The end of ‘speculation spring’?

In 2009, 2010 and 2011 energy prices were in a bullish trend by this time of the year. Certainly for electricity, there was a returning pattern. Year ahead prices rose during the first six months and then dropped back in the second half. We dubbed this phenomenon ‘speculation spring’ at E&C. During the first six months, the year ahead is still far in the future. This gives the market ample possibilities for speculation about the disasters that might affect the supply – demand balance by the time the year ahead is near. However, as the end of the year approaches, reality sets in. That cold winter that year ahead bulls counted on, doesn’t materialize. Governments across Europe shut down less nuclear power plants than expected. Demand for energy doesn’t recover in line with the economic recovery. The disasters don’t materialize and prices start to fall. Such speculation in forward energy markets is supported by the fact that market participants seem to systematically underestimate the price lowering effects of certain evolutions:

1. As I have commented earlier, there is a dogma of rising energy prices. Analysts systematically underestimate the combined effects of delocalization of heavy industry and increasing energy efficiency on natural gas and electricity demand in North-West Europe. We recently saw another example of this. Carbon dioxide emissions of ETS companies dropped by 2,4% in 2011 whereas the market had expected a maximum 1% drop and some even a 1% increase. If carbon dioxide emissions of ETS companies drop, this clearly means that large industrial consumers of energy are reducing their consumption.
2. The price moderating effects of increased inter-connection is also often under-estimated. Specifically in large countries, analysts tend to look at supply and demand conditions in their own country only. This is specifically true for analysis of gas markets which is largely focused on conditions in the UK.
3. Everybody has underestimated the rapid growth of renewable energy production in Europe. Even legislators are surprised by the developments and struggle to adapt policies as output outstrips their targets (see my previous blog). Many power market analysts predicted supply shortages for this period due to the closure of nuclear and older power plants. They never thought that the combination of increasing renewable production, more interconnectivity and rapid growth of renewable would be able to fill the supply – demand gap.
4. Gas storage capacity in North-Western Europe has been expanded by more than 60% in the past five years. Due to this, seasonality in the gas markets has been reduced as more gas from storages is available in the winter time and more gas to fill the storages is needed in the summer. Still, markets continue to worry over the effects of a cold winter on gas demand. The seasonality in the forward gas market is often exaggerated if you compare to the actual difference between summer and gas prices in the spot markets. As gas prices are the main driver of power prices, a similar mismatch of forward and spot seasonality can be seen in the electricity markets.

In most discussions with representatives of energy companies, you are consistently bombarded with scary stories of future energy shortages. Same stories on conferences. Even our new Belgian state secretary of energy Wathelet spread a scare story last week. At current low power prices, there would not be sufficient investment in gas-fired power stations which would lead to power shortages in Belgium, he remarked. A great display of policy consistency, I would say, as that same man had a law voted to freeze energy prices at current levels a week earlier. Ask any man in the street whether he thinks energy shortages are around the corner, and a large majority will say yes.

Energy shortages do occur … sometimes. During those few cold days in February, for example. However, have you remarked how short-lived the price spike was? If you look at the average spot price levels for North-West European gas and electricity of the past four years, you can only conclude that during most of the time there was more than enough energy.

Spot prices don’t lie. In most of our markets, spot price determination mechanisms have been installed that make sure that the price is a correct reflection of supply and demand of energy at that moment. It is much harder to speculate against spot markets, specifically in electricity markets where storage capacities are non-existing and gas markets where they are very limited. Because speculation in the spot market can only be physical speculation. Producers or traders have to consciously withhold capacities from the market to drive up prices. If you own a gas-fired power plant, and the electricity price that you can get is higher than your gas costs, you can turn in money by producing. You can’t say, I’ll produce and keep it in store for when prices are higher. Average spot prices in the gas and the electricity markets in the past years have consistently been lower than the average forward prices. This means that there has been sufficient supply to cover for the (declining) demand.

Forward markets are much more subject to speculation. Basically, if you sell on a forward basis you make a trade-off against the future spot prices that you expect. That opens up the possibility of speculating about supply – demand tightness. The further into the future, the more room for speculation: so many things can happen between now and the end of the year. This explains the “speculation spring” phenomenon” on the heavily traded year ahead contract. By the second half of the year, we saw in the past three years how reality kicked in. The supply reductions and demand increases didn’t materialize. The spot price remained at relatively low levels over the summer months. And if you are the 15^th of December and your spot price for power is still around 50 euro per MWh, it becomes hard to make your case for 60 euro per MWh for supply of power in the year that starts in two weeks. It is a law written in stone that as a forward contract gets near expiry, it will get closer to the spot market level.

Rising prices in the first six months, bear correction in the next six months. We saw this pattern three years in a row. Obviously, in our struggle with the unpredictability of energy markets, we are tempted to call this pattern eternal. If only life would be that easy. If only prices would be at their best level at the same moment year after year. Buying energy would become the easiest job in the world, just wait for the pre-determined moment and buy. If only … This year’s development, with speculation spring not taking off shows us once again that the reality is more complex. And we need to continue to be careful. Maybe in 2012, it will be the other way around. Maybe we will see a bull market in the second semester. Nobody can tell, it will depend on the extremely complicated equation of energy supply and demand.

