When delving into the wholesale energy market you better have a game plan.
If you don’t, you will be eaten up for breakfast.
When buying energy in any form, whether as a domestic customer or as a large flexible buying business, there is an associated risk with the purchasing decision.
But what separates large flexible businesses from the rest of the pack in terms of overall risk is the sheer scale of consumption and access (if desired) to the wholesale energy market. This creates a scenario where huge savings on energy can be taken over time, or leaving the business paying well over the odds for their energy…
These are by no means the only buyers in the wholesale energy market, far from it.
Due to intense deregulation, buyers are now comprised of people from all walks of life, all types of business, and differing motives… One thing that ties all of these buyers together?
They are all there to beat the market and to save/make money from energy.
So what strategies are implemented to ensure the market doesn’t chew you up and spit you back out again?
Background – The wholesale market, flexible contracts
The wholesale energy market allows suppliers to buy and sell large quantities of energy to and from one another. It is not just buying and selling between producers and suppliers but rather multi-stage trading between entities from more operational backgrounds than you can shake a stick at.
The wholesale gas market for the UK has only one price for gas irrespective of where the gas comes from. This is called the National Balancing Point (NBP).
Flexible gas contracts are still quite new and novel. Essentially, flexible energy contracts allow customers to take advantage of the incredible price volatility in the wholesale energy market to make massive savings on energy purchases.
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 main bulk of demand and is the predictable portion of the customer’s energy. The peak is essentially the spike in demand outside of predictable baseload. The stuff that nobody foresaw needing. This peak demand makes up the tradeable volume that is able to be traded within flexible contracts.
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.
Approaches to buying energy
Most buyers of wholesale energy have worked out that the timing of price fixings is probably the most important factor in determining how much you will be left to shell out. These buyers will have contracts in place with suppliers allowing flexibility for the fixing of the wholesale value. Flexible contracts like this allow for multiple fixing moments on different forward products and/or leave volumes open for spot indexation.
In the energy markets that have developed a little more than the rest, traders are well versed in working with such products. There is still a little resistance from many industrial consumers where deregulation is lagging a little behind, labelling it as ‘speculative’.
There is one problem with this. This is trading, not speculation.
As trading is maybe not the most natural environment for industrials, it is understandable that many feel a little apprehensive, many failing to find the right approach to energy trading.
The wholesale energy market is unpredictable. 95% of buyers acknowledge that.
So, now we have established the core make-up of energy buyers in the market when it comes to personal beliefs held regarding the market – what does this translate to in terms of buying strategy?
Buyers that believe price can be predicted – 5%
Roughly 5% of buyers in the wholesale market staunchly believe that prices in the energy market can be predicted with absolute accuracy – If they are able to ‘crack the code’ mathematically, that is.
The strongest argument against this operational belief is an incredibly simple one. If those who truly believed that the price of the energy market could be predicted truly believed this, why on earth are they energy buyers!?
If prices could be predicted this easily – why not become a full-time energy trader? The profits you would stand to make are mind-boggling…
If those who truly believe market prices can be predicted truly believed, they would ditch their day job in a heartbeat. This in itself kind of debunks this idea of ‘perfect predictability’.
The wholesale energy markets are incredibly unpredictable by nature. Supply and demand forces are complex and difficult to understand. There are too many variables to track, let alone quantify.
A huge amount of time is spent analysing past trends through complex mathematics to reveal trends and correlations. But in this market setting, this doesn’t necessarily help you very much. Revealing only that one unknown factor is indeed correlated with another unknown factor does not provide much help with pinpointing future prices.
Energy markets are too volatile and too vulnerable to exogenous shocks to ever be predicted. Look at the response of the international energy market to the Fukushima disaster – anyone claiming they can predict the energy markets is also claiming to be able to predict events like these. What’s more, they are also claiming to be able to quantify the effects of such disasters…
Maybe a bit of a tall tale.
