We're now two weeks into April, over a month since the lockdown began in Italy, a little over two weeks since it began in the UK, and energy looks and feels rather different to how it did at the start of this kerfuffle.
The chart above indexes the major energy market commodities since the start of the year. What is interesting here is the extent by which oil prices plunged compared with the relatively moderate declines in power, gas and coal.
This makes some sense, given that the lockdown hasn’t impacted electricity and gas demand nearly as much as it has gasoline, diesel and jet fuel, three of the biggest refined products.
Data seems to bear this out. According to ICIS, power demand between March 9 and April 5 dropped 15% in Italy, 13% in the UK, 12% in France, 10% in Spain and just 3% in Germany.
Three percent! Reports say German factories are running at up to 80% of capacity, though forecasts suggest the country’s economy will shrink by 9.8% in the second quarter. So perhaps Germany will see further decreases in power use.
Meanwhile, U.S. demand for gasoline fell by 30% in the week to March 27, and IHS Markit says it could shrink by up to 50%. For jet fuel it will be even worse.
Industrial demand for natural gas will also have fallen. ICIS reports that Italian gas demand fell 3.25% below the 5-year average for the period of March 9-17. Power generation saw a 5.5% drop in consumption while industrial use fell 4.75%.
In Spain, March gas demand was down just 0.5% from the 5-year average, while France consumed 4% more than the 5-year average, ICIS data shows.
“The key takeaway is that demand will not be expected to fall uniformly across all sectors until a sustained period of lockdown is achieved,” ICIS says. “Gas consumption in the residential sector for example would likely increase for a period as people work from home, until temperatures climb into April.”
So, to go back to the chart at the top, it’s logical that crude should have plummeted by as much as 55% and that coal, power and gas should have fallen by much less.
For their part, EUA prices dropped as much as 35% between March 5 and March 18, but have been slowly recovering ever since. March 18 also saw the biggest daily volume on ICE Futures for six years as prices fell to a 20-month low.
Spreads
What did the price action do to spreads? For a start, the drop in German baseload power prices was even more accentuated in the nearer contracts, with the front-month and quarter losing 40% and 31% respectively between March 5 and their low point on March 27.
In comparison front-month natural gas fell 18% and the front quarter lost 13% over the same period. In contrast, April and Q2 coal both gained 8% between March 5 and 27.
So the near-term clean dark and clean spark spreads both dropped like a stone for a few days but are now heading back to their trends. Note though how the front-month spreads have been trending steadily lower over since December, while the front-quarter clean spark flat-lined.
Carbon
The drop in carbon far outstripped the losses in power, gas or coal, the three markets to which carbon is, or should be, most closely correlated. So why did EUAs overshoot?
(I should make it clear at this point that pretty much all these observations are based on anecdotal information, i.e. chitchat with traders and analysts, rather than scientific data or analysis.)
For a start, it’s commonly acknowledged that the carbon market is disproportionately populated by speculative interests. It’s likely that many of those participants liquidated in a hurry, some of them to avoid or limit losses, others perhaps to free up cash with which to play in other markets.
Secondly, carbon prices had been declining already, before the whirlwind sell-off began on March 6. EUAs had been within touching distance of €26 as recently as late February, so there may have been some new speculative length being added during the slow decline. There has been plenty of talk among market participants that speculators seem prepared to bet on a significant rally in carbon.
Additionally, the annual increase in compliance demand in the run-up to the end of April deadline would have bolstered expectations of likely price movements.
So when the crash sell-off started on March 6, it was largely a matter of getting rid of as much volume in as short a time as possible. As Exhibit D above shows, prices fell all the way to a 21-month intraday low of €14.34 on March 23.
Amidst all this selling there were probably options traders who were buying the underlying to cover short put positions, as well as others selling surplus long call hedges. And others were just shorting the futures contract.
Check out the open interest in the Dec 20 contract over the last month: you can draw some elementary conclusions about who was selling and buying simply by aligning the price move with the change in open interest:
The early part of the rally that has characterised April’s market may well have been down to traders covering short positions, amplified by options traders managing their underlying positions. But there are also signs that the rise in prices back above €20 is tempting some speculators to dip their toes back in the water.
The week before last, open interest rose along with prices, suggesting traders were adding length, while last week’s rally was accompanied by a drop in open interest, which suggests shorts were covering their positions.
So what next? Well, recent past performance is absolutely no guide to future results, for a start. Words like “mad”, “crazy”, “irrational” and “weird” have all been used to describe the market rally over the past ten days.
One perplexed trader summed it up like this: “When the market is this irrational I prefer to stick to fundamentals, and the fundamentals are telling me not to buy, but to sell.”
In essence, participants are confused why the market would rally at a time when Europe is still in lockdown, when industrial output for the first half of 2020 is likely to be shockingly bad, and when analysts predict that EU ETS verified emissions in 2020 could be anything from 130-400 million tonnes lower as a direct result of the pandemic.
And it’s not just carbon that has rallied, though its 38% recovery is the biggest except for crude oil (39%). Power is up nearly 15% from its March 23 low, while natural gas has rallied 10%. Coal hardly declined at all – its biggest loss was 5.7% – and it has regained 2.3% since then.
There seems to be some optimism in the markets that the lockdown will come to an end sooner rather than later and that things will return to “normal”. But that has yet to be borne out, nor is it clear what “normal” will look like.
Others have also pointed to a correlation between carbon and equities, but data shows that this behaviour seems to be episodic at best.
On Wednesday we should get official confirmation from the EU of the verified emissions data for 2019, even though it’s been ten days since analysts produced results based on 97% of the data. The publication of the Commission’s Excel spreadsheet probably won’t trigger anything in particular, but we then need to wait for the calculation of the Total Number of Allowances in Circulation (TNAC) in May. That will set the auction pattern for the period from September to August 2021.
The Financial Times called the March sell-off the “first real test” of the MSR. That implies that the MSR will react in the short term to offset the drop in demand, but we know that the MSR will only adjust supply to account for the coronavirus impact in September 2021.
Between now and September 2021 we have to see how the energy market as a whole behaves, and you can bet that a lot of fresh water will pass under the bridge. By the time the MSR actually reacts to March’s demand destruction we will probably be in a very different world.