Filed under: Energy demand, Forecasting, Market analysis, The market today

The dogma of rising energy prices

This week, I was speaking at a conference for Flemish procurement professionals on energy markets. I was a bit of an exception there, as I was the only person in the room that was not convinced that energy prices can only rise. In fact, this was another event at which buyers of energy were indoctrinated with the dogma of rising energy prices. And oh yes, there was even a forecast, and oh miracle, all the sophisticated econometrics applied in making it, resulted in a remarkably round figure. Power would cost 100 euro per MWh in the future! I am not saying that this is impossible, I am just saying that it is not sure. And buying energy (or any other commodity) out of a conviction that it can only get more expensive, will inevitably make you buy energy at prices that are too high. You just don’t take into account that it could fall.

The problem is not just that people – educated or not – so easily jump to the conclusion that energy prices can only rise. It is also that they do this regardless of what the price level is at that moment. Let’s return to the first six months of 2008. Oil prices were near 150 dollar per barrel, gas prices rose over 40 euro per MWh and power prices in North-West-Europe hovered near 100 euro per MWh. Every day, news articles were published that repeated the dogma: the price of energy could only get even higher. Oil prices would rise to 300 dollar, said a Goldman Sachs analyst. Buyers fixed prices. And saw themselves extremely on the wrong side of the market when six months and a financial-economic cataclysm later, prices were more than halved.

To the huge crowd of energy market bulls, I want to say the following. Your theories look very plausible, just like they did three or five years ago. BUT: there is no empirical evidence for your theories, rather to the contrary. A few demystifying remarks:

1. All graphs shown by these speakers claimed that in the coming decades energy demand in general and Belgian power demand specifically would continue to rise. Well have a good look at the graph below. Yes, power demand has started to rise again after the crisis of 2008 – 2009. But it didn’t come back to previous levels. The highest monthly power consumption in Belgium dates back to January 2006. 2006 was also the year of highest consumption. 2007, 2010, first half of 2011, these were not years of deep economic recession, were they? Remarkably, September 2011 was a month of historically low power consumption. Since 2005, only June and July 2009 had lower consumption. Of course, this was a September month with extremely mild temperatures. And yes, this decline in power consumption could be a signal of looming recession. But, if you take all of this together, you can see that power consumption has stopped to rise. This is good news, it means that all our purchasing of high-efficiency lighting bulbs, freezers, dishwashers, laptops, etc. is having an effect. It shows that Belgium’s industry’s efforts in the framework of energy efficiency covenants are having effect. Strangely enough, most analysts assume that power consumption trends for the next years will just continue to rise, as if there is no such thing as a Kyoto policy that stimulates increasing energy efficiency. Of course, if we all start driving electrical cars, power demand will increase. But again, taking that potential switch for a fact, is speculative.

 

2. All speakers assumed that by producing more electricity from renewable sources (wind and solar), power prices would become more ‘peaky’. Well, my dear analysts, anyone keeping track of the energy markets will tell you that peakload power prices are historically low compared to baseload prices. Since 2005, the amount of power from windmills and solar panels on the North-West European has risen sharply. However, as you can see on the graph below, peakload, baseload spread on the Dutch spot market has fallen, not risen. Belgian and German markets show similar patterns. I always find it stupefying to find speakers using the results of a single day in the spot market to prove, for example, that more extreme peaks occur. This week again, one day on which prices peaked in the spot market was used to demonstrate the more peaky character of power prices. If you look at the table below, you will actually see that spot markets have recently shown a lot less extreme spikes. In this table, we calculate the number of hours during which the price was more than four times higher than the average hourly spot price for that year. You will see that in 2010 and 2011 no such days have occurred. And this is data for the German market, where the proportion of wind and solar power on the grid has rapidly risen in the past five years. So, the theory that more renewable energy on the grid causes more price spikes just isn’t true. That is, if you are willing to look beyond the results for one particular windless day.

 

 

year	Number of hours for which the EEX price was more than 4 x average price
2001	48
2002	26
2003	39
2004	0
2005	55
2006	72
2007	70
2008	2
2009	2
2010	0
2011 ytd	0

 

There are solid reasons why electricity markets are becoming less peaky. The flattening of power markets is a result of two evolutions:

-          The increasing degree of physical and financial interconnection of the markets. Decreasing wind power output in Germany can be compensated by increasing gas-fired power input in the Netherlands.

-          The evolution towards more gas-fired power production, increasing the flexibility of the market to react to price increases.

