cycles: www.oecd.org
5 www.oecd.org
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Coffee causing a stir in commodity markets- Aneeka Gupta, Director, Macroeconomic Research, WisdomTree
Coffee prices are trading at their highest level in 10 years and is the second-best performing commodity Year to date (Ytd)1. A combination of a production shortfall in Brazil (the world’s largest coffee producer) due to extreme weather conditions coupled with supply disruptions should continue to propel coffee prices higher in 2022.
Lower inventory levels to keep prices vulnerable to supply shocks
The coffee harvest has a biennial cycle. This implies that a crop year with a good harvest (the “on year”) will be followed by a crop year with a lower harvest (the “off-year”). The last crop in Brazil was disappointing not only because it was an off-year, but Brazil also faced unfavourable weather conditions resulting in weaker supply. This was evident from Companhia Nacional de Abastecimento’s (“CONAB”) latest estimate for Brazil’s 2021/22 coffee crop, which is down 25.7% over the prior year3. As a consequence of lower output, global ending inventories are expected to decline from 7.9mn bags to 32mn. The weaker forecast represents the lower availability of coffee for exports, following weather setbacks to the 2021 harvest and logistical bottlenecks. Further obstacles have emerged towards the latter half of 2021 in the form of elevated shipping costs and high fertilizer prices, which are also likely to lend a tailwind to coffee prices. According to the United States Department of Agriculture (USDA), Brazil’s coffee exports are expected to slump by 12.45mn bags over the prior year to 33.22mn bags in 2021/224. A decline of that level would represent the largest decline in volume terms by a distance and the sharpest fall in percentage terms at 27% since 1985/86. USDA has been citing more cases of “defaults”, where coffee farmers failed to deliver pre-agreed contracts on the physical market because of excessive hoarding of coffee beans amidst the steep rise in prices. USDA also expects global consumption to rise by 1.8 million bags to 165.0 million, with the largest gains in the European Union, the United States, and Brazil.
Outlook for 2022/23 clouded in uncertainty
While the Brazilian 2022/23 coffee crop will be an on year (of the biennial cycle), there is still plenty of uncertainty shrouding the outlook of the coffee crop. According to Fitch, the La Nina5 weather phenomenon could cause further problems for the upcoming crop. The arrival of the La Nina weather phenomenon, which tends to bring dryness in the southern part of South America for the second consecutive year, has also dampened the outlook for the coffee crop in the upcoming season.
Conclusion
The supply tightness on the physical market has also pushed the front end of the coffee futures curve into backwardation from contango, thereby yielding a positive roll yield of 0.2% versus -1.4% a month back. Coffee stocks in the International Continental Exchange’s (ICE) warehouses have declined further and currently find themselves at a 9-month low of 1.78mn bags. Net speculative positioning in coffee remains 1-standard deviation above the 5-year average underscoring the bullish sentiment towards coffee. While the recent rise of the Omicron variant could threaten demand as countries decide to restrain mobility, we believe the fast-spreading variant could also complicate supply-chain disruptions and potentially drive Arabica prices higher.
Sources
1 Bloomberg, tracking commodity futures price from 31 December 2020 to 8 December 2021
2 Bloomberg Ticker - KCA Comdty, price performance from 31 December 2020 to 8 December 2021
3 Companhia Nacional de Abastecimento (Conab) – Brazil leading coffee forecasting agency
4 United States Department of Agriculture – Coffee: World Markets and Trade Report
5 La Niña is a complex weather pattern that occurs every few years, as a result of variations in ocean temperatures in the equatorial band of the Pacific
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Geopolitical tensions lend a tailwind to natural gas prices- Aneeka Gupta, Director, Macroeconomic Research, WisdomTree
Natural gas prices have declined sharply by 32.8%1 over the prior month. As we discussed here, market price action had run ahead of its underlying fundamentals. A combination of expectations of a warmer than usual winter period in North America2 coupled with the implied reduction in natural gas demand resulted in the recent sell-off in US natural gas prices. There has been little evidence of net physical tightening as storage levels have risen seasonally in a normal fashion, as illustrated below. Net speculative positioning in natural gas futures is below the 5-year average and approaching the 1-standard deviation mark underscoring weak sentiment.
