Banking on Bonny Light

Aided by the socio-political crisis in the MENA region, a weak US dollar and a mild recovery in demand form developed economies in Q4’10 and Q1’11, Bonny Light Crude has enjoyed significant price support Year-To-Date. Thus far, it’s has outperformed the traditional US benchmark, West Texas Intermediate (WTI) and all heavier-sourer crudes from the MENA region and Eastern Europe. However, recent indications of an economic slowdown in the United States and falling demand from China and India have put pressure on all crude oil grades of crude including Bonny Light. While, significant head winds to the global economic recovery have emerged, the outlook for Bonny Light remains supported relative to other grades by continued shortage of supply due to cut backs from Libya and the shortage of natural substitute for the grade. Despite pressure in recent weeks, the spread between Bonny light and WTI reached its all time high of US$25.2 per barrel in trading last week. Since May 2011, it has declined 10.6% compared to a 18.3% in WTI. On the back of this performance, the three tiers of Nigerian government accrued ~US$9 billion in excess crude revenues Year-To-Date, recording US$4.5 billion in average monthly, which is 41% above the FG’s budget benchmark.

possibility of fiscal constraints in the H2’11 due to the in FG’s inability to fund its deficit from such extra-budgetary income sources as the sale of assets leading to increased government borrowing with the attendant effects of increasing yields. While this scenario remains a possibility, recent developments including; the passage of the SWF—which provides for up to 60% of all accruals for budget supplementation—and increased crude production provide some reassurance on the FG’s fiscal position. Incidentally, the recently released schedule for Q3 debt auctions by the DMO reveals no marked departures from H1 despite significant increases in commitments coming due during the period, adding to the growing number of pointers towards a more benign outlook for bonds in H2 2011.

In previous commentaries I noted the possibility of fiscal constraints in the H2’11 due to the in FG’s inability to fund its deficit from proposed extra-budgetary income including sale of assets, leading to increased government borrowing with the attendant effects of increasing fixed Income yields. While this scenario remains a possibility, recent developments including; the passage of the SWF- which provides for up to 60% of all accruals for budget supplementation- and increased crude production provide some reassurance on the FG’s fiscal position. For instance, the recently released Q3’11 debt issuance calendar shows little signs of a government in fiscal crisis despite significant increases in commitments coming due during the period. In fact, the DMO only increased its total borrowing allowance for each auction in Q3’11 by N10 billion and decreased the issuance rage to N15-20 billion from N35-45 billion. While the FG’s fiscal position remains unclear, its shift in policy direction indicates an increased capacity to meet its deficit obligations.

As it stands, the combination of convexity effects at the longer end of the yield curve and possible increase in demand relative to potential supply is creating greater upside for longer dated instruments than projected downside. This effect may be strengthened as confidence returns to the financial system beyond the timeline set for the resolution of the banking crisis in Q4 2011, with the removal of the interbank guarantees by the CBN prompting a flight to safety. However, the potential restructuring of the revenue allocation formula in Q1 2012 could pose risks if the government is unable to finalise on asset sales beforehand. 

Mandela Toyo

Can Naira withstand the pressure?

At last Wednesday’s WDAS auction the Naira declined 0.14% to N153.59/USD, its lowest point since the inception of the current currency regime, as the CBN once again sold US$400 million, US$67.69 million less than was demanded. Wednesday’s move also left the Naira just 91 kobo shy of the upper limit of the CBN’s stated +,-3% of N150 band. In the interbank market the Naira closed at N157.50/USD, but has since appreciated to N156.35/USD even as the parallel market remained at N160/USD. While demand pressure on the Naira is not unexpected given recent inflationary figures and increasing global risk aversion, the extent of Naira devaluation in recent weeks increases my concern about the CBN’s ability maintain stability in the short term.

 To this end, there appear to be two clear short term drivers of the Naira-Dollar exchange rates. Firstly, judging by the CBN’s reluctance to defend the Naira at 32 of the 39 actions held thus far in 2011, it appears the apex bank has opted to rely more heavily of monetary policy tools to drive it’s the exchange rate policy,   probably in a bid to conserve dollar reserves which have witnessed muted accrual thus far in 2011. To date reserves have accrued just US$228 million in 2011. In view of this fact, coupled with the elevated inflation, continued fiscal expansion and relative recovery in the financial sector, monetary tightening and fixing linkages within the WDAS system presented the logical alternative to reserve depletion.  However, these methods have proven to be ineffective at controlling exchange rates. Of note, the newly introduced document requirements has done little to impact demand, while the CBN’s forward market has accounted for only US$160 million in maturities thus far. Furthermore, in spite a total 150bp hike in Monetary Policy Rate (MPR), portfolio flows remained negative. 

On the demand side, activity appears to be driven by increased portfolio outflows. In particular, direct remittances, a proxy for non-trade related WDAS demand composed largely of financial instrument transfers by Non-Nigerian individuals and corporation to their home countries , has risen to 61.3% of WDAS demand in May from 33.1% in January, likely as a result of increase risk aversion globally and the flight to safety in US assets.  This phenomenon is also the logical explanation for the CBN’s reluctance to supply what it may perceive as “transitory” demand and suggests that policy makers believe that the “fundamental” demand at the WDAS is close to US$400 million. While this may be the case, it remains unclear, how the CBN will choose to respond to the current demand situation, as further declines in the Naira will likely result in even greater demand pressure on the currency as investors rush to hedge currency exposure ahead of a possible breach of the +,-3% band.

In light of the above, I believe that policy action is limited to increased currency supply, as other monetary tools have proven ineffective in calming growing demand and are unlikely to create significant momentum to quell growing speculative activity. As such, more than ever before, I see the rate of dollar reserve depletion as the primary determinant of Naira stability in the short term. As such, my expectations for the Naira is that it will remain under pressure in the short run as the continued depletion of national reserves weighs on the CBN’s commitment to maintain stability. However, this outcome is not inevitable as several events, including significant increases in oil prices; the likely marginal crude oil bidding round and the disposal of PHCN assets are could all lead to significant foreign exchange inflows. In the event that these factors come together, it would significantly decrease pressure on the dollar reserves. 

Mandela Toyo