3. It was also claimed that the intermittent character of renewable energy would create a scarcity of gas-fired power production. Scarcity, that should normally mean that the price of gas-fired electricity increases, I would say. So, spark spread should go up. If there is a scarcity of gas-fired power production, the marginal MWh’s should be produced by less efficient gas-fired power production units, raising the spark spread level. Well, again, the opposite is happening. Spark spreads are historically low. And again, there is a reason for that. We think that low spark spreads are due to the sharply increasing quantity of electricity produced in CHP units. Putting electricity on the grid with your CHP remains profitable even in cases of negative spark spreads. I agree that there is a problem looming with investment in CCGT, high-efficient gas-fired power stations.  The low spark spreads are discouraging and we do see power producers that cancel their CCGT investment projects. But this has nothing to do with the growth of renewable energy production, it’s the CHP’s that create this situation.

I am not claiming that energy prices are sure to fall in the next decades, I just want to point out that this is not unthinkable. We even think that if we are to start large-scale production of shale gas in Europe, a low power price scenario becomes quite realistic. I just want to make clear that prophecies that energy prices are sure to rise are based on: a negation of current trends and a biased selection of future scenario’s. Doomsday prophets sell better. That is why it so much easier to hear the ‘increasing energy prices’ dogma in the press than a more balanced view. And that is why so many buyers of energy take wrong decisions because they get convinced of that dogma.

Filed under: Belgium, Forecasting, Risk management

7 questions that will determine energy prices in the next decade

I am not in the forecasting business, so futurology is even less my cup of tea. Still, last week, in the margin of the E-World fair in Essen, I had a very interesting conversation with a client. Over dinner, we discussed the current outlook for the energy markets and some interesting ideas popped up. We are today facing some evolutions which will very probably have an important influence on worldwide prices for oil, coal, gas and electricity. Asking these questions is interesting in itself. Anyone with a good sense of reality will acknowledge that making a forecast about the outcome of any single one of them is impossible. The energy prices of the future will be determined by the combination of outcomes of all of these questions, which makes it even more difficult to forecast them. So, according to me, these are the issues:

1. Will we all drive an electrical car in ten years? Car companies, and even governments, are betting heavily on this. Today, oil is mainly consumed for transportation. If we all (or most of us) drive an electrical car, the consumption of oil will fall in favor of electricity. Where will that electricity come from (see questions 4 and 5)? Will this cause prices of oil to fall and prices of coal and natural gas to rise?

2. Will the peak oil theory materialize? According to some we are already witnessing the peak. According to some dissidents from the International Energy Agency, oil producers are not able to produce more than 90 million barrels per day. They claim that they were forced by their organization not to tell the world about this fact.

3. Will there be a post-Kyoto climate change policy? And how stringent will that be? Will Europe continue to try to be the best of the class? Or will it be joined by the other countries? And if Europe is that lonely front-runner, how enthusiastic will it continue to be? Or will it rather scale down its efforts? Or is the drive towards greenery unstoppable, even without a world agreement on climate change efforts? This will obviously have impact on the outcome of other questions such as 1 or 4 or even 6.

4. Will renewable energy technologies such as wind or (large-scale) solar become competitive with traditional methods of power production? Or will these technologies continue to need state aid to become widespread? The outcome of this question obviously depends on what the outcome of all the other questions is on the energy price. The higher the energy prices, the more competitive the renewable energy technologies will become. But then, because of their low variable cost, renewable power production pulls down the electricity prices.

5. Will shale gas cause a glut of natural gas in the United States, Europe or China? Shale gas is now being produced and all big energy companies (even Exxonmobil) are investing in it. If it is really recoverable in the quantities such as announced, even with a huge increase in gas consumption, we are not facing a gas supply shortage in the next decades. With abundant gas around the corner (Germany and Poland are said to have big prospects in shale gas), the fundamentals of energy shortages change completely.

6. Are we really at the brink of a nuclear renaissance? In Asia, many new nuclear power plants are being started up. In the US, Mr. Obama is betting on nuclear also. In Europe, governments are more hesitant. As with renewables, the low variable cost of nuclear tends to pull down electricity prices (which again, makes investment in nuclear less interesting).

7. Will Europe continue to be a liberalized energy market? It’s hard to see a way of turning it back. Is it possible in democratic, open market countries to create new monopolies without a cavalcade of court cases from the heavily disadvantaged competitors? But on the other hand, consumers (voters) and their governments are growing increasingly frustrated with the results and – logical – consequences of energy market liberalization. But maybe, the market will take some hybrid shape, something in the line of what France is currently trying to create.

None of these questions is hypothetical. I am not speculating about some undeveloped question, such as the possibility of nuclear fission. Electric car technology is being developed, peak oil theory discussed as a real possibility, Copenhagen was a failure to reach a post-Kyoto agreement, prices per kWh of renewable electricity are falling, the gas market is massively investing in shale gas, nuclear power stations are being built in Asia and the discussion on liberalization was opened even in ultra-liberal Britain last week. These are all factors that will determine the price we will pay for energy in the next decade. And moreover, new questions and issues will pop up.

Filed under: Energy history, Energy technology, Forecasting, Market analysis

Hubbert’s peak or just a bump?

