ANALYSIS: Banks still happy to “carry” EUA trade as utilities pull back

Published 16:02 on June 16, 2015  /  Last updated at 10:14 on June 17, 2015  /  EMEA, EU ETS  /  No Comments

The spreads between EUA futures prices have narrowed as banks and trading houses seek meaty returns in the face of negative government bond yields, and as utility demand for carbon wanes amid lower expected power generation, more renewable energy capacity and evolving hedging patterns.

The spreads between EUA futures prices have narrowed as banks and trading houses seek meaty returns in the face of negative government bond yields, and as utility demand for carbon wanes amid lower expected power generation, more renewable energy capacity and evolving hedging patterns.

While spreads between all major EUA vintages have narrowed since the start of the year, those out to the December 2018 contract have been markedly squeezed in the past month.

The Dec-18s, which have averaged €7.84 so far this month, are one of the EUA contracts currently being closely watched by the market. This is because many large utilities across western Europe will this year buy those carbon futures to lock in profits as they ramp up sales of forward power for delivery in three years.

But utility demand is falling short of the market’s expectations.

“The lacklustre demand of utilities seems to be continuing by virtue of narrowing (EUA) spreads,” said Louis Redshaw, head of London-based Redshaw Advisors.

Narrowing EUA spreads or falling returns from buying near-term contracts and selling further out ones can flag various trends including increased appetite for these so-called ‘carry trades’, easing demand from utilities – the natural buyers of the further-out futures – as well as expectations of lower future interest rates.

The spread between the Dec-17 and Dec-18 EUAs, which should in theory reflect the cost of carry between the two contracts, or essentially the euro zone’s risk-free rate, had fallen to 14 cents as of last Friday’s close – equivalent to an annualised return of 1.79%.

This is down from an average of 17 cents or 2.26% in May, during which the Dec-18 futures also averaged €7.84, and from an annualised 2.35% in Q1.

Looking at the near-end of the EUA futures curve, the spread between spot prices – which represent the vast majority of fresh allowance supply coming to market via government auctions – and the Dec-18s has also slipped to an annualised 1.32% from an average 1.48% in May, and from a 2015 high of 2.18% in early January.

(See below for a full table of the annualised yields implied by the spreads between the most liquid EUA futures, recorded in monthly intervals between Dec. 2014 and last Friday)

HEDGING

Waning utility demand has played a role in squeezing the spreads as according to analysts, while several of Europe’s largest utilities have hedged proportionally more forward power in the first quarter of 2015 compared to the same period last year, absolute electricity sales are down.

That’s due in part to sluggish demand from industrial manufacturers in the wake of Europe’s recession and increasing output coming from renewables. Both of those trends yield lower utility demand for carbon permits.

Clean-adjusted dark and spark spreads – the profit margins for the EU’s coal- and gas-fired plants – also remain near historic lows, pushing utilities towards the lower bounds of their hedging profiles, and thereby trimming EUA demand.

Calendar 2018 German baseload power prices have also declined recently, adding downward pressure to both dark spreads and carbon prices, after German media reported that the country may shelve its plan to force its oldest lignite plants to pay fines using EUAs if they exceed set emissions limits.

In addition, looming regulatory restrictions on utilities’ trading activities could be prompting many of these companies to minimise the amount of forward hedging they engage in, so that they stay within potential MiFID II thresholds.

Analysts have said this factor could result in the market moving to a structurally-lower level of hedging, adding further bearish pressure on EUAs.

Furthermore, the share of renewables in the EU energy mix also continues to rise, making up an estimated 15.3% of the bloc’s total energy consumption in 2014, the European Commission said on Tuesday.

CARRY TRADE

“There’s doesn’t seem to be a whole lot of utility demand (for EUAs), but the market is showing that people are still after the carry trade. Even at (annualised returns of) 100 basis points (1%) banks seem to be willing to do it despite the potential for margin calls,” a trader at a trading house said.

That healthy appetite can be seen in stable demand at allowance auctions, which have recorded an average oversubscription rate of 3.14 across May and June so far compared to 2.25 in April.

It is also contributing to flattening the EUA futures curve, which is leading to diminishing returns for all EUA carry trades.

Traders said with rock-bottom interest rates and negative euro zone bond yields, currently ranging from -0.28% for one month to -0.12% for three years, a locked-in annualised return of 1% will likely look attractive to many banks.

“They are still happy to lock some thin arbitrage compared to the risk-free rate,” a third trader said, adding that if banks decide to curb their enthusiasm for the EUA carry trade or if annualised yields drop too low, all while utility demand remains muted, government allowance auctions risk failing and EUA prices could tumble.

GREXIT

But traders added that, for now, demand for longer-term carry trades or those with both legs shifted down the EUA futures curve is growing as Greece’s exit from the euro zone becomes more likely – an event that would throw both European and wider global money markets into turmoil.

Talks between Greece and its creditors broke down again on Sunday, bringing the crisis-ridden nation closer to a default by the end of the month that could push it out of the single-currency bloc.

“Some traders are moving their positions further out as things getting a bit hairy at the front (of the Euribor curve). As you move down the curve, there’s less volatility,” said Mark Owen-Lloyd, a trader with MVAJET, the proprietary trading arm of London-based Curzon Securities.

“There’s lots of uncertainty and fear. If Greece do exit then there will be mayhem, most of which will happen at the front-end because things will likely have settled down within three years.”

He added that with the near-daily flow of spot allowances from auctions, risk managers may be requesting that traders diversify their positions by shifting them further down the EUA curve as “things might be getting a bit full at the front-end”.

Below is a table of the annualised yields implied by the spreads between the most liquid EUA contracts.

Date Spot-Dec18 Dec15-16 Dec15-17 Dec15-18 Dec16-17 Dec16-18 Dec17-18
31-Dec-14 2.094% 1.907% 2.076% 2.299% 2.273% 2.516% 2.745%
30-Jan-15 1.879% 1.818% 1.926% 2.048% 2.060% 2.180% 2.288%
27-Feb-15 1.701% 1.399% 1.653% 1.869% 1.931% 2.121% 2.300%
31-Mar-15 1.521% 1.148% 1.415% 1.687% 1.702% 1.972% 2.320%
30-Apr-15 1.496% 1.077% 1.337% 1.627% 1.598% 1.918% 2.228%
29-May-15 1.470% 1.087% 1.215% 1.555% 1.344% 1.803% 2.255%
12-Jun-15 1.324% 1.138% 1.151% 1.359% 1.180% 1.481% 1.790%

 

By Mike Szabo – mike@carbon-pulse.com

Comment