A few years ago, we used to enjoy the delight of being one of the first companies talking about “the next new thing”. E&C started proposing risk management oriented solutions for buying energy to its clients as early as 2006. We would then often hear clients comment: “you are the first consultants that ever talked to us about such an approach”. This obviously was a key factor to our early days’ success. However, the fate of the innovator is that he will be copied. And, as I’ve noticed again, whilst participating in last week’s energy procurement conference in Berlin, a Unipower conference, it is probably very hard these days to find an energy procurement consultant that is not talking about risk management. Still, I did observe that we still have quite a different take on it. In this blog article, I want to give a summary of my speech last Friday in Berlin, and I hope that it will give you some food for thought on the energy price risk management practices in your organization.
What is risk management?
Evident as it might sound, from the different presentations during the conference, it became clear that energy buyers have a variety of answers to this question. To start with, people have a different apprehension of what type of risk the subject “energy” is creating for their organizations. I saw some pretty impressive schemes on risk typologies. Some companies selling products to end consumers, might focus their attention on the risk of being perceived as an unclean company because of the burning of fossil fuel. In large companies, the procurement staff might be facing legitimacy risks if they fail to produce energy contracts that are in line with overall expectations of those contracts’ internal stakeholders. A company that is operating on a global scale might focus on the regulatory risk. As each country has its own set of regulations, regional differences can produce risk of delocalization.
As energy procurement consultants we tend to focus on the pure market price risk, the risk created by the volatility of the wholesale energy markets. This is also what I did in the conference and what I will do again in this blog article. This doesn’t mean that we are blind to these other risks, you will find my interest in them expressed in other articles on this blog. I focus on market risk for clarity and shortness’ sake. Regarding other risks of buying energy, and before starting my article, I want to briefly point out the financing risk that is now created by energy procurement. Energy suppliers are increasingly acting as a financial services company for their clients. They procure energy for their clients in the wholesale market. They hedge this energy and they take the financial derivatives for these hedges (futures, forwards, swaps, options) in their own books. They pay the margin calls when these instruments move out-of-the-market. They often pre-finance non-commodity components of the bills: grid fees and taxes. And they deliver all this financial service in the knowledge that in case of a client going broke, they will end up with – best case – three months of unpaid bills. You have to consider that the energy business is one of the few where the supplier cannot shut down the supply in case of non-payment. It is no coincidence that energy companies implement ever more strict credit policies. Most consumers have contracts that stipulate that their energy suppliers are entitled to demand pre-payments, shorten payment terms or demand a three-month bank guarantee if their credit situation worsens. This means that a company in financial distress is now under the added risk of seeing its cash flow position further affected by an energy company exercising this right to cover its payment risk.
However, as I said, I will focus on the market price risk of buying energy. As energy prices have seen 200% volatilities in the past five years, it has become clear that buying energy at the wrong moment can severely impact the financial solidity of a company. Hence the importance of adopting solid risk management practices. But then, even the presentations during the conference made clear that different companies and/or consultants have different views on what risk management means. I know it’s not the most sympathetic way of doing it, but still, I want to start with a negative definition, making clear what, according to me, risk management is not:
- Risk management does not equal market analysis. Obviously, if you are not aware what the markets you buy energy in are doing, you are running a serious risk. But contrary to what many companies think, just knowing what the market is doing is not enough to manage your energy market price risk. I am always surprised when presentations on risk management are for the largest part made up of slides with market information.
- Which brings me to my favorite topic of risk management vs. forecasting. Some companies and consultants take their market analysis a step further and pretend that they can figure out what prices will be in the future. This knowledge is supposed to protect you. However, this is false protection as even the most fanatic energy market forecaster will at the end of his presentation always show a fat disclaimer saying that you shouldn’t believe anything of what he just said.
- Risk management is not about managing your contract. We still get that question regularly: “we have just signed a multi-click or tranche model contract, can you help us with doing the risk management for this contract”. That’s not the right way, it is the other way around. The contracts you sign are the tools to execute your risk management.