In the past five years, I have hardly met anyone who wasn’t convinced that energy prices could only increase. Most buyers of energy were strongly convinced that we had reached the point where demand growth is outstripping the growth of supply and discovered reserves. This point is called ‘Hubbert’s peak’ after the US geologist M. King Hubbert. The man successfully predicted the decline of US oil production since the 1970′s. He then went on to predict a similar future for the world’s oil production. He gathered an enthusiastic group of followers called the ‘peak oil theorists’ (www.peakoil.net). Mister Hubbert also predicted that live past the peak would be characterized by the high prices and increased volatility that we suffered in energy markets in 2005 – 2008. This made many people believe that peak oil theory is indeed correct. To them, the backdrop since July 2008 was due to the economic crisis. It wasn’t a fundamental reversal of the longer term rising trend. ‘In the long term, it can only rise’, is a phrase that I often heard in the past one and a half years.

The energy procurement strategy in line with such bullish sentiment is a strategy at securing long term energy prices. Many buyers have fixed prices for volumes up to three, four years into the future. Recently, I ran into one of the largest buyers of energy in Germany and observed that they were also following such a strategy of securing prices for the long term because of their fear that energy prices could only rise. This long term – rising trend conviction even made some buyers fix prices for large volumes when the oil price reached record highs of near 150 dollar per barrel in June 2008.

Meanwhile, what do we observe in the markets?

1. With Chinese oil demand growing at record levels, the Brent price broke above the 80 dollar level in the beginning of January. It’s still very early to call ‘bear’, but today the Brent traded below 73 dollar.

2. European gas prices in the spot market have traded below 15 dollar this winter, even while demand has reached record highs due to the cold weather.

3. With Chinese coal demand back on its previous growth path, the coal price dropped back below 100 dollar this week.

4. Power prices in most European markets are back below 50 euro per MWh, which is half the level of before the correction in 2008. With European power demand getting back to previous level, the power prices show no sign of rising.

Of course, it all depends on how you define ‘long term’, but anyway, today’s market is not resuming the bullish path of before the 2008 – 2009 correction. Moreover, there are some developments on the supply side that undermine the vision that from now on, demand growth will continue to outstrip supply:

1. Some expect Iraqi oil production to ‘plug the gap’ in the oil market in the coming years (see my previous blog entry).

2. The bull trend in coal prices was mainly due to logistical issues which have been solved. Coal seems to be abundantly available.

3. The US has expanded its natural gas reserves figure to 100 years of consumption due to developments regarding the production of shale gas.

And how certain is the continuation of demand growth? We shouldn’t forget that oil prices were already falling in July 2008, two months before the financial crises broke out. Oil prices started to fall because of the fact that consumers in the US were adapting their consumption behavior, e.g. by buying less fuel-thirsty cars. How durable will that trend be? The Brussels car show has ended this weekend. Salesman told journalists that they clearly saw a trend of buying cars with better fuel economies.

In ten years time, we will be able to assess whether we were indeed standing on the wrong side of Hubbert’s peak in 2010 or whether the prices of 2005 – 2008 were just a temporary bump. In the meantime, I strongly recommend buyers to forget that energy prices ‘can only grow’. Adapting a ‘it can fall as well as it can rise’ attitude to buying energy simply breeds much better results. More on that in a next entry.

Filed under: Energy demand, Forecasting

Short-sighted energy market analysis

Energy market analysts have recently been puzzled by the rise of oil prices. To many observers it looked like this rise was not supported by any fundamental shift in supply or – more importantly – demand. ‘Speculation’ is then easily blamed for the rising price. This was even done in the US Senate during debates over oil market manipulation (click here). As I have said before, I don’t believe that the forces of speculation are strong enough to shift the market direction. My natural reflex in such cases is to wonder whether there isn’t some change in supply and demand which we are ignoring. And more often than not, some piece of information pops up that does indeed show such a ‘hidden’ fundamental.

I was therefore not surprised to find the following piece of information through LinkedIn this week:

 “Chinese imports of oil in July hit a new record at 4.6 million barrels of oil per day, the equivalent of half of Saudi Arabia’s daily output. This eclipsed the previous record of 4.1 million barrels of oil per day set in the spring of 2008”, click http://wallstreetmess.blogspot.com/2009/08/china-commodities-and-financial-media.html for the full article by Tony D’Altario. (I don’t agree with the overall conclusion of the author that this means that the US is no longer the world’s economic superpower. Impressive though the 4.6 million barrels might look, the US is still consuming at least 4 times more oil. But micro-economic experience shows that it is growth rate rather than sheer size that often defines the economic attractiveness.)

Somewhere on this planet, oil consumption has been growing in the past months. Oil traders must have picked up that signal in the spot markets. Does this justify a 75 dollar oil price? I don’t think that we will ever be able to answer the ‘justified price’ question. If we could, everyone would calculate the price and the market would become sterile. I do believe though that demand growth in China justifies a reversal of the bearish into bullish mood.

Even if the author is perhaps a bit to polemic, I do agree with the conclusion that analysts tend to be too much focused on US data. We could even call much oil market analysis short-sighted as it doesn’t look beyond the reality of the US. This is a profound methodological issue. Oil prices are influenced by so many different aspects that it is simply impossible to keep track of all of them. This means that any analysis system will have some data selection mechanism. Now, as any scientist can tell you, this data selection entails a huge systemic risk. Get your data-set wrong and you get deceptive conclusions.

