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.

 

  1. 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.

  1. 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.

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