Central Banks and the Economics of Energy

May 3, 2016 Aaron Parker

Central Banks and the Economics of Energy

Central banks are a lot like political caucuses — everyone knows they’re important, but no one really understands how they work. In recent years, casual stock traders have recognized the correlation between low interest rates and higher equity prices, but a more complete understanding quickly becomes a minefield of dogmatic rhetoric and Keynesian economics.

Dogma and Keynes: An even less pleasant combo than Kim and Kanye.

However, despite the murkiness, connecting the actions of today’s central banks to energy prices is more straightforward than most would think.

For example, if the European Central Bank (ECB) lowers interest rates, winter electricity price spikes in the Northeastern U.S. likely go down. A fairly intuitive link. Right?

Maybe not. And, truthfully, there is no direct relationship. Mario Draghi, the ECB President, does not have affinity for or against New England’s utilities. However, a closer examination reveals that the actions of a central bank have a clear, linear impact on something as distinct as New England’s wholesale power prices. It’s a good case study to illustrate the central bank-energy costs association.

So, to start. If the European Central Bank lowers interest rates, then the value of the dollar relative to the euro goes up. This is a fairly logical process. Foreign exchange traders — and anyone with a bank account — would prefer a currency earning higher interest. If the euro dips, the dollar starts looking better and its value increases.

And here’s where energy comes into the picture. Over the last two years, the dollar index and the price of crude oil have an inverse correlation of more than 93 percent (see below). In other words, when the dollar goes up, oil goes down. That’s because crude oil is priced and traded in U.S. dollars. For foreign currency holders, a stronger dollar translates to more expensive crude. Therefore, the basic laws of supply and demand dictate that a strong dollar negatively impacts demand for crude, leading to lower oil prices.

Central Banks Fig 1

Fig. 1: The price of Brent crude and the U.S. dollar have a well-documented inverse relationship

This brings the conversation a step closer to electricity prices. Liquefied natural gas (LNG) is a major source of power generation in many parts of the world. While LNG is delivered globally, there is not one hub with the assets of the International Exchange, where millions of Brent contracts are traded every year. As a result, LNG contracts often piggyback on oil’s liquidity. If oil goes up, LNG goes up and vice versa. So in this scenario, a suppressed euro boosts the dollar, pushing oil prices lower, which drags LNG prices along for the ride.

Central Banks Fig 2

Fig. 2: Because many LNG contracts are benchmarked to oil prices, they experience the same long-term trends

Enter power prices in Boston and surrounding areas. For the vast majority of the year, LNG does not figure into the regional generation mix. However, as temperatures drop in winter and snowflakes fall (and fall), the demand for electricity spikes and utilities fire up LNG-powered peaking plants to produce the necessary megawatts. Natural gas imports become the marginal provider. Thus, falling LNG prices may not lower year-round prices, but they have an impact on the magnitude of the most severe price leaps. So, in short order, we have the euro down, dollar up, crude oil down and LNG down, leading to low price spikes from December through February for New Englanders.

Central Banks Fig 3

Fig. 3: Mass Hub’s spot winter price spikes have declined in recent years; while weather has played a key role, the drop in global LNG prices has dramatically lowered the commodity cost of peak power

Now, the ultimate question: Why does it matter?

With central banks becoming increasingly active and creative with their monetary policy, any complete analysis of energy markets requires an understanding of the downstream impact of this activity. The traditional supply-demand dynamic is only one piece of a puzzle that continues to grow. Accounting for currency shifts, economic uncertainty and heightened volatility is key to a successful energy management program.

That said, political caucuses still remain a mystery.

Contributed by Robbie Fraser, Commodity Analyst, Schneider Electric, Energy & Sustainability Services

The post Central Banks and the Economics of Energy appeared first on Schneider Electric.

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