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Energy Risk in Emerging Markets

by Erik L van Dijk, LMG Emerge

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Your Lecturer

Erik L. van Dijk

Principal ; strong network in the international investment community including Emerging and Frontier Markets and Islamic Finance

Erik has 19 years experience in institutional investment management both as asset manager (CEO of Palladyne Asset Management from 1997-2000; and as head of Quantitative Strategies at Fortis Investments from 1995-1997) and as implemented consultant at LMG and Harry Markowitz Company

From 1987-1990 Erik worked as Asst. Professor of Finance at the Free University in Amsterdam, The Netherlands

Since 1997 Dr. van Dijk has worked closely together with Noble Prize Laureate Dr. Harry Markowitz. Their work on optimization and risk management has been published in the Financial Analysts Journal (March/April 2003) and other publications. In 2007 MIT Professor Mark Kritzman showed the value of the Markowitz – van Dijk approach in an independent test.

Erik has published dozens of academic and professional articles and one book on quantitative investment management.

Advisor to the Centre for Energy and Value Issues (CEVI)

The American CFA Institute incorporated the Markowitz – Van Dijk work in a webcast that is part of their permanent education program

Part of Erik’s strong network in Emerging Markets in general and Eastern Europe-Russia in particular is related to his active involvement with Chess, including (2007-09) a representation of Holland at the board level with the FIDE, the world chess federation

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Table of contents

Energy Risk in Emerging Markets

Introduction: The World Has Changed

A New Balance of Power in International Capital Markets

International Money Flows: What to Expect?

The Pivotal Role of the Physical Energy Sector

Macro Sensitivities of Countries/Sectors to Energy Risk Factors

1

2

3

4

5From Macro/Physical to Financial Energy Risk Sensitivities

Evaluation

6

7

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1.Introduction: The World Has Changed I

Up until the 1990s Emerging Markets as a group did not really outperform developed markets in a structural manner- True, there were great periods and individual countries with strong

developments, but sooner or later negative surprises in combination with excess volatility / risk would cause disappointments

But since the beginning of this century things seem to be different, with the BRIC nations developing into a true global growth catalyst.

This has also positively affected growth in other Emerging and Frontier Nations (compare for instance GSAM‘s Next-11 concept)

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1.Introduction: The World Has Changed II

When looking at the available production factors, we see that:

1)Situation in Developed Nations has deteriorated2)Situation in Emerging Countries has grown better3)Globalization works as a catalyst for this trend4)Energy situation is most worrisome when comparing prod. factors

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2.A New Balance of Power in International Capital Markets

Globalization , ‘Securitization’, Demographics, Geopolitical Factors and Diversification have changed the balance of power in international capital markets

- Relative financial advantage of Developed Nations at the government level has deteriorated

- Larger role for institutional investors and sovereign wealth funds

- Growing interest in foreign direct investments and cross-border portfolio investments

- Reduced dependence of Emerging Nations on loans from banks

- Dambisa Moyo & Muhamad Yunus/Micro Finance Movement: Economic Support instead of (Dead) Aid

- And let’s not forget: to a large extent it is mean-reversion back to a situation similar to the one before the Industrial Revolution!

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2. The ‘Old World’ of the Large Institutional Investors

Based on market values of investable assets

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2. The New ‘Three Bloc World’

Distribution of Global Wealth based on GDP

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2. The EM’s do now have the money!

Large Gold and Foreign Currency Reserves

Financial Position

12 of the 20 richest countries in the world when looking at Gold and Foreign Currency Reserves are now Emerging!

The Chinese Gold and Foreign Currency Reserves are 3-4 times larger than what the US needed to rescue its financial system in the 2008-09 Global Crisis!

And it is definitely not only China.

But what about debts? (see next slide)

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2. The former ‘Rich Nations’ are now the ones with large debts!

Debt Positions after Correction for Gold and Foreign Exchange Reserves

Net External Debt Position

All big Debtor Nations are ‘Developed’!

These countries do still have larger economies to bear those debts, but the gap is getting smaller and ‘debts are debts!’

Emerging Nations as a group have far lower debt levels (i.e. possibility for more leverage) and faster growing economies (5-10% per annum versus 1-4% per annum)

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3. International Money Flows – What to Expect?

Sources: LMG Emerge Country Classification, Goldman Sachs Asset Management,

Morgan Stanley Asset Management

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3. Income Inequalities in EM’s still larger but economic growth has positive effect

The Gini Coefficient is a widely used measure of income inequality.

Larger scores indicate a larger inequality.

