Carbon comment

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Macro & FICC Research Published: 2021 06 30 13 20

Carbon comment

A Schizophrenic Bipolar carbon price rally

The EUA price now needs to solve two opposing tasks at the same time. One: Make coal the cheapest alternative to save gas for the coming winter. Two: Make natural gas the cheapest alternative for 2022 and onward to reduce emissions. One requires a low carbon price. Two requires a high. Europe is in a fight for LNG imports with Asia but right now it is losing that fight since TTF prices are not high enough. It is a global nat gas price rally. Not a European. EU nat gas prices needs to move higher and faster than Japanese LNG in order to attract more LNG imports. A further rally in the EUA and thus EU nat gas pries could make that happen.

From now to April 2022 the EUA price needs to be low enough to make coal the cheapest alternative rather than gas. If the EUA price keeps moving higher then EU TTF prices will have to move higher as well in order to still make Coal the cheapest option. EU needs yet higher nat gas prices in order to attract more LNG away from Asia. Thus a price-spiral between EUAs and TTF prices into the autumn of 2021 could be the natural market solution for the current situation as it would attract more LNG to the EU and away from Asia.

The CO2 price is still to a large degree adhering to Coal to Gas differentials. But right now it is an increasingly challenging task as it needs to solve two opposing tasks at the same time. This requires the CO2 price to be both high and low at the same time.

If we look at the current power market conditions in EU we have a situation where natural gas inventories are very low after a cold winter. The system needs to rebuild these inventories in the run-up to next winter. The physical market solution for this is to run as much coal fired power as possible and as little natural gas power as possible in order to save and rebuild natural gas inventories. So from now to April 2022 the CO2 price needs to be low and not high in order to solve this physical puzzle.

Thus from now to April 2022 the CO2 price needs to adhere to the following equation:

Eq.1: Coal + a*EUA < Gas + b*EUA

I.e. the burning of coal plus CO2 needs to be cheaper than the burning of gas plus CO2. Here “Coal” and “Gas”

are the respective costs for these fuels in a quantity needed to generate 1 unit of power, say 1 MWh. The “a”

and “b” factors are the amounts of CO2 emitted to produce this power. Here a >> b in a typical magnitude where a is about 2.5 times higher than b. I.e. a/b = 2.5.

If the EUA price becomes too high then Eq.1 will not hold. The power system will start to burn more natural gas in order to emit less CO2 but that is not in line with the physical needs of the EU energy system right now where it needs to save and rebuild natural gas stocks for winter 2021 22.

So if the EUA price now moves higher, then the natural gas price needs to move higher as well in order to still make Coal + a*EUA the cheapest choice. Also, if the Coal price moves higher then either the natural gas price also needs to move higher or the EUA price needs to move lower in order to fulfill Eq.1.

This is typically leading to the argument where higher and higher CO2 prices will lead to higher and higher natural gas prices in EU because the higher the CO2 price goes the more the system wants to burn natural gas. And if natural gas is physically in limited supply then the natural gas price must indeed move higher as well in order to solve this physical market puzzle.

So is this the reason for the current rally in natural gas prices in EU? It is true that EU needs more gas and as such the gas fundamentals in EU are bullish. But the current rally in natural gas prices is global. And to us, for all we can see it is driven by strong imports of LNG to Japan, South Korea and China rather than ultra-strong

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gas prices. So to us it looks like we currently have a global LNG price rally driven by Asian imports which is driving LNG prices to record levels. The 3mth Japanese LNG price is now more expensive than the 3mth Brent crude oil price and that is very unusual.

EU gas prices are chasing the rallying Japanese LNG prices higher. The EU is not leading that rally in prices.

The EU is not in the drivers seat. If that was the case then the price spread between EU gas prices and Japanese LNG prices would have narrowed or even reversed so that EU gas prices were higher than Jpn LNG.

Since March however the price spread between the front-month Japanese LNG price and front-month TTF gas price has widened. And imports of LNG to Northwest Europe & Italy has weakened significantly in June versus May on a cumulative basis. The EU is thus now in a fight with Asia for LNG imports and so far in June it seems to be losing that fight. I.e. the EU gas prices are currently not high enough in order to drive sufficient amounts of LNG towards the EU and away from Asia.