This short-sightedness of oil market analysis is not strange. I can even see it with the analysts that we have at E&C. The price is rising and the analysts are under time pressure for finding an explanation (as consultants are calling them because they want to inform their clients). The most readily available data is then more easily selected than the information that you have to go after. Fortunately, we are not in the forecasting business, so we don’t make any systematic data selection and we don’t give clients advices on whether to buy or not because we believe that we can calculate what the future price will be from the data that we selected. But for any market analyst on this planet, it is a constant effort to keep reminding ourselves that we need to look further than the information that is in front of our nose. And from what I hear from our clients, we manage to do so quite successfully at E&C.

That US oil data comes in focus is not surprising. No country in the world is better in providing oil market data than the US. Every Wednesday, two reputed institutes, the API and EIA publish data on supply, demand and storage. It is a market in itself. Days and hours before, the market price is being set as traders take positions in anticipation of the news. The moments before, the market seems to hold its breath as liquidity drops and the price stops moving. And then the reports come out and frantic trading activity takes place as computers programmed to give the ‘buy’ or ‘sell’ signal when they find certain words in the API and/or EIA reports start trading. The market takes a first initial direction, but the definitive direction becomes clear only hours of active trading later, when we start to see whether the majority of market players interprets the reports as ‘bullish’ or ‘bearish’ news.

The quality of this and other economic data coming from the US is undeniable. And it stands in sharp contrast to the proverbial shadiness of Chinese statistics. The ‘short-sightedness’ of oil market analysis is therefore understandable. But is not justifiable. Any oil market analyst worth the name should presently be looking for sources for better grasping the dynamics of oil markets in emerging markets. And I refuse to believe that US oil market analysts refuse to do so out of economic nationalism.

Filed under: Forecasting, Market analysis, The economy, The market today, US

Madoff: the lessons for the energy market

Bernard Madoff has just been sentenced in the New York courthouse (http://amfix.blogs.cnn.com/2009/06/29/victims-life-term-for-madoff/). It looks like the person that set up the largest investment fraud ever is going to spend the rest of his days in jail, that is, if he doesn’t live for more than 150 years from now on. As Europe’s energy markets share more and more characteristics with stock markets, what can we learn from this story (which would have been the financial story of the decade, if it hadn’t coincided with the financial crisis)?

1. Damages in markets are often impossible to compensate.

2. Scandals will continue to occur as people will continue to believe that some know better where the market is heading.

3. Authority is dangerously attractive.

Mister Madoff’s wife has to pay back 80 million dollar from the family fortune. Lucky for her, the judges have been compassionate enough to let her keep 2,5 million dollar which should allow her to continue a more or less comfortable life. This looks like a sound judgment, as the poor woman apparently was as much surprised by her husband’s wrongdoings as the rest of the world. After having lost her husband and her family’s reputation, condemning her to poverty would have been cruel. But the 80 million dollar stands in dark contrast to the estimated 65 billion dollar in damages caused by her husband’s fraud. This means that this money will allow to pay back a little bit more than 0,1% of the damages. For those involved, they will probably never see a penny back of the money that they had entrusted Mr. Madoff with. They will have to take some comfort from the fact that the man spends his old day in jail. 

In energy markets, we also observe that the damages can be so large that it becomes impossible to compensate them. This risk is obvious from the consumer’s point of view. Power failures can cause huge economic damage if they occur in an industrial zone. If the grid companies that are responsible for avoiding such failures would be responsible for compensating that damage, they would have to raise grid fees to astronomical amounts. Consumers of energy should be aware that energy suppliers also have huge liabilities in the wholesale energy markets where they source the energy that they sell to their clients. If for example a big industrial consumer stops consuming, the supplier can remain stuck with an off-take obligation (physical risk) or with a certain amount of futures contracts that he has bought to hedge the price for that client (financial risk). Another form of counter-party risk became clear when Lehman Brothers went broke. All of a sudden, the counter-party in many hedges had disappeared. The financial crisis has confronted energy companies with these risks. We can daily see that they are consciously trying to mitigate them by adding new clauses or interpreting old clauses more to the letter regarding take-or-pays, financial securities or payment terms.

People tend to look at markets with the deterministic approach that we apply in our daily physical life. If I let a pen drop, I can be pretty sure that it will fall on the floor. The fact that it has done so in the past, gives us relevant information of what it will do in the future. This is not the case in economics. First of all, the number of factors influencing markets is huge. Therefore, the market price is not the result of a simple cause and effect process like dropping a pen. It more resembles the mishmash of causes and effects and effects that cause new effects, and so on, that we know from weather forecasting. And we know how difficult it is to interpret such multi-cause and effect systems. This weekend was supposed to be rainy, according to last Friday’s weather forecast. It was the sunniest weekend of the year. Moreover, markets are made by people. People react on the information that they get. And this adds a crucial element of unpredictability to markets. But we fundamentally dislike this unpredictability. Therefore, someone telling that he can read the future of the markets better than everybody else, looks like an attractive proposal. That is the reason why people entrust guys like Bernard Madoff with their money. And we can see the same thing happening in the energy markets. Consultants that base their services on forecasting will continue to find clients for that. I also find the mathematical wizardry that they apply to support their advices often quite impressive. Only, so far I haven’t seen one of those systems give the right kind of information. On the contrary. Most systems are so hapless in identifying trend reversals that they constantly make clients fix energy prices much too late. If your interest as an energy procurement consultant is mainly in building long term relationships with your clients, you will carefully avoid forecasting. But people will continue to pay money for forecasting services to consultants that create the impression that they have a better knowledge of where the market is heading.

