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Focus: Dec '13 carry trade loses value but worth it further out

22 Nov 2013 16:07:32 | edcm

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Carry trade in the carbon market is becoming less attractive as the expiry of the December 2013 contract approaches and its premium to the spot getting thinner, ICIS analysis shows. It is still lucrative when done on contracts farther out, however.

Carry trade sees companies with cash to invest buying spot EU allowances (EUAs) and simultaneously selling futures. This locks in the premium future delivery holds over the spot market.

Carry traders can buy spot allowances in the auctions held on ICE Futures Europe or the European Energy Exchange, or from any party in need of cash or credit.

With the carbon curve in contango, the strategy is well established in the market and is usually done by banks or investment firms.

Still convenient?

Carry trade is convenient for companies that have low borrowing costs.

Across the year, the premium of the Dec ‘13 to the spot has shrunk as the delivery gap of the two contracts narrows. According to ICIS data, the premium was 3% at the start of the year and is now close to zero. This has made carry trade on Dec ‘13 unattractive.

But further out, it still offers opportunities. Despite declining through the year, the premium the Dec ‘14 holds to the spot stood at 3.3% on Thursday.

“That’s what we do at this stage, as carry trade on spot and Dec ’13 is not really convenient, if you also take into account the clearing fees,” said one trader at a bank.

According to Trevor Sikorski, head of natural gas, coal and carbon at consultancy Energy Aspects the Dec ‘13-’14 contango and the Euribor offering 0.35% mean “there is still a lot of mileage to be made from the carry trade.”

“The others [spreads] are still lucrative,” confirmed a trader at a trading firm. “The only problem is that two-year credit can be expensive,” he added.

Interest rates cut

The recent interest rates cut announced by the European Central Bank (ECB) is expected to have a marginal impact on carry trade.

“You can do two things as a bank: borrow overnight the cash to buy the EUAs or borrow at a fixed cost to [depending on] your spread [say, spot-Dec ‘14],” said the source. “Ultimately, most bank fund themselves at an internal funding cost”, which is not necessarily at ECB rates, he added, but can be based on a plus-minus spread to Libor.

If the rates are moved lower, this could be an incentive to place cash into carry strategy, but they would have to be significantly lower, he added. A small cut “would not necessary attract more people to carry trade as it is already full of people who have understood very well how to do it,” he said.

The other side of the coin

In order for carry trade to be done, there must be another counterparty buying the futures financials sell. This is usually done by utilities hedging their forward power production by selling power and buying carbon and the fuel at the same time.

This means that lower demand from utilities would in turn slow down carry trade unless financials do want to go long.

But according to Sikorski utilities are still “willing buyers”.

“Utilities are always hedging – as the profile shifts forward every year,” he said. Silvia Molteni

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