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

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

The forces of speculation

This week’s Economist states that not having enough derivatives in the world’s financial and commodity markets might be worse than having too much of them. It is true that the current economic crisis started with excess quantities of financial derivatives in the mortgage markets. It is true that this caused market participants to believe that any amount of risk could be hedged away. This inspired the greed that bred the disaster. This makes it easy for the public to come to the conclusion that the crisis was caused by ‘speculators’. Moreover, ‘speculators’ are, like ‘big corporations’, an easy scapegoat, as they are not very popular with the larger public anyway. But we shouldn’t forget that the credit crisis was caused by fundamentals. If Americans hadn’t been so desperately over-borrowed and if they had continued to pay off their mortgages, the crisis wouldn’t have happened, regardless of the amount of CDO’s or CDS’s that were circulating. The derivatives magnified the effects of the credit crisis and leveraged a local mortgage problem into a worldwide crisis. But they didn’t cause the crisis.

People that blame speculators for all that went wrong, seem to forget that they have been a huge victim of the credit crisis also. Their speculations in the commodity markets were aimed at prices going higher. With the credit crisis came a huge bearish market correction and most speculators lost a lot of money in it. This has stifled their appetite for risk. The result is that the risk premiums included in prices for derivatives have risen. Counterparty risk has also become an issue, now that it has become clear that even a large bank like Lehman Brothers can fail. Airline companies and industrial companies are confronted with refusals based on counter party risk to enter into fuel or currency derivatives. And those companies are not buying those derivatives because they want to speculate, they need them to hedge the business risk that they have to deal with.

We observed the effects of speculators withdrawing from the markets in electricity and natural gas markets also. To swap an oil-indexed gas price into a fixed price, constructions with oil forwards are necessary. We have observed that risk premiums in those fixed prices have risen. Moreover, we see that energy suppliers are more and more reluctant to take volume off-take risks when entering into such fixed price deals. Especially suppliers that use banks to make the swaps for them seem to be affected.

Speculation and hedging, they are two sides of the same story. Speculators provide the liquidity that is necessary to make markets with derivatives function. And if you want to hedge, you need such liquid derivatives markets. It is true that speculators turbo-power these markets. When prices rise, they rise more quickly as all the speculators jump on board. But as we have seen very clearly in the past ten months, the opposite is also true. When the market goes down , it goes down deeper as all the speculators sell off their positions. Speculators also curb the power of dominant market players. It becomes more difficult for e.g. dominant power producers to influence the wholesale power prices. So, we should be very careful with chasing those speculators away from the markets. Without them, hedging business risk will become a lot more difficult and expensive.

Filed under: Risk management, The market today

To hedge or not to hedge, that is the question

It is a word that we use daily in our profession, ‘hedging’. Therefore it is strange that many people seem to lack understanding of what it means. Often people confuse hedging with speculative behavior. I believe this is due to the association with the word ‘hedge fund’, that part of the financial industry which is considered by many to be extremely speculative. Hedging itself is considered to be an activity where profit maximization goes hand in hand with taking huge risks. Hedging to me has everything to do with the expression ‘hedge your bets’. Take positions so that whatever direction the market takes, you never lose everything. The counterside to hedging is that it also means that you foresake the chance of maximum succes. As such, hedging is the exact opposite of speculation.

Last Friday, I had an interesting discussion with a client with a US mother company. Like many other American companies, this company also expressed its reluctance to apply hedging. In buying energy, there is a tendency among US companies to opt for spot price contracts instead of fixing prices. Price fixings are considered to be hedges and these are undesirable. This allergy to hedging is probably due to financial regulation which makes publicly traded companies publicize figures on the mark-to-market of their hedges. This means that if such a company has fixed prices, and the price has fallen since, it will have to report a loss on hedging positions in its financial reports. That explains of course why companies are afraid of energy price hedgings. They want to avoid reporting such losses on hedges, fearing the reactions of shareholders.

In a way, a contract where the actual price is the result of averaging spot prices, is a way of hedging in itself. It means that you always pay the average price, never the highest and never the lowest. As such, it might be considered as the only possibility for non-speculative behavior in the energy markets. The trouble with it is the high volatility in spot energy markets (especially electricity). Consumers buying at spot prices will see their budgets rise and fall rapidly. And for many companies, this is incompatible with the desire to have some visibility on energy budgets.  Most industrial companies do not want to end the year with an electricity or natural gas that is twice or even thrice as high as the budget that they had filed at the beginning of that year. And those responsible for buying that energy do not want to explain to their superiors that this derailing of the energy budget is due to the winter weather conditions, or the absence of wind during the fall, or the technical failures in French nuclear facilities, etc. To avoid this budget uncertainty, companies will have to enter into some sort of hedging. The nice thing about European energy markets is that most suppliers offer contract types that allow for price hedging without the difficulties regarding accounting. These could be multi-click contracts or more advanced products with caps, floors or collars. Even the simple fixed price contract is a kind of hedging contract. The nice thing about them, is that the futures, forwards or options that need to be obtained to deliver on them, go into the books of the supplier and not into the books of the client. As such the client can avoid the mark-to-market issues that public US companies fear.

This brings me to my discussion on Thursday with a German client. Like many in his country, he has no experience yet with multi-click contracts. So far he has entered into fix price contracts for longer periods. As the market in the past years was mostly bullish, they didn’t do to bad with this, seeing that the prices that they had fixed were mostly lower than the current prices (or had a positive mark-to-market).  Nevertheless, there are some serious downsides to this approach. First of all, with such an approach you will see serious jumps in the budget of one year compared to the previous year. Secondly, sooner or later they will end up on the wrong side of the market, having been obliged to fix at a high rate and see prices fall afterwards. This could be because they have waited too long in a bullish market. Another pitfall has been witnessed by many in June 2008, at the highest point of the energy prices bull rally. Having waited for a long period before fixing anything, there is a large risk for panic at such record levels.  The multi-click contract is a perfect remedy for this. By fixing prices for parts of the yearly volume, one avoids having fixed too much at the wrong moment. By fixing prices for several years into the future at the same moment, the budget swings from year to year can be moderated.

This is probably the reason why this contract type is so popular among industrial consumers in many countries. I have seen many people that were extremely happy with having fixed the price of a large volume in one moment (through a fix price contract). They had fixed at low levels and were happy to have seen prices rise afterwards. If they were intelligent, they realized that luck was a larger contributing factor in such successes than skill. And this is proven by the fact that I have also seen people extremely dissatisfied with large volume price fixings, up to the point of getting fired for fixing at the wrong moment. By entering into a multi-click contract and then applying an intelligent spread strategy, one can avoid these emotional extremes. Therefore, I have rarily seen anyone dissatisfied with this approach.

Filed under: Risk management