One of the reason’s that Bernard Madoff could attract so many people to what was basically a simple pyramid system or Ponzi scheme, was his reputation. The man had been non-executive chairman of Nasdaq and as such he was regarded to be an authority. (And judging from his pictures, he looks like a sympathetic guy.) Even if it is a medieval idea, we attach more importance to authority than our enlightened spirits confess doing. Just look around at conferences. The guy with the huge experience at a reputed institute gets a lot more attention than the one from the start-up, however interesting the latter’s ideas might be. Again, we often observe this in the energy market. I once saw a client waiting to fix prices because their CEO had talked to the boss of a major oil company that had told him that he was convinced that the oil prices would fall. Many people take advice from their energy suppliers when taking their price fixing decisions. That is, they believe that energy suppliers are authorative when it comes to talking about the direction of the market.

However deep their knowledge of the market, I don’t believe that energy suppliers know any better where they are heading than any one of us. If they would, the price development in those markets wouldn’t be so volatile. Moreover, if they had that knowledge, why would they share it with their clients? I would imagine that such information would be considered to be of strategic importance. It would give them a huge edge over their competitors so would they send out their account managers to share it with everyone? The same applies to a consultant. If I would know what the future of the energy prices is, I could win a lot more money as a hedge fund manager than as an energy procurement consultant. It’s a phrase often used, but mostly ignored: anyone that knows what the future price of energy will be, would sit under a palm tree in the Bahamas.

The Madoff case reminds us that no miracle solutions for dealing with markets exist. The future of the market is unpredictable. We better protect ourselves from the risks of that unpredictability instead of trying to bypass it.

Filed under: Forecasting, Risk management

Bullying the market

Goldman Sachs has lifted its target for oil prices to $75 per barrel (WTI). ‘Here we go again’, is what many among you probably think. You might even have some bad memories of the first half of 2008 when Goldman Sachs kept raising its oil price targets as the bull run was battering the market. Frightened by such a reputed institute talking about $300 oil, many energy consumers were scared into fixing energy prices at very high levels. As prices started to fall later in the year, this turned out to be a disaster. Victims of this false call now have to pay high energy bills in the middle of a severe economic downturn, and it hurts. That the market picked up the news of the new Goldman Sachs forecast again is a sign of the bullish mood that is momentarily predominating the oil markets. It also raises a chicken or egg questions: is the news picked up because of the bullish mood or is the mood bullish because of the news?

I really wonder why a reputed institute such as Goldman Sachs involves itself in the forecasting business (although that reputation is now somewhat less shining than a year ago). The longer that I follow the energy market, the more I get convinced that it is utterly impossible to tell anything about its future. The more I learn about the multitude of factors that influence it. How every time that you think that you understand some causality, a new causality pops up behind it. You find correlations in interpreting energy markets. But then these factors that the market is correlated to turn out to have a high degree of unpredictability of their own. If you simply look at the current market situation. Whether the price will continue to grow or not, will largely depend on the kind of economic recovery (or backlash?) that we will get in the next months. Who can tell for certain how firm the apparent start of a recovery is? Who can tell how much that fragile recovery would suffer if rising oil prices (like targetted by Goldman Sachs) would cause a new bout of inflation? I am convinced that many very smart people work at Goldman Sachs. But even with a busload of Einsteins I still consider it impossible to predict market evolutions. In June 2008, Goldman Sachs was talking about 200 dollar oil by the end of the year. They missed that target by 400%, so how much should we confide in them?

The trouble is that people do. The unpredictability of markets is what makes it so difficult to deal with them. It’s like driving a car without knowing whether it will drive 200 or just 50 kilometers per hour when you kick the gas pedal. Human beings try to bring order into the surrounding chaos by looking for causal relationships. And often, this works very well. When I jump off a roof, I can be pretty sure that I will fall down. But in markets, causality is too mishmashed for human brains to understand. Still, we like the thought of some sort of superbrain that is able to see through it all. This is the reason why financial scandals have occurred and will continue to occur. We like to think that someone like Mr. Madoff has discovered how it all works and can use this to beat the market. When somebody fixes prices because Goldman Sachs or some other authoritative voice says that the price will rise to this or that level, it is actually the same psychological process which is at work. There will always be a market for forecasting as there will always be people that believe that by thinking and analyzing deeply enough you can find out where the market is heading for.

