Japan And The Energy Market Impact

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– Short term economic contraction should give way to medium term economic growth in Japan
– The Kobe quake in 1995 provides lessons
– Demand for crude, LNG and coal should increase to offset lost nuclear power
– The longer term impact on nuclear energy as a whole is of concern

By Greg Peel

As the impact of the Japanese earthquake and subsequent tsunami became apparent, the response from global financial markets was rapid yet not based on any level of certainty. Initial logic centred around a drop in Japanese economic growth and thus a sell-off ensued in commodity prices. The fall in the oil price reflected the shutting down of Japanese refineries and hence a fall in demand for crude. The Japanese Nikkei stock index fell and will continue to fall today, while the yen rose on expectation of the repatriation of foreign investments to fund rebuilding necessity at home.

It is the Japanese stock market which will likely bear most of the brunt of the earthquake's financial impact, analysts agree. While the images have been graphic, it is nevertheless not simple to estimate the extent of damage at this stage, nor the time needed to clear up and commence rebuilding. Uncertainty will linger for some time, but history does provide us with some guidance.

The earthquake which hit Japan in 1995 was less powerful than this one, caused what will likely prove to be fewer lost lives (6500) and what will likely prove to be less widespread damage. However the 1995 quake occurred underneath the city of Kobe which is Japan's major export distribution point. Hence Danske Bank, for one, is already suggesting the economic impact of Friday's quake will prove less than that of the Kobe quake.

In the days following the Kobe quake, the Nikkei index fell 7% but was quick to recover. Industrial production dipped on the month of the quake but rose again in the following two months as rebuilding commenced. There was little ultimate impact on either the yen or Japanese bond markets. All up the Kobe quake wiped 2.2% off Japan's 1995 GDP.

Danske does not believe Friday's quake will derail Japan's tenuous economic recovery. “If anything,” say the analysts, “it will be a short-term boost to growth”.

We are reminded that in the view of the Reserve Bank of Australia, the devastation in Queensland and elsewhere earlier this year (and still ongoing in some parts) will provide only a temporary impact on Australia's GDP. This March quarter may produce a negative growth result but ultimately the impact will be offset by the growth resulting from the rebuilding phase.

The same expectation is held for New Zealand. While the timing of Christchurch's recovery remains uncertain, the same offsets on GDP are assumed. The Reserve Bank of New Zealand has made an emergency cut in its cash rate to accommodate immediate costs and household relief.

While the Bank of Japan is scheduled to make a regular policy announcement tomorrow, Danske Bank does not believe any more than some emergency fiscal hand-outs will be announced. The BoJ's cash rate is already only 0.1% so there's little room to move, but Danske does not expect any major monetary policy changes anyway.

There is nevertheless another element to Friday's quake than just straightforward GDP impact, and that relates to the shutting down of nuclear energy capacity. There is also a major meltdown risk.

History also provides us with some guidance on the nuclear front. When a smaller earthquake hit the Niigata region of Japan in 2007 it shut down the world's largest nuclear power plant. JP Morgan notes that the result was an increase in global natural gas, crude oil and oil products prices. While circumstances were different then to now, JPM believes it should be noted that the Nymex natural gas price hit US$13/mmbtu as a result (current price around US$4/mmbtu).

And therein lies the rub. The initial response to the Japanese quake in Friday's trade was to sell oil futures, but markets closed before the extent of the damage to nuclear energy supply became apparent. Japan is the world's largest producer of nuclear energy with nuclear power accounting for 35% of electricity demand. It is estimated that the plant shutdowns in the wake of the quake represent 21% of Japan's nuclear capacity. Given the apparent extent of damage it is expected that capacity will be down for quite some time. It takes years to build or rebuild a nuclear plant.

The offset will come from LNG and coal-burning power generation, JP Morgan suggests, as well as crude oil burning. There will also be an increase in light sweet crude and diesel demand. Hence the drop in the price of oil seen on Friday night may well now reverse.

For the oil price, any sudden increase in demand comes at a difficult time. Saudi Arabia in particular, along with Kuwait and Nigeria, have been using up their own limited spare production capacity to cover for lost production out of Libya. And all MENA nations are witnessing local unrest. Further spare capacity is not a given.

The Obama Administration has flagged the possible release of strategic reserves to offset the rising price of gasoline resulting from the rising price of crude. However, analysts and oil companies have railed against any such release on the basis that global oil supply is yet to actually be disrupted. High oil prices simply represent rampant financial market speculation, they argue, and not any supply shock along the lines of those experienced in the 1970-80s.

On the other hand, nevertheless, there is plenty of gas about. So much so that Australian CSM LNG aspirants are having trouble finding the long term customers they need at the right price to render projects economically viable. The US imports very little LNG, so despite the 2007 experience there is not expected to be any big jump in the US natural gas (Henry Hub) price. But the impact could well be felt in Europe and Asia.

Japan is going to need LNG right now, so while this may result on further immediate sales to Japan from Australia, the impact on planned LNG projects is not as clear. Coal exports should also, in theory, increase to Japan. With the weather still hampering Australia's coal production and transport, one can only assume coal prices will rise as well as local gas export prices.

And what of uranium exporters? Well, today's stock price movements make the response there abundantly clear. The loss of Japan's nuclear capacity means less import demand for uranium until such time as those reactors are ready to be rebuilt or replaced, albeit it does not take a lot of uranium to keep a reactor going once it's on line. The wider impact is that of potential nuclear disaster – disaster which, like Three Mile Island in the 1970s and Chernobyl in the 1980s may well scare the world away once again from the dangers of nuclear power.

Japan's reactors are the most sophisticated in the world and their earthquake-related warning and back-up systems state of the art. Yet it appears at least one, if not more, Japanese reactors could melt down due to damage to those very back-up systems. As I write Paladin ((PDN)) shares are down 11% and Energy Resources of Australia ((ERA)) shares down 9% while the shares of gas producers such as Woodside ((WPL)) and Santos ((STO)) are only down 1% in a generally weak session.

At the same time the Nikkei – only just opened – is down 2%. The Australian market is clearly suffering an “all this and Japan too” response following on from the MENA and euro debt-driven weakness of last week. If the global oil price does now spike it means increased headline inflation for the likes of China, for example, which would exacerbate the need for further monetary tightening. Will this be Beijing's response to Japan's woes? We can only wait and see.

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