Geopolitical tensions escalate over the Russia/Ukraine border
Another angle on the natural gas market is the rise of geopolitical tensions, which could tell a more compelling story. Storage levels in the European gas markets are below the seasonal trend at a time when tensions are rising over the build-up of Russian military on the Russian/Ukrainian border. The US is expected to urge Germany to agree to stop the contested Nord Stream 2 gas pipeline if Russian President Vladimir Putin invades Ukraine. President Biden’s intentions were made clear at an important video call between the US and Russia on 7 December 2021. Nord Stream 2 is important both for President Putin, as a route to sell more gas into Europe, and for Germany, which relies on supplies from Russia. This has led to further uncertainty on Russian pipeline supply pertaining to the approval process for the Nord Stream 2 pipeline. At the start of December, European gas in storage was at 67.5% of capacity, compared with a 5-year average of 84% for this time of year, according to Oxford Economics. Additional Russian natural gas supply via the Nord Stream 2 pipeline was expected to gain approval by early January, but the German regulator BNetzA suspended the certification procedure in mid-November. The intentions on the Russian side also remain unclear. The latest Gazprom supply auction suggests that the October and November flows are likely to be mirrored in the December flows, which will do little to counteract the extremely low inventory levels. Added to that, natural gas shipments from Norway are expected to slump by nearly 13% after the Troll field suffered an unplanned outage, according to the Network operator Gassco AS. There are further signs that other sources of sustainable energy from nuclear power are unlikely to be made available in the coming months due to maintenance work being carried out in France’s nuclear power stations.
Natural gas futures curve heads back to seasonal norms
In November 2021, the front end of the futures curve was very elevated (see 09/11/2021 line in Figure 2). Excluding the very front-month seasonal contango3, the curve was extremely negatively sloped for the following 4 months (backwardation), indicating market tightness at the time. Today (see 09/12/2021 line in Figure 2), the front end of the curve has dropped and is more in line with what is seasonally normal (see previous year curves around this time of year). This indicates abnormal tightness has largely dissipated for the US.
The outperformance of front-month tracking broad commodity strategies relative to optimised strategies (that tend to invest further out on the curve observed last month has now largely evaporated with the drop in the front end of the natural gas futures.
As an example, let’s look at the Optimised Roll Commodity Index (EBCIWTT), which invests using the same weights as the Bloomberg Commodity Index (BCOMTR) at yearly rebalance in January but, typically, invests further on the curve on contangoed commodities. Over virtually the whole year, it was invested in the April 2022 contract, which led it to underperform as the front end of the curve rose by a much larger extent.
This quickly reverted when the gap between the front contracts and the April 2022 contract started to close (see Figure 2), helping the optimised index catch up with BCOM performance and eventually start outperforming from the beginning of December 2021.
This is particularly striking when decomposing the return difference between these two indices. In Figure 4, we decompose it by sector, splitting Energy between Natural Gas and the Oil Complex. See how Natural Gas represented much of the underperformance when the front end of the curve was extremely steep. That negative contribution quickly shrank from November this year, eventually turning positive in December.
Conclusion
US natural gas prices have fallen with supply and inventory conditions returning to normal in the country. However, tightness in Europe could once again translate to higher demand for US exports. Amidst the depth of the European winter, as heating demand grows, low stockpiles in Europe would mean elevated demand to replenish them when the summer season arrives. This is likely to translate into higher demand for US natural gas at a time of higher uncertainty of supply from neighbouring countries such as Russia and Norway. However, in the absence of renewed tightness in US natural gas stemming from the higher European demand, US natural gas futures curves could maintain their current structure. That could leave prime conditions for optimised commodity strategies to outperform front-month tracking strategies.
Sources
1 Bloomberg – Henry Hub US Natural gas prices as of 7 December 2021
2 NOAA – National Oceanic and Atmospheric Administration
3 See “Commodity ETPs are exposed to futures contracts not the physical spot. Why does it matter?” for a description of contango, backwardation and why these are important concepts in commodity market futures investing.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