This brings us back to the question why Goldman Sachs is doing this. They are known to be a huge investor in commodities in general and oil in particular. They make these investments for speculative purposes only. When the market is rising exponentially, like it did in 2007 – mid 2008, it is accelerated by speculation. It is institutions like Goldman Sachs that pour extra money into the market and this makes the prices rise faster. This makes it very conspicuous that they launch this sort of messages. They must realize that there are many people that tend to believe them, hence to buy to protect themselves against these forecasted higher price levels, hence to push prices higher to the predicted level. Are they trying to force a self-fulfilling prophecy? If this is indeed the case, we could compare their behavior to Opec’s. The oil producers’ cartel also makes a habit of launching forecasts of prices higher than the current level, in the hope that this will force the market to buy up to that price level. And when it has reached that level, they launch a higher level again. We could call this ‘bullying’ the market, forcing a bull trend. Reactions of consumer countries’ authorities make it clear that we consider this bullying to be improper market participant behavior. We can fly to Ryad to discuss that with the Saudi King, like Mr. Obama did, but we cannot stop it. But we can decide what a US-based bank like Goldman Sachs does. In the current climate anyone with some belief in the open market left over should beware af calling for politicians to regulate market practices, but still, I find it very curious that parties with such a big position in the oil market are allowed to make statements that clearly have such a big impact on other market participants.

Proponents of forecasting and speculators will retort that it is impossible to influence the market. They are partly right. It is true that if in the physical world supply is larger than demand, the price will ultimately fall. We saw that in the middle of 2008. But as Kobe has remarked on my entry called ‘The End of a trend’, demand was already higher than supply in the first half of 2008 and still the price was rising. And this was the moment when people like Goldman Sachs were launching so many forecasts that were clearly meant to feed the bull trend. I have been talking to the victims of this. I have been talking to the purchasing managers that decided to fix their 2009 energy prices at that moment. I have assisted companies in trying to find solutions for paying record high energy prices at a moment that the market for their own products is shrinking. I saw the needle and the damage done.

By uttering such ‘targets’, speculators are not only trying to force a bull run. I believe that they are also lying (bull-lying . Because, if they would really know for which price the market is heading, they would have every interest in hiding this information from the market. It would namely be extremely valuable. Giving it away for free in the newspaper would be extremely stupid.

Filed under: Forecasting, The market today

The end of a trend

As oil prices are approaching 70 dollar, it becomes more and more difficult to maintain that energy markets are still in a bear trend. Short term technical charts show a firm bull trend, but what is the broader picture? We are having animated discussions among ourselves here at the E&C office as to what could be the reasons for the current uptrend. Is it just speculation and will we see the downward correction that the International Energy Agency has predicted? Or is something else, something more fundamental going on? Could it be that worldwide energy demand is growing again and that this is the cause of optimism in energy pricing? Has the bearish trend, not only of the oil prices but also of the economy in general ended?

Recent market evolutions have learned us a few lessons:

1. Don’t speculate that it is all just speculation. We have seen in the past years that speculators can indeed push prices. For me, however, it has not been proven that they can push it in a direction that is not supported by fundamentals. When the oil price was rising, demand for oil was higher than supply. Speculators picked up this signal and accelerated the pace at which the price was rising. When the oil price started to fall, this was due to demand erosion. Again, the sell-off by speculators accelerated the market movement. But if today’s price would be rising without any change in the supply – demand dynamics, this would be an uprecedented case of speculators moving the market.

2. We will only know about these supply – demand dynamics in a few months. This brings us to another lesson. Information on fundamentals is too slow to be a reliable energy market indicator. If prices are rising, it is because of what market participants feel now when they are in the market. It is because people keep on buying even at higher prices because they really need the product. It takes a few months before we get reliable data on such real world demand rises. The data collection process is simply too complicated. Therefore, anyone that relies on fundamental analysis, is still focused on demand erosion today and believes the uptrend to be exaggerated. Even the International Energy Agency is claiming this. With prices continuing to rise day after day, this is an increasingly uncomfortable position.

3. The end of a trend is not frontpage news. This makes it so difficult to recognise trend reversals. The moment that all analysts agree that a trend is over and the newspapers start reporting on it, is mostly when prices have already risen (or fallen) substantially again. For industry, grasping that currently the downward trend could be over, is further complicated by the fact that many companies are still going through the deepest point of their own economical crisis.

4. The price is always right. It could very well be that in a few weeks or months time, we will indeed see that the current bull run was false or exaggerated. But today it is there and it tells us a clear story: the risk of derailing energy budgets is higher again than a few weeks ago. And at that moment, the price message was also clear: it was a deep dip and a very good moment to do price fixing. And day after day, it becomes more clear that it was.