Inequalities in the USA have also remained high!

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3. What about Corruption in EM’s? Economic Growth will have positive effect

Compare study LMG Emerge, 2009Passau (GER) Transparency International Seminar

Measurement Issue: Who to blame?

Donor or Receiver?

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3. EM’s ‘too dangerous’? Again: economic growth will have positive impact

Based on number of murders per year, the darker the more dangerous a country

US sad exception to the rule

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3. Large Institutional Investors will diversify internationally and increase EM allocations

Large Differences in Types (DB, DC) and Size (Large, Small) per country

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3. Almost USD 20 trillion available

Institutional Investors

Western Pension Plans still dominate

But Sovereign Wealth Funds grow faster

Demographics work against Pension Plans

LT Goals of SWFs give them the opportunity to achieve higher growth rates

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3. SWF’s mainly an EM phenomenon

Sov Wealth Funds

Asia and Middle East dominate

Energy Wealth and Excess Economic Growth

SWF’s Oil and Gas related Wealth = 60 percent; other 40 percent

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3. The World’s Largest SWFs

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3. Trends in Money Flows

Within the new three-bloc world order we can expect the following trends:- Structural – but volatile - long-term inflow of portfolio investment capital into EM

and FM countries

- Structural – but less volatile – growth in Foreign Direct Investments in EM and FM countries

- Tensions when large EM and FM corporations and investors want to expand in Developed Countries

- Geopolitical nervousness

- Within EM and FM shifts (= changing comparative advantages)

Commodity Producers versus Consumers

Development of the Financial Services Sector

Development of Domestic Consumer Markets

‘Africa Middle East’? And ‘Asia from Emerging to Developed?’

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4. The Pivotal Role of the Physical Energy Sector

Problem:Increased Energy Efficiency Developed Markets +

Increased Production Primary Energy Sources≤

Consumption Growth (mainly due to demand in EM Countries)

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4. Increasing scarcity when looking at three main primary energy sources

Developed Nations have a huge energy problem

Energy as key ‘bottleneck’

Developed Nations consume too much, notwithstanding the fact that their ‘energy efficiency’ improved

Developments in Renewable Energy not fast enough

Dependency of fossil fuels (Oil and Gas) grows, taking into account environmental resistance against Coal and Nuclear Energy

Will Asia continue its growth path? Odds in favor of Middle East, Russia and Africa?

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4. So far so good, when looking at developments per primary energy source?

When looking at trends for main primary energy sources, things seem to look reasonably OK:

But:- Reserve positions still OK – even in Oil and Gas – due to price increases

in the market, which made it economically feasible to start new explorations

- Doubts if process can continue at same pace, even with price increases due to availability limitations and growth in EM’s

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4. More Alarming Story 1: Crude Oil Price Development

Annual Averages; except 2010-11(Jan) EOP

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4. More Alarming Story 2: Reserve Positions Oil and Gas Grew, but Prices Went Up!

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4. More Alarming Story 3: Coal Looks Like Solution, but what about the Environment?

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4. Coal - 1: Discovered by EM’s as cheapest prime energy source

• JAP and USA only densily-populated Developed Countries that resist Environmentalist Pressures• Energy-hungry Asia Pacific largest market

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4. Coal - 2: Limited Cross-border Trading, with exception of Japan

• Large Consumer JAP largest importer, irrespective of Environmental problems• Turkey and Vietnam deplete resource to benefit from relatively low prices

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4. Coal – 3: Expected Trends

• USA still the biggest, but can the government resist environmentalist pressures? Or will they use them to increase their nuclear program?• Definitely a huge asset for RUS, KAZ, UKR, SAF and AUS• Will population density issues stop CHN and IND from exploiting this cheap resource to the fullest?

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4. Nuclear Energy: If we don’t want coal, can we then resist increased nuclear programs?

• USA and FRA dominating world leaders• JAP, KOR, CAN rising ‘stars’• What to expect from CHN?• Is the Iranian program as illogical as Westerners suggest?

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4. Hydro Energy: Still relatively unimportant, but does it have sufficient growth potential?

• Still relatively unimportant• ‘Hidden’ growth potential mainly in EM’s: BRA, CHN• But what about USA, CAN, RUS, IND, NOR, VEN?