- Risk management is not just about applying hedging techniques. Caps, floors, collars, straddles, etc., they sound very impressive. But just applying them is not managing your risk. Like contracts, hedging techniques are tools to execute the risk management, nothing more.
- Which brings us to an aspect that is often over-looked. Risk management does not equal trading. On the contrary, one of the main things you need to do if you want to avoid the risk of an energy trading catastrophe is separating your risk management from your trading. Edouard Chevalier, the speaker of GdF-Suez during the conference used an interesting image in that perspective. He described the GdF-Suez trading floor, explaining about the traders in the middle and the risk management people by the side. Do you remember Nick Leeson? The rogue trader that brought down British reputed financial institution Barings Bank by making wrong bets on the Tokyo stock exchange? One of the reasons that this could happen was the fact that Leeson was both trader and risk manager. If I look at many of the portfolio management solutions that are currently presented to buyers of energy, they suffer from precisely this problem. The portfolio manager is trading and gets paid based on the performance of his trading. And he is also handling the valves of the risk management … As companies take their energy buying to a next level of sophistication by not only buying tranches or clicks but also selling them, and as they often outsource this, we might be waiting for a few disasters.
Looking for a positive definition, this is what I found on the internet:
Risk management is the identification, assessment, and prioritization of risks followed by the coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.
Hubbard, Douglas in The Failure of Risk Management: Why It’s Broken and How to Fix It (2009)
I was intrigued by the title and date of publication of the book (which, I have to admit, I haven’t read (yet?)). Back in 2009, right after the debacle of Lehman Brothers, people in the financial sector must have suffered a huge hangover of the risk management party that they had engaged in during the previous decades. They had spent fortunes in developing software systems, building up data center capacity, hiring “quants”, prodigies in mathematics with impressive academic credentials (Chicago!) that helped them to implement the sophisticated statistics necessary for risk management of diversified asset portfolios. Now, despite all these billions of dollars and euros spent, their industry had just suffered the worst systemic crisis in almost a century. And not a million Monte Carlo simulations had helped them avoiding that. (We cannot help but remark the irony of having banks refer to one of the world’s most famous casinos when they describe their risk management methodology.)
Mister Hubbard’s definition makes clear why it will always continue to go seriously wrong from time to time in financial markets. Even in 2009, he could not avoid using the maximization of opportunities in a definition of risk management. Risk management is involved in everything we do in life. When we cross a street, we balance the risk of getting run over by a car with the opportunity of getting to the other side without losing too much time. When we marry, we balance the opportunity of building a happy family with the risk of our partner running of, etc. The overly prudent end up poor and unhappy as their risk-aversion keeps them from realizing opportunities. The overly audacious end up poor and unhappy because they hunt an opportunity that ends up in a nightmare. Success in life depends on our capacity to balance risk and opportunity. Just read one of Warren Buffet’s books and you will notice.
People hate unpredictability. When we step on board of an airplane, we like to have the certainty that there is a 99,99999…% chance that we will actually get to our destination. Human life is supported by an impressive technological system that is completely based on the prevalence of predictability. Science is all about reading future outcomes in present datasets. Therefore, when we enter into markets, we try to find the same degree of reassuring predictability. However, markets are completely unpredictable. Just think about what happened in April 2011. Energy markets were quiet. And then we saw a sequence of events: an earthquake in Japan, a Tsunami striking the Japanese coast, an election in Baden-Württemberg won by the Green Party and a German chancellor shutting down eight nuclear power plants over the weekend in a knee-jerk reaction. Markets for electricity and gas in North-Western Europe were up 20% in less than a week. Anyone that says that he can forecast the energy markets is somebody pretending that he can forecast natural disasters, election results and reactions of politicians …
For E&C, a risk managers’ approach to buying energy is all about radically accepting this unpredictability of the market. When people take a price fixing decision, they want to be reassured that prices will (continue to) go up the next day. Well, nobody can say that for sure, not even the most sophisticated market guru. When you take your decision to fix (or unfix) your price, you know only one thing for sure. The chances that the price will go down the next day are equal to the chances that it will go up. If you adopt this 50/50 approach to your energy buying decisions, you will start adopting the necessary degree of prudence to avoid that you take too much risk. Grasping the opportunities is about carefully observing the markets to find the opportunity moments (now, in the present). Risk management is about determining how much you buy in one moment to avoid the risk of potential future market movements.