Filed under: Energy demand, Forecasting, Market analysis, The market today, Uncategorized

How to recognize a trend reversal

Last week’s upbeat mood in many markets was not sufficient to convince most commentators. This weeks’ Economist for example, referred to the Japanese stock exchanges in the 1990′s, which saw several upticks only to see prices fall even lower afterwards. They also point at the dangers that are still looming ahead of us. With the US consumers facing a massive pile of debt, it looks like they are not going to plunge into the kind of debt-fuelled spending binge that they lived on in the past ten years. With the Americans probably consuming less in the next few years, an important motor for economic growth is missing. Moreover, for many industrial companies, the crisis is still getting worse and worse. As we hear from many of our clients, most factories are still struggling to cut costs at an equally rapid pace as the decline they see in sales volumes. The round of lay-offs is still going on and with so many people losing their jobs, the overall purchasing power is not improving.

On the other side, for the first time in many months we see positive signals. 1: as we have learned from the stress tests for US banks of last week, the risk of banks toppling because of the credit crisis is now much smaller than a few months ago. The fact that many banks report better than expected first quarter results is supporting this image of a recovering bank sector.  2: with much lower raw material prices some manufacturing companies are currently producing at much higher margins than what they saw during the commodity price boom. This might be just temporary, as the prices of their products will also come under pressure as consumer demand falls. But at this moment, many companies are doing much better than they dare admit. 3: many economic indicators such as US purchase managers’ confidence have stopped falling and some are even turning positive. 4: The engines of the boom of the past years, countries like China and India seem to be doing relatively well. China, for example, claims that the production volumes are picking up again, as the excess storage of goods has been emptied.

The big difference with a few months ago is that back then every single indicator was bearish. Today we can hear the first bullish signals. Only time will tell whether these signals really marked the beginning of the turnaround or whether they were premature. What will be the consequences of massive unemployment in the Western economies? What if the credit crisis would flare up again? What if a huge company such a General Motors would really fail? But then again, such things might not happen and we might see next month that things are a bit better again, and the next month again, and again, and again. If that happens, it is highly probable that energy prices will climb along. Therefore, why take the risk? Why gamble that it is all just an uptick and therefore nothing should be done, just wait for prices that will certainly fall again?

Nevertheless, we have witnessed in the past week that many people were ill-advised regarding the risk of not doing anything. Sometimes, I am stupified by the sort of arguments that are put forward (and accepted) to support such advice. We heard from some people last week that were advised not to do anything as the stress tests would certainly show that banks were still in big trouble. One supplier told clients not to do anything before Friday, because on Friday prices always fall (Hello? Where are the statistics that support this? Why did prices rise on this Friday?)

Many people were also confused with data on fundamentals. Yes indeed, demand for energy at this moment is still lower than supply. But the trouble with such reasoning is double. First of all, data on energy demand and supply is hazy. Secondly, the price of energy futures doesn’t wait for demand to rise over supply before it starts rising. This is only true for spot prices. Futures prices are based on expected future evolutions. If they rise today, it is because of the expectation that the economy will (slowly) recover in the next quarters. If you do not lock in some volume on these futures prices today (which are still just a little bit more than half their value of six months ago) you are gambling that these expectations get it wrong and that the spot prices will remain low.

The ambiguity of today’s market situation is once more a strong argument in favor of contracts that allow you to lock in futures prices for parts of your volume. Anyone that says today that he is convinced that the market will either go up or down, is saying that he is capable of grasping the total status of the world’s economy. And that he sees exactly where it is going in the next few months. Nobody can do that. That is why forecasting is always gambling. Don’t gamble, don’t speculate. Fix forward energy prices in tiny portions and you are not commiting to the market going either way, up or down. You protect yourself against another bull run and at the same time, you keep open some volume to grasp the opportunity of another bear crash. This makes it all the more surprising that in countries such as Spain, it remains difficult to convince suppliers that they should offer these type of contracts and hedging services to their clients.

Filed under: Forecasting, Spain, The market today

Feverish headlines

‘Swine flu causes feverish energy markets’, I’ve read as a headline in an energy market report  sent to customers by a Dutch utility on Tuesday. My congratulations, what a beautiful headline. Connecting the ‘flu’ element with ‘feverishness’ in the market, great association! Just one little problem: the facts don’t really fit. Having read the headline, I immediately called our analyst. What was happening? Were we missing something? Because our analysis is that we see a very quiet market these past few days with low volatility. This low volatility in itself is news, after months of extremely high volatility. But, of course, ‘Swine flu causes a decline in feverishness in the energy markets’, that is not such a nice headline, is it? So the energy report sent a message into the world that the market was feverish.

This makes me think about the many times that I have been contacted by clients in panic about something they had just ‘read’ or ‘heard’. The panic that I felt myself when that news is contrary to our assessment of the market. The times I’ve called the analysts to ask them why we missed that news. And the many times that it turns out that the news was in fact something that happened a few days before and was already outdated by newer events. The many times that the news turned out to have been invented of an over-reaction.

Energy markets are like most other global markets, populated by masses that are being motivated by greed and fear, and these emotions make them nervous. Nobody wants to miss that tiny piece of news that can lead to a fantastic deal. In such a ‘feverish’ climate, it is not strange that information gets misrepresented. It teaches us how important it is to treat information (whatever its source) with caution and to verify it and trust the firsthand information, such as the price information itself.

Filed under: Forecasting, Market analysis, the Netherlands