Know your onions

Concern over the role of speculators in Europe's energy markets is overplayed

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“How can we ignore the fact that food has become an object of speculation or is connected to movements in a financial market that, lacking in clear rules and moral principles, seems anchored on the sole objective of profit?”

Pope Benedict XVI

Fears that geopolitics could present a material risk to natural gas supply has fuelled a surge in speculative bets on higher European natural gas prices.

Investment funds increased their net length in TTF futures by 60 TWh in the week ending 2nd August, according to data from the European Securities and Markets Authority (ESMA) and analysed by

Energy Flux

.

Funds are now sitting on their biggest net long position in TTF (+192 TWh) since September 2021, during the period ahead of the Russian invasion of Ukraine. The switch apparently triggered as much by the closing out of earlier short positions as it is by taking out new long positions (see A market driven by illiquidity).

Ukraine in the cross sights of investment funds

The prolonged build in net length really began to gain momentum during March and into April. Aside from the ever present geopolitical fears stalking the Middle East, attention has switched to the conflict between Ukraine and Russia.

The recent Ukrainian military incursion into Russia has forced market participants to monitor gas pipeline flows at the Sudzha compressor station. The potential flash point could result in a complete curtailment of piped Russian natural gas into Europe; transits via the station account for 5% of total EU gas imports.

Meanwhile fears over the Russian response has meant that European gas traders have shunned Ukraine’s large underground gas storage facilities. Several attacks occurred during the spring, largely affecting above ground infrastructure. If these were to suffer serious damage it could affect traders ability to move gas out of Ukrainian storage.

Gas market perhaps not as comfortable as it appears

The uber-bullish positioning comes despite high European gas storage levels, despite moribund gas demand growth from European industry, and despite an expected surge in LNG capacity (estimated to be up to 270 bcm per year), with the majority due to come online before the end of the decade.

As so often happens in commodity markets, it’s what happens at the margin that’s important. And here it seems speculators are sniffing out the potential for stronger demand growth than expected, as countries, particularly in Asia increase demand for cooling amid heatwaves and switch to LNG.

In addition, the narrative that there is a wave of LNG supply on the horizon is also being tested amid concern that exporters may struggle to build liquefaction capacity. Supply fears are heightened by concerns that geopolitical risks may well get worse, before they get better - perhaps even affecting a broader array of the worlds LNG supply.

Funds dominant role in TTF price formation

The correlation between fund positioning and the TTP price is growing according to

Energy Flux

. Econometric analysis reveals that fund positioning accounted for 63% of changes in the weekly TTF price during the period November 2023 to August 2024.

Energy Flux

concludes that as “speculative capital becomes an even more dominant force in gas price formation, we should expect more extreme price swings in response to fast-moving geopolitical headlines.”¹

Whether this is a problem or not is an open question. Speculators play an important role in price discovery in commodity markets. If there is a risk that fundamentals are going to get much tighter then specs pushing up the price of futures contracts should provoke a response - either lower demand or higher supply, or some combination of the two.

Spec squeeze affects other commodity markets too

Arguably the spec squeeze affecting natural gas prices is similar in nature to that observed across a number of soft commodity markets. For example, structural changes in the market for cocoa (accelerated by climate change) have contributed to much higher prices, an increase in volatility, and a reluctance by market players to short the market.

Funds have taken advantage of this, taking long-term long positions in the cocoa market, confident that the highly inelastic nature of cocoa supply means there could be several years of larger and larger deficits. It’s worth noting that the cocoa market has slumped by 40% since April, as some of the froth has left the market. At $6,000 per tonne it remains very high versus historical levels, at least on a nominal basis.

This may look dramatic but its par for the course in commodity markets where fundamentals are tight and the supply response is measures in several years, rather than a few months (see The sword of inelastic supply cuts BOTH ways).

Knock-on impact on EU carbon market

The surge in speculative positioning in TTF is also having a knock-on impact on the EU carbon market given the strong correlation between natural gas and EUA prices. To recap, as natural gas prices increase in value, it eventually reaches the point at which utilities are better off reactivating thermal coal plants. This leads to higher emissions versus gas-fired facilities, resulting in more demand for EUAs.

The correlation does break down occasionally. The parabolic movement in TTF during 2022 did not lead to a commensurate movement in the EUA price, and so the correlation broke down. More recently, the relationship also broke down in the aftermath of the European Parliament elections. Traders had been unduly pessimistic in interpreting the vote result as being negative for EUA prices. The correlation has since recovered to levels near those seen earlier in 2024 (see Europe's green backlash was priced in a long time ago).

In contrast to the large net long position in TTF, EUA positioning data reveals that hedge funds and other ‘managed money’ remain net short. In early 2022 the market was net long almost 43 million EUAs. Two and a half years later the market is net short 15 million EUAs. If TTF remains bid its likely means that there will be an element of catch-up in the EUA futures market. Traders that play the EUA-TTF spread may have already moved to a net long position, but it’s now for the rest of the market to follow.

Some degree of concern is justified

The rising impact of investment funds on price discovery in TTF, and by extension the EU carbon market, will be a concern for many market participants including Europe’s climate policymakers. Higher energy prices and elevated carbon price volatility may suggest that the market has lost any semblance of an anchor, namely to the marginal cost of decarbonisation (see Boiling over).