Energy market price risk assessment
During the conference, there were some animated discussions among the participant end consumers. The companies that presented their approach to risk management all made the case for buying energy in the spot markets. Other participants thought that this was too risky. This made clear that energy market price risk is not the same for every company. Each company has its own specific risk exposure, meaning that each of them will apply their own specific approach to managing that risk. Comparing approaches is pointless, as what is good for company A isn’t necessarily right for company B. Yes, it is true, as some of the speakers have argued, that in the past five years, the spot markets traded some 5% below the average forward market prices. The “Forward premium”, the premium for buying energy upfront, is not just a theory but in the past five years also an empirical fact. However, for a company that aims at stabilizing its energy budgets, buying all your energy in the spot markets isn’t a good choice of strategy.
Five years ago, E&C designed a very basis categorization scheme for energy market risk exposure. On the one hand, we have the budget risk clients. These are for example companies that have to put products in the market in a very stable pricing environment. Think about the automotive industry. Or companies producing premium price consumer goods. Or many pharmaceutical companies. They don’t want to see a sudden increase in energy budget as such budget increases eat directly into the profitability of the company. With such companies we design energy buying strategies that aim at stabilizing the energy budget. We apply strict stop loss limits that we watch very closely. When opportunity moments occur, we click prices for several years into the future. Even if there are such phenomenons as backwardation and contango, still we see that at any given moment, the prices for the next calendar products are always close to each other. By fixing the price at the same moment over several of these calendar products, you get a stabilization effect. Ideally with such clients, you can just move from dip to dip and end up having a stable budget below market average. However, this is only possible if you have a market without strong bull runs that oblige you to make stop loss price fixings to avoid budget derailing.
On the other side of the spectrum, we have the category of market risk clients. Such clients put products in markets with strong price competition. Cost decreases because of lower energy costs will immediately be used by some of their competitors to lower the product prices. Although this is often the subject of tough negotiations, such clients manage to raise their prices to a certain extent when energy prices increase. The worst thing that can happen to such a company in the energy market is having bought too much at the peak of the market. In that case, they will see their competitors lower the prices of their products as the energy markets fall. In the case of energy intensive businesses, they will eventually observe that their competitors sell their products at prices below the cost that they have for producing the product. The main pre-occupation of market risk clients is that they don’t pay too high above the prices of their competitors. Of course, there is no information available on what competitors pay. However, if you consider that in the end all the energy is bought according to the same benchmark, namely the underlying power or gas market, the wholesale prices can be considered as the best proxy of what your competitors actually pay. We will therefore click on a very regular basis on this wholesale value to make sure that prices don’t deviate too much from the average value. Of course, the question pops up: which average? In a very commoditized business (I’m talking about the markets the clients sell their products in again), this could be the spot price. In businesses with yearly contracts (e.g. the food industry), this could be the average year ahead price. Through skilful price fixing and unfixing we will then try to manoeuvre the price below market average.
There is a last category of clients that we call – and I know that the choice of word isn’t very sympathetic – the survival risk clients. These are companies that have to operate in markets with over-supply. In such markets, there are always competitors ready to sell products below marginal production costs to protect or gain market share. This means that in case of falling energy markets, such companies immediately feel the pressure of competitors lowering their product prices. On the other hand, when energy markets rise, it is impossible to negotiate a price increase with clients. This is obviously a very tough condition to buy energy in. Basically, we advise such clients to buy their energy very much the same way as market risk clients do. Don’t be the unfortunate company that has to shut down because you gambled and ended up buying too much energy at the wrong moment. We also add to this the advise to ‘lock in a margin if possible’. If prices have reached a level where you are saying, “we can make profits with such low energy prices”, than you shouldn’t hesitate and fix.
