After spending six weeks cycling in a technical range (21.3-25.7 €/t), EUAs finally broke out to the downside late last Tuesday (12 February). This did not trigger a massive EUA sell-off, but prices failed to return to the previous support level, which is likely to herald a period where the market hunts for a new range in which to settle. Trading ranges of late have been wide, reflecting a market in which historic d/d volatility tends to be above 50%. The new range is still likely to be driven by technical indicators. To the downside, fairy strong technical support is likely to come around 17.99 €/t while 21.3 €/t looks like it could emerge as the upward resistance, after EUAs failed to break above that level after a couple attempts in the second half of last week. The drop out of its last trading range to the downside largely backs up our argument last week that the market’s bullish consensus has been starting to ebb. The loss of upside conviction comes as fundamentals are starting to point to another year of a y/y decline in EUA demand as gas-fired power generation is getting very competitive thanks to gas prices falling relative to coal prices. While fuel switching should occur regardless of the EUA price, the significant downside risk event that is Brexit is still very much on the table. While common sense suggests that the UK will secure an extension to the Article 50 deadline, such sense has generally been in short supply over the last couple of years. As such, a big downside pricing event is potentially only five weeks away. Until there is more clarity on Brexit, speculative capital would be foolhardy to come into the market in volume to push prices up. In fact, the question is do the more conviction buy and holds stay long carbon given the drop to the downside and growing indicators that the EUA market in 2019 is going to be less well supported than previously thought? We think a hard Brexit would be a trigger for almost all the buy and holds to cut and run and, if that happens, it will be a long, slow process to get EUAs back to where they started this year.
|Fig 1: EUA daily trading ranges, €/t||Fig 2: Gas breakeven against coal, €/MWh
|Source: Refinitiv, Energy Aspects||Source: Various, Energy Aspects|
EU price action
With Brexit unlikely to be resolved over the rest of the year, EUAs will likely settle in a new trading range, which could well be between 18.0–21.3 €/t. One question the market tends to tie itself up in knots over is how does the EUA market balance with EUA primary supply falling in 2019 by around 300 Mt y/y (MSR removals minus extra Polish and Norwegian sales)? The answer comes from the fact that the EU ETS has started the year with 1.6 Gt of surplus EUAs held by market participants, effectively in storage. The 1.6 Gt is effectively being used to cover utilities’ needs for carbon in 2019, most of 2020 and a little of 2021, plus the compliance needs above free allocation for industry. Now, for simplicity, if we put industrials to one side and basically treat them as a net zero sector (so not contributing sales of EUAs or market purchases), then will the market balance given some 570 Mt of primary supply will come to market in 2019 through auctions? This is where the potentially large amount of fuel switching in 2019 comes into play. If 2019 power sector emissions drop by 80 Mt y/y, this suggests that the power sector will be oversupplied in 2019 by that volume and over-hedged by most of that volume again in 2020. In effect, power sector demand for additional EUAs for future hedges would be reduced by 160 Mt. If this is the case, then the incremental draw on inventory is around 140 Mt, a number which is within the volume of surplus that we think is being held in more speculative positions (around 200 Mt). We see some indication that volumes are coming back into the market already, as open interest on ICE contracts has fallen by 14 Mt over the last eight trading days. How much speculative volume eventually is sold depends on whether the market retains its bullish consensus or sees a period of weakness before the MSR has enough time to tighten the market.