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Breconomics: Brexit and the Energy Markets

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In the realm of loaded terminology, Brexit stands alone (outside of curse words and pejoratives, perhaps). Essentially non-existent only a year ago, the term given to Britain’s departure from the European Union quickly became the centerpiece of conversations ranging from sovereignty to stock markets. While proper analysis of those subjects could easily fill more volumes than Winston Churchill’s A History of the English-Speaking Peoples — only 1,700 pages of light reading, people! — there’s another area worth significant attention, but maybe not a tome. And that’s energy.

This is an especially important subject of the Brexit fallout because it exists within the most dangerous classification in academia: Things that appear simple, but aren’t simple.

Edinburgh, UK - June 24, 2016: The front pages of a selection of British newspapers on the day following the referendum on membership of the European Union, known as the Brexit referendum.To start, it’s useful to first look at why Brexit’s impact on energy is potentially deceiving. The best example is also the one people tend to be most familiar with — stock markets. In the initial days after the surprising vote to leave, the Dow dropped nearly 1,000 points.

That’s fairly significant, except that those losses rebounded just as quickly as they fell. Less than a month after the vote, the Dow Jones, S&P, NASDAQ and even London’s FTSE rebounded with enough momentum to chart annual or even all-time highs.

Shifting to commodities, global oil prices shared a similar experience. Brent crude, oil’s global price benchmark, fell nearly 10 percent in the initial aftermath before recovering in only two days to pre-vote pricing. While the question “why didn’t we see this coming?” guided the sell-off, asking “why do we care so much?” fueled the rally back.

Indeed, Brexit or not, the long-term supply/demand fundamentals for crude oil are unlikely to see significant changes. As many have heard, the actual Brexit vote is merely the first step in a much longer process. At an undetermined point, the U.K. government will trigger Article 50, formally beginning a two-year timeline for exit negotiations. During this time, many trade deals, economic arrangements and environmental agreements would likely be renegotiated or clarified. While there are certainly ways in which this process could be altered, all parties involved will have a keen interest on safeguarding the economy of both the U.K. and the EU.

This leads many to suggest the U.K. might end up in a situation similar to Norway — technically not in the EU, but operating as a member in many important aspects. Then it’s back to “why do we care so much?”, the same question that pushed the S&P 500 to new highs.

The most visible answer is currency. The pound plunged after the vote, the euro dropped against the dollar and the dollar appreciated against essentially every existing currency. Navigating that type of monetary web can be tricky, but it’s already impacted energy prices.

brexit_chart

While the Dow Jones and other global stock market indicators rallied back from their Brexit lows, the British pound has yet to fully recover.

For example, consider the relationship between U.K. National Balancing Point (NBP) and Dutch Title Transfer Facility (TTF) gas contracts. These two heavily traded benchmarks tend to move almost completely in-sync with one another. Because England connects to mainland Europe via natural gas pipelines, the economics of arbitrage keep the correlation so high that the two rarely differ by more than a percentage point on a daily basis.

However, following the Brexit vote, TTF prices dropped like seemingly every global market, but NBP contracts actually rocketed higher. This had nothing to do with fundamentals, but everything to do with currency. With diminished expectations for U.K. exports, the pound shot lower and lost substantial ground against the euro. And while stock markets seem to have recovered their Brexit-based losses, currencies like the pound haven’t. Because TTF is priced in euros and NBP in pounds, the two closely connected contracts were forced to readjust based on rapidly changing exchange rates. In other words, they moved in opposite directions in order to maintain connection.

brexit_chart_2

Traditionally, NBP and TTF gas prices have maintained a nearly perfect correlation. However, following Brexit-induced turmoil that began in late June, the correlation has largely broken down.

This scenario played out in commodity markets as traders were forced to rapidly adjust to swings in the pound, euro and dollar. While these especially volatile currency movements were a short-term factor, the Brexit effect continues to be a key driver of foreign exchange rates. The Bank of England, European Central Bank and U.S. Federal Reserve will all be under an even larger than usual magnifying glass in the coming weeks and their words continue to have the potential to impact commodity price swings.

Of course, that’s merely the impact on energy costs that’s already apparent. Longer term, there are a number of factors which shape tomorrow’s energy market that haven’t yet been realized. A particularly prominent example rests with the terms of planned power interconnections between the U.K. and lower-priced power markets in Denmark, Norway, France and Belgium. The projects would theoretically provide a massive boost to Britain’s existing interconnection capacity and would pull the cost of electricity more in line with cheaper Continental prices.

London, UK - June 24, 2016: People walk past a newspaper banner in which The Evening Standard in London reflects the news that the UK has voted to leave the EU, and its PM David Cameron has resigned. These papers were seen on the streets of London, near The Strand.However, these projects have been planned and developed as part of a union-wide energy vision that would rely heavily on EU funding. Now that the main beneficiary of those funds is negotiating an exit, things become a bit more complicated.

A British departure does not necessarily mean a cancellation of the existing framework. Indeed, the U.K. could continue with plans to be a part of the EU interconnection efforts, but what was once seemingly a matter of time, is now a matter of complex negotiation. Similarly, other energy-related cooperation, such as Britain’s participation in the EU Emissions Trading System, aren’t as certain as they had long appeared, leading to added volatility in carbon market pricing.

As with most things energy, any fallout will likely have a ripple effect on the broader global economy. The move to leave the EU has already demonstrated it’s more than capable of shifting prices in the U.K. and connected markets. Yet that’s only the starting point; energy markets around the world will inevitably feel swings based on Britain’s liquefied natural gas import demand or the fate of its North Sea Oil fields.

Simply put, a quick market recovery isn’t the most telling sign o’ the times (rest in peace, Prince). The truth of the Brexit-energy connection, like pretty much all truths, is complicated and somewhat hazy. A look under the microscope already shows the vote’s imprint on the energy markets. And that imprint is bound to cut more deep and wide.

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