As you can notice from what we have discussed above, making up a good energy buying strategy not only demands in-depth knowledge of the energy markets. What is mostly needed is a good knowledge of the markets that the client is operating in. This also means that as an energy buyer, you might lack the information for making up the strategy. You have to imply other people in this strategy assessment, your top management to start with, as they are the ones that bring the information regarding procurement and sales together. Depending on how energy intensive your company is, this can be the CEO and/or CFO. Key stakeholders of the energy budget, such as business unit or production managers can also get involved. It might even be a good idea to talk to the sales and/or business development managers to get a better view on how the markets work. If companies operate in different markets, it might even be necessary to differentiate strategies for different business units. As you can see from the above, the strategy depends heavily on the particularities of a client’s own business. This means that no two clients have the same strategy. When energy buyers explain the strategy that they apply at conferences such as the one I attended in Berlin, they always try to explain why theirs is the best strategy. This provokes protest from the buyers in the audience that come up with comments why theirs is better. This obviously doesn’t make much sense. The question is not “who has the best energy buying strategy?” (probably meaning: leading to the lowest price). In the framework of risk management, the question is: “who has the energy buying strategy that is best fitted to mitigate their specific risk exposure in the energy markets?” Each company has its own best strategy.
Implementing your energy buying risk management strategy
Do you remember the strategy – tactics – operations sequence from (business) school? For the successful implementation of an energy buying strategy, this is quite crucial. Once you have your strategy set out and the strategy note written, it is important that you implement the right operational practices to get the desired results. In your day-to-day operations, you can also use a few tactical principles to increase the success of your price-fixing decisions. The most important tactical principle, which we have applied with great success in many cases is: “let the profits run”. Don’t fix a price in a falling market, don’t unfix in a rising market. Wait for the turning point of a downtrend before you start fixing. If you apply this, it is of course not always possible to distinguish between a turning point and a short-lived uptick. Therefore, we recommend again to adopt a risk management approach to this decision. If you want to fix 25%, fix 12,5% the first day that it turns around and 12,5% if it continues to rise the next day.
In terms of operations, it is obviously extremely important that you adequately monitor your portfolio position. Especially in large organizations with many sites, just keeping track of your different contracts for your different sites might already be a huge challenge. On top of that, you need to keep track of all your price fixings. To take good price fixing decisions, you need to know your portfolio values: “what will I pay next year, if I fix everything now, taking into account what I have fixed already and what the market price is now?” Your management will probably also be interested in mark-to-market values: “what would we pay, if we hadn’t fixed anything yet?” You will be asked to keep track of your clicking performance: how are you performing against the market (average)? If you have minimum and maximum percentages to be fixed by certain dates, you will have to make sure that you know how much you have fixed at any point. If you have stop loss limits to watch, you need to monitor them, and you will have to roll out some sort of value-at-risk calculations to make sure that you make (partial) fixings in time to avoid going over your stop loss level. If you are having one production plant, with one simple four-clicks on the Calendar products contract, this might still be relatively easy. But what if you have to monitor 30 sites with 6 contracts and fixings on Cals, Q’s, M’s, volumes left open for the spot market, etc? How will you keep track of your unfixing decisions if you take them? How do you keep track of future volume changes? Of course, your energy supplier can help you with portfolio monitoring. However, you have to be careful that depending on your supplier for your monitoring needs is not necessarily good for your position in contract negotiations. As an energy procurement consultant, we have invested a lot in setting up portfolio monitoring tools, because we see that many organizations struggle with this. You wouldn’t be the first company that loses an opportunity or is confronted with a surprise budget increase because you didn’t have a timely and correct view on your portfolio positions.