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4. Oil - 1: Oil-hungry North America and Europe get company: Asia Pacific

• Still the most important fossil fuel• Europe and Asia Pacific full of users without sufficient production or reserves• USA still by far largest consumer, but EM giants catch up quickly

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4. Oil - 2: Oil production; Middle East dominates

• Middle East dominates; but geopolitically very tense region• Can the rest of the world catch up, when price increases make search for new reserves worthwhile?• USA still important, but gradually losing its prime position

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4. Oil - 3: Oil Reserves; Middle East dominates

• USA eating its reserves with high current production and consumption• Main players: KSA, IRN, IRQ, VEN, KUW, RUS• Africa has potential

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4. Gas - 1: Global Consumption growing rapidly in both Developed and EM Countries

• Second most important fossil fuel; reasonably dispersed across regions• To what extent can it fill the gap caused by growing scarcity of oil?

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4. Gas - 2: North America and Europe largest producers; but others are catching up

• USA and RUS still dominate• CAN, NOR, IRN other giants• UZB, QAT, KSA, ALG, CHN, IDN rising EM producer stars

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4. Gas - 3: Growth potential almost completely in Emerging Markets

• RUS and ME producers have the future• VEN, NIG, IDN other rising EM stars• Former stars NED and NOR eating their reserves and USA has to take care

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5. Forecasted Trend Extrapolation: Energy Winners versus Losers

• Ideas to remove RUS from BRIC do totally forget the energy situation; if anything we have to worry about BRA first.• Developed nations in Europe and Japan most endangered• Energy Risk in EM’s less of a problem than in Developed Markets• Increased investments in Renewable Energy and Nuclear Energy a MUST for many countries

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6. From Physical Risk to Financial Risk: What about Stock Markets?

• Academic Paper Basher-Sadorsky (2006)• Daily Data; December 1992 – October 2005• Table 1 : Base Data• Picture not immediately clear MULTI-FACTOR APPROACH

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6. Are Kurtosis and Skewness Important Risk Factors next to Beta and Volatility?

• Basher – Sadorsky (2006) do look at the following risk factors:• Market Beta (Systematic Risk) – including a squared BETA• Oil Beta – including a squared Oil BETA• Volatility (Total Risk)• Kurtosis• Skewness• Exchange Rate Risk (Trade Weighted vis-à-vis USD)

• High Kurtosis (-) = Platykurtic = More outliers make average less informative• Positive Skewness (+) = Positive Surprises in the Tail• Squared BETA factors to test for non-linearities

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6. Oil Price Sensitivity? Positive Factor for EM’s as a group

• Positive constant : EM’s good, already in tough period

• Conditional models work best

• Positive link with Oil Prices

• Conditional link with BETA

• Non-linearities

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6. Oil Price Risk in Developed Markets? So far, not a big impact on Stock Markets

• Developed Markets more efficient when looking at tested variables

• Conditional models work best

• Impact of Oil Prices so far not big

• But scarcity clock ticks against Dev Markets

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6. But things are changing: Developed Markets performing poorly during last 10 years

• Average LMG Energy Category indicates ‘issues’ in the future

• Poor overall performance during the last 10 years

• Energy ‘Winners’ CAN, NOR, AUS among best performers

• SIN, DEN, HKG and SWE amazing positive exceptions

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6. Main Emerging Markets didn’t derive performance 2001-2011(1) from Energy

• Average LMG Energy Category indicates ‘issues’ in the future

• And: lots of EM’s less energy efficient than Developed Countries

• Good overall performance not really Energy-related so far

• But ‘Energy Winners’ COL, RUS, IDN and to a lesser extent MLY didn’t do bad

• Energy Losers more volatile

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6. Frontier Markets: Is this where the winners are in an Energy-scarce future?

• Frontier Markets better equipped for an Energy-scarce future

• But due to illiquidity and lack of market structure their performance so far not better than EM’s

• Goldman Sachs’ Next-11 (IRN, KSA, IRQ)

• Mean-reversion patterns plus ongoing developments in main EM’s make Energy-rich FM’s most likely winners of the future

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7. Evaluation

Trends in Energy Market will favor Energy-rich EM’s and especially FM’s

Quest for increased Energy Efficiency and focus on sectors that consume less Energy remain important for Developed Nations and EM’s alike

Energy-poor EM’s and FM’s are the most volatile group with high (negative) sensitivity to Energy Market trends

These countries need to specialize in other directions- And/or: provide services to potential winners (e.g. Turkey as logistical partner for

Energy-rich countries like IRN, IRQ, RUS)

Renewable and Nuclear Energy might mitigate things, but most likely only in the longer run

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Contact:LMG Emerge

ZeistTel: +31 30 695 3828

erikvandijk@lmg-emerge.nlhttp://www.lmg-emerge.nlhttp://www.facebook.com/NewEconomies

Any Questions?