The Energy Correlation Coefficient

The recent divergence between the stock and bond markets has caused a stir among analysts concerning the direction of the economy. With the Dow hitting new highs, many equity observers have proclaimed a new bull market. Bond market analysts, on the other hand, have seen yields decline, a typical indication of a coming recession.

While it is evident that the performance of certain commodities is directly correlated with the performance of the economy, other commodities are much harder to predict. In this article, we will examine how the performance of the general economy affects the energy complex, specifically crude oil prices.
The correlation between GDP growth and energy demand is highly variable depending on which area of the world is being discussed. In highly developed countries, such as the United States, the relationship is approximately .4, indicating that demand for energy increases .4% for every 1% gain in US GDP. Similarly low correlations are seen throughout the European Union, where renewable resources produce a large amount of consumed energy. Prices for electricity in these areas typically bear less resemblance to oil prices, as input costs to produce hydroelectric and wind power change little regardless of prices in the energy complex.
In the developing world, a lack of infrastructure has previously separated much of the poor from consistent energy sources. With growing prosperity though, developing nations are quickly building a need to provide power sources to more and more people. With little in the way of renewable sources, the prices for electricity generation and motor fuel is highly linked to the market prices for natural gas, crude oil, and propane.
In China, where the correlation is approximately .8, every percentage point increase in GDP sees an almost equivalent rise in energy demand. With China and India growing at around 9-10% a year for the past two decades, total energy demand has increased almost 250% during this time frame. Even at this level, per capita consumption of crude oil in these areas is still a mere 1/25th of consumption in the United States.
To come up with an idea of how energy prices will behave in relation to economic growth, we must examine the future performance of both developing and non-developing countries. Using .8 as the correlation for developing countries, and .4 as the correlation of the developed countries, we can approximate an equation for future energy demand based on world GDP growth:
% change in oil demand = .4 * developed GDP growth + .8 * developing GDP growth
The equation allows us to see that overall demand for energy is twice as dependant on the domestic economies of China and India than in the US or Europe. As crude oil prices have dropped 25% in just a few months time, it is possible to conclude that some of the developing countries are currently undergoing an economic softening. As more and more reports about a Chinese housing bust are hitting the wire, this conclusion is consistent with some of the most recent data. More importantly, however, this equation is critical to understanding why the future of energy prices will ultimately be determined by the economies of the 21st century as opposed to the economies of the 20th century.
Those who want to invest in oil or natural gas futures and equities must be sure to have a firm understanding of the domestic Chinese and Indian markets. At The Commodity Investor, we believe the recent huge drop in the energy complex signals an imminent downturn in the Shanghai and Bombay stock markets.
The Commodity Investor

, ,

Comments are closed.