From now to April 2022 the EUA price needs to be low enough to promote coal rather than gas.

Beyond April 2022 however the EUA price needs to do the complete opposite thing. It then needs to promote gas rather than coal in order to reduce CO2 emissions. And this is the current schizophrenic bipolar challenge of the EUA price: To fully place coal in-the-money to April 2022 and then a complete reverse to place coal fully out-of-the-money beyond that point.

Thus beyond April 2022 the EUA price needs to solve the following equation:

Eq.2: Gas + b*EUA < Coal + a*EUA

We thus have a situation where the EUA price needs to solve both Eq.1 and Eq.2 at the same time though for different time horizons. And that is indeed confusing and challenging and not the least mind-twisting as the EUA price needs to be both high and low at the same time.

But what we see is that the market is indeed doing exactly that. Coal is totally in the money in the EU power market for the coming three months while it is more or less totally out of the money for 2022 and 2023.

So how can this play out going forward.

If the CO2 price continues to rally higher so that it breaks Eq.1 then it will indeed end up driving natural gas prices higher as well to a point where short-term EU nat gas prices takes charge of the global nat-gas price rally so that TTF prices moves closer to Jpn LNG prices and possibly beyond so that much more LNG is directed towards Northwest Europe rather than Asia. We have not seen this happening yet, but that would indeed be the only possible solution if the CO2 price just charges ahead higher. For example on the back of the revamp of the EU ETS which is expected to be released on 14 July. If coal prices keeps on moving higher then nat gas prices will also need to move higher in order to keep Eq.1 intact. Or the CO2 price could move lower, but we don't think that will happen as it would violate Eq.2.

If we look beyond the coming winter then we have a recent outlook by BNEF for the global LNG market to 2025 forecasting an average market surplus of 30 m mt from 2022 to 2025. As far as we can see it rests much on the upstart of the North Stream II from Russia to Europe which brings an added capacity to EU of 40 m mt pa thus reducing LNG import needs to Europe.

Current very high natural gas prices are global in nature. They are however experienced locally in Europe and it might be the political dynamite needed for EU politicians to fast forward a solution of the North Stream II and get it online sooner rather than later despite political differences with Russia.

But if political differences between Russia and western countries increases going further then it could postpone the North Stream II. It would lead to continued elevated global LNG prices and thus TTF prices with continued support to EUA prices as well.

Over the past week the front-year CtG differentials have moved significantly more to the upside than the EUA price.

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Source: SEB, Bloomberg

As such the relative strength of the EUA price versus the 38% to 45% front-year CtG differential has softened from a 48% premium to now only a 20% premium.

Since June 2020 the EUA price has moved up slightly less than the highest CtG switching band

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For the nearest three months we see that the EU power market is pricing natural gas totally out-of-the- money. I.e. full promotion of coal. That is what you need to burn in order to save nat gas for the coming winter.

For 2022 however it is almost the total opposite. For next year we see that natural gas is is predominantly in-the-money with only the very most efficient coal plants managing to run economically. We see that switching levels for 2022 have moved upwards more than the EUA price lately.

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For 2023 CtG differentials we see that the current EUA price is completely pricing coal out of the money.

Burn gas, not coal is what it is saying on a forward basis.

Incredible rally in Japanese LNG prices. Now more expensive than Brent crude on a 3mth forward basis.

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Versus normal relatives of oil prices versus LNG prices we see that the current price is indeed an out-layer.

Data back to June 2015

Comparing nearest 3mths of forward contracts for Japanese LNG and EU TTF gas prices we see that they are following each other tightly. Also that since March the spread has widened out in favor of Jpn LNG. If TTF was in the driving seat then the spread would have narrowed rather than widened. EU is currently in a fight with Asia for LNG imports and with current TTF gas prices it is losing this game with LNG imports to EU down in June versus May

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Brent crude prices versus Japanese LNG prices. Jpn LNG stronger and stronger versus crude oil prices.

Bjarne Schieldrop bjarne.schieldrop@seb.no

47 9248 9230