Between 2011 and 2016, energy markets were in a perpetual state of freefall.
Energy buyers thought the good times would never end…
But they did.
Unexpected Bullish Markets
Ever since April of 2016 energy prices have been on a firm bull run – coal prices worldwide, natural gas prices and electricity prices for Europe, Asia and Latin America are all far higher now than 26 months previously.
The only exception to this rule is the US natural gas and electricity markets mainly due to improving US gas production. For the rest of us? The previous two years have been a stark reminder that you can never predict unpredictability.
Depending on how far into the future (and how much) energy buyers fixed their energy by when prices were low, buyers faced increasing energy costs in the last few months.
Buyers have been caught out for a variety of reasons. The most common mistake observed is that buyers didn’t have contracts in place and weren’t ready to begin making long-term hedges when markets started their upwards trajectory.
Other reasons may have been that buyers were caught while their energy procurement strategy wasn’t defined yet. It may have even been caused by having too many stakeholders involved in the decision-making process – too many cooks spoil the broth. Maybe buyers held on to a wrong forecast or belief that the markets would return to their previous state…
Regardless of scale or operational nature, unexpected costs can be crippling…
Yet there remains absolutely no reason to be a sitting duck waiting to be hit. Even though the market state has changed, it doesn’t mean that there is no room to manoeuvre.
There is always going to be an opportunity to exploit energy markets, even in a bullish market.
Energy Buyers and Flexible Contracts
Flexible contracts are a somewhat new contract type that helps to pass on the benefits of the wholesale energy market to consumers, with the price they pay for their energy being dependant on movements in wholesale price.
The profile shape of the customer’s demand (consumption) trend is split into two separate categories. These are the baseload and peak.
The baseload can be thought of as the bulk of demand and is the predictable portion of the customer’s energy. Most businesses will be able to provide very accurate estimations as they have access to much more detailed levels of data. This is usually through combinations of smart meters, sub-meters, and even auditing.
The peak is essentially the spike in demand outside of predictable baseload that nobody foresaw needing. This peak demand makes up the tradeable volume which is able to be traded within flexible contracts.
The wholesale market trades this volume in set blocks, although the match-up between the block and customer profile may not entirely match. As a result of this, customers are able to buy a block of energy that may or may not exceed their total usage. There are actions to resolve any mismatches of demand and purchased volume.
Where the purchased baseload and peak volumes exceed the customers profile the gas can be sold back to the supplier. In addition to this, when purchased baseload and peak volumes fall under actual customer consumption needs, customers are able to ‘top-up’ and purchase extra volume in smaller blocks.
This is where the term ‘flexible’ energy contract really comes from – it allows a much greater degree of freedom to the customer. This is the vector by which the risk and reward of the wholesale market are passed onto customers.
Third party hedging
Third party hedging is when hedging happens outside of a physical supply contract.
This means that supply contract negotiation can be completed at a different moment – which can be a great option for businesses that have difficulties negotiating their physical supply contracts on time to do long term hedges.
There are several ways in which this can be done – firstly, by ‘swap arrangements’ with a bank. Often, these can be difficult to realize without a physical supply contract already signed. Customers would be purchasing forward products with the bank to then later be swapped against buyers’ formula.
A far more realistic option is ‘sleeving’.
Buyers purchase their hedges with one supplier and then once they have their physical supply contract negotiated, pass them on to their physical supplier. Some will have already their preferred supplier and then go into the market once they want to tender the physical supply.
The tender should mention that the customer has already bought 6 MW and that the new supplier should take over this 6 MW.
A further option could be for a customer to hedge with their current supplier further in the future, even if they don’t have a contract in place yet. When buyers have been working with the same supplier for a long time without any issues, the risk should be minimal.
If none of the options covered so far are available to you and suppliers are not able/willing to move in that direction, it does not mean you are out of options. There is no need to panic just yet.
It may be possible to sign a physical supply contract and then on a certain day, anything that has already been hedged with another party is sold back to that party, then bought back again with your physical supplier. Although this sounds needlessly complex, it is a neat little trick to neutralise any cost-effects.
Advanced Hedging Techniques
Hedging doesn’t always have to be complicated – although there are certainly layers of complexity that can be added as comfortability grows.
The first option would be to buy and sell forwards, although it is possible that some internal procedures will not allow for this. However, prime moments for selling forwards have been few and far between recently.
For those who are a little hesitant about taking stop loss decisions, ‘options’ can be a great solution. When markets go down following reaching the stop-loss, the ‘option’ allows customers to go down with the market. If prices have been fixed at a stop-loss level, this is simply not possible.
Financial departments often turn their nose up at this technique, due to the low liquidity, additional complexity and the high premium prices with options. Although it has to be said that customers don’t actually have to buy an option product – they can also make a physical supply contract with a cap included. In which case, the supplier will be buying the option to ensure that the contractual price doesn’t rise above a certain point.
Power Purchase Agreements (PPAs)
This is where a customer would have a supply contract directly with the producer themselves – such as a renewable energy producer. Power Purchase Agreements have become increasingly popular ever since renewables reached grid parity. This means that the cost of producing electricity by something like solar panels has dropped below the cost of consuming that same amount of electricity from the grid.
For budget-risk customers, there is a chance to make a deal at a fixed price and reduce exposure to volatility. For market-risk customers, it is possible to make a deal at a discounted market price. This ensures that customers stay beneath the market – offering a competitive advantage over other businesses.
In many countries, customers have the opportunity to exploit a win-win scenario by setting up a PPA – saving on both taxes and grid fees. In countries like Brazil, it is possible to obtain a reduction in grid fees and taxes if the grid is used for consuming electricity from a renewable producer outside of your facilities. Even if the producer raises his prices than the relative market price, they will still likely find consumers willing to pay this price because of the lower taxes and grid fees.
So, in summary – if you or your business were blindsided by the bullish energy markets we have observed recently, then it is advisable to research long-term strategies to avoid leaving yourself vulnerable to it happening again.
The best thing?
We can help you with that.
Niccolo Gas – Here to Help
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If you are looking for an energy supplier with extensive industry knowledge, a range of business gas products suited to all sizes of business, that is supported by one of the largest gas suppliers in the UK – then look no further!
Give us a call today on 0131 610 8868 or email us at info@niccolo.co.uk.
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