Buyers that believe you can’t predict price, so should not trade energy – 10%
This small group of consumers fully understand and readily accept the energy market volatility. Most commonly this group will delete deliberate trading decisions from their energy procurement practice, linking energy prices to the spot price, to an average forward price or buy at randomly chosen moments to produce an average price.
This is a bit more of a hands-off approach than others, and it is especially popular with larger energy consumers. This is to do with scale of consumption and the sheer volume of energy these guys buy.
Every decision to fix or not is a matter of millions of pounds, if your consumption is high enough, that is. Many businesses decide that they shouldn’t leave this to the energy buyer, and will instead set up a trading desk or automated buying.
Buyers that believe you can’t predict price, but can create business value by actively managing prices – 10%
Active price management should look a little bit like this:
- Analyse the impact of energy market price volatility on your business and find a strategy that helps to minimise risk. The strategy should not determine when you buy, but more so determine how much you buy and how far into the future. If the main risk for your company comes from financial vulnerability, it is advisable to buy larger volumes for further into the future. If the main risk is market vulnerability (loss of competitiveness from fixing prices higher than the market) then you should buy more regularly and in smaller volumes, at opportune prices. How far you buy in the future is determined by the pace at which prices for your products adapt to changes in energy costs.
- Following the markets to determine when to buy. This type of market analysis doesn’t take future forecasting into the equation, simply what the market is doing at this moment in time. If the markets are in free fall, holding off on purchasing any serious volume. This is the most basic ‘buying the dips’ approach.
- Combining forecasting with ‘buying the dips’ – this takes into consideration the erratic movements in the wholesale market. By looking at forecasting data, it can help to predict any potential upticks (that aren’t just temporary movements).
An energy risk management approach to buying energy means a totally different approach to the false upturn dilemma. When making a price-fixing decision a 50/50 approach should be adopted. This stance looks at the problem like a child that doesn’t understand statistical probability – but it works. In a nutshell, it is this – ‘There is a 50/50 chance that I guess the movement right, either going up or down’. An example energy risk management policy allows you to fix up to 50% of an annual volume at a time.
This can be divided into four different buying points, 12.5% at a time. When the market first turns around, the first quarter should be purchased. If it continues to go up, another quarter is fixed. This is continued until 50%. If the market drops again, nothing is purchased and only 12.5% is fixed on a temporary upswing.
Honestly, this active price management strategy produces incredible results, allowing businesses to achieve pre-defined risk management goals. At the core of this strategy is the positive results from fixing markets whenever they ‘turn around’, ensuring that results are always relatively good when compared to the rest of the market.
You can’t predict energy prices, but I would still like a forecast when making a trading decision – 75%
There is only a tiny proportion of buyers who truly believe in predicting the future price with accuracy. A large majority of this group will still not take purchasing decisions without some kind of forecasting. Why?
The use of forecasts is so deeply embedded within the business world, and even has its roots based in deterministic economics. Economists make a living trying to create mathematical equations to produce correct predictions time and time again. This service is then sold to businesses looking to bring on a forecasting consultant.
It is difficult to see so many energy buyers in the wholesale market still with an overreliance on forecasting – even though they know it doesn’t work. Not truly. It is far more rational to pursue an active price management approach (as described earlier), instead of entirely trusting forecasts.
Risk Mitigation
At Niccolo Gas, we are well versed in the wholesale energy market – knowing it like the back of our hands. We have even begun to offer flexible contracts to our customers to help them share in the same benefits that we do as a supplier.
If you are looking to get started in the wholesale market, but don’t know where to begin – give one of our energy experts a call today!
We can be reached through normal UK office hours at 0131 610 8868, by webform, or by email at info@niccolo.co.uk
We look forward to hearing from you!
Google Snippets
Can you accurately predict the price of wholesale energy?
There are many different answers floating about for this one, with many buyers believing you can. As many again oppose this view vehemently. A sensible answer is no, you cannot predict the future price of the wholesale energy market, but you can make a very good educated guess.
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