A red hot fuel market will no doubt shape power prices in Europe in the winter of 2021-2022. With so much anxiety surrounding energy prices, we examine the increasing impact of weather fundamentals on the market.

But, first, a quick look at the tight fuel market situation.

Gas market in a frenzy

The European gas market is in a frenzy. The front-month TTF contract reaches new all-time highs almost on a daily basis. At the time of writing, it is trading well above €80/MWh, up from around €12/MWh at the same time last year.

The long-awaited Nord Stream 2 pipeline was completed on 10 September, but first flows are pending a regulatory green light that – if not fast-tracked – could delay the start by several months.

Fresh flows from Nord Stream 2 are keenly awaited to fix Europe’s storage scarcity and to ease the dependency on expensive LNG. Winter temperatures this year as well as the actual launch of Nord Stream 2 (and the extent to which it will negatively impact Russian imports through other routes) are key factors to watch going forward.

Surging coal prices

While gas is on everyone’s radar, the rising coal prices have received less attention. Of course, the soaring gas prices are partly to blame for the increasing coal prices as they are driving gas-to-coal switching around the world.

But coal is running off its own mix of bullish fundamentals as well. After years of declining global investments, the rebound in coal demand is now being met with a muted supply response.

Furthermore, output from Indonesia and South Africa has been hampered by weather events and Covid related restrictions. China is sourcing from several suppliers globally as the country’s ban on imports from Australia remains firmly in place.

Closer to Europe, strong Russian production has not been reflected in exports due to supply chain and logistical constraints. The tight supply chain makes Russian exports vulnerable to any disruptions, as seen in July when a railway bridge collapsed, causing delays in eastward deliveries.

In addition, coal stocks are at very low levels at terminals in Europe and globally.

This explosive mix of general market tightness, logistical constraints and low stocks summons the prospect of a coal shortage in Europe this winter, where simply getting enough coal to power plants may prove difficult.

Weather fundamental simulations for winter 2021-2022

Given the current constellation of gas and coal short-run marginal costs (SRMC), in the graphs below we reveal our expectations from a fundamental point of view. We take into account the actual availability in thermal supply and the contribution coming from normal weather. In our simulations, we assume normal SPV and wind production calculated with ERA5 using the weather years between 1986 and 2015.

#1 Power production forecast for coal in Germany

In graph 1, we show how out of the fundamental model the dispatch of the coal fleet in Germany has increased in the last two months.

Graph 1: Power production forecast for coal in Germany out of fundamental model.Comparison between 15 September and 15 July 2021.

In graph 2, we show the same comparison on an hourly granularity, pointing to a strong increase, particularly in weekdays off-peak.

Graph 2: Power production forecast for coal in Germany out of fundamental model.Comparison between 15 September and 15 July 2021 and predictions for 1 – 18 November 2021.

#2 Major price formation role for wind

Even more than usual, in the winter of 2021-2022 the wind will play a major role in price formation in Germany and on the continent. To tackle the sensitivity that the different weather patterns might deliver, we show the difference in our forecast taking into account the weather years of 1987 and 1990. They represent two extremes for wind generation in Germany.

Running the model using 1987 and 1990 weather patterns gives a difference in baseload price for the whole winter of 31.5 euro/MWh. This delta is up to 69,2 euro/MWh base for the month of January.

Graph 3: Power price sensitivity for winter 2021-2022with a comparison between weather years 1987 (orange) and 1990 (blue).

In graph 4, we show the onshore wind production from the German fleet taking into account the weather of 1987 (in orange) and 1990 (in blue).

Graph 4: Power generation comparison for winter 2021-2022 with weather years 1987 and 1990.

#3 German price pushed up to Italy North

In graph 5, we show in orange Italy North prices and in blue German prices delivered in the spot exchanges. In green is the shape of wind production of the German fleet.

During the last weeks, we noticed that often the German price is pushed up to the Italian North price – mainly on windless days. The graph shows also that on certain rare occasions Germany has delivered above Italy North.

Graph 5: Power prices in delivery vs. actual German wind.

Conclusions

The start of the winter season on 1 October is upon us. We enter the winter with low gas storage in Northern Europe, limited stocks of coal and lower than normal hydro reservoirs in the Alps. From our perspective, the extremely high levels of fuels justify the upside risk that the market is currently pricing in. We expect strong volatility in delivery, with German prices fluctuating up to the Italian equivalent depending on the wind output.

Speculations about lower than expected delivery to coal plants in Germany have only partly been confirmed by our sources. Any reduction of fuel supply to thermal plants compared to current expectations might result in spiky events in the spot exchanges with strong convergence between markets in Europe in case of low wind output.