Once you have your monitoring under control, you need an important instrument to execute the strategy: the right energy contracts. At this moment, we see the current approaches to energy price fixing:
- Many clients still go for the fix price contracts, fixing the price for a few years into the future. Need I say that these are mostly budget risk clients. There are also some regional differences. German clients, for example, are always very tempted by proposals to just fix the price. Fixing the price for a few years obviously gives you budget stability for the period during which you fixed the price. But this also gives you a false sense of security. Many companies with fix price contracts are surprised by big budget shocks as they go from one contract to the next one. Making clicking contracts for the next three years and than fix the price for parts of the volume for each of these years at the same time, builds a much more sustainable long-term budget stability. On top of this, from a risk management perspective, the fix price contract is always the worst choice possible. It’s the win all – lose all solution. If you are lucky to have fixed at the lowest point, you will be wearing a very big smile for the duration of your contract. And in the past years, we have met with some smiling people that managed to move from dip to dip with three year contracts. But we also met with some very sad people who ran out of luck and had to fix at the worst moment possible.
- That is why most clients these days have multi-click contracts. The chances are big that as you read this, this is exactly the contract that you have. You try to avoid risks by fixing in a few moments. If you are budget-risk oriented, you will fix large tranches for many years into the future. If you are market-risk oriented, you will have adopted a more prudent approach and fix smaller tranches, not too many years ahead and with smaller intervals between two fixing moments. If you are unhappy with the outcome of your price clicks, don’t blame this on the multi-click contract. Ask yourself questions like these:
- Are you aware that zero risk / 100% opportunity is impossible in markets (as in life in general)? Are you not expecting too much (of your energy buyer)? Are you willing to sacrifice the possibility that you will fix everything at the lowest point possible by spreading your fixing decisions?
- Are you sure that your approach to the price fixing fits with the risk exposure that you have in the energy markets? Are you applying strict stop loss limits while you are a market risk client? Are you too prudent in fixing and does this make you loose chances of building more stable energy budgets, as you are a budget risk client?
- Have you lost opportunities because your monitoring of your portfolio failed? Did you lose track of your positions?
- Have you exercised strategic discipline? Or did you give in to the colleague (higher in the ranks of your company) that forced you to fix everything because he believed a bullish forecast? I’ll come back on this topic of strategic discipline in the conclusions of this article.
- Sooner or later, market risk oriented clients find out that if you make a lot of price clicks, it becomes very challenging to “beat the average”. The gains in terms of difference to market average are often not in line with the efforts of doing all these clicks, again and again. Therefore, we see more and more of these market risk clients choosing averaging contracts, which can be contracts indexed to the spot market or the average year ahead, or quarter ahead price. Obviously, if you are indeed subject to market risk, this is an excellent choice of contract. However, you need to be aware that you are subject to the systemic risk of choosing the wrong average. What if you are on the average spot price and all your competitors are on the average year ahead price? Moreover, you will find out that sooner or later, the feeling of loss of opportunity will pop up. Just imagine that the markets (and your average price) are running up after a moment of very low prices (think about the first months of 2009). Are you sure that nobody will say: “why didn’t we fix more in those good moments?”
- A growing number of clients start to develop something close to full trading activities. Trading means that you will not only close positions but that you will also give yourself the chance of opening the positions in a falling market. By fixing and unfixing your prices, you reduce the market price risk, that is for sure. However, you get a lot of system risk in return. I’ve already said above that you need even better monitoring capacities to make sure you don’t loose track of what your portfolio position is. And are you sure that you completely understand how it works? Many clients are therefore hesitant to develop the in-house capabilities for managing such trading contracts. They prefer to hire a portfolio manager. However, we often see that these are proposing black box solutions. You get no insight into the details of the strategy that is being followed (this is supposed to be top secret, it’s the million dollar, always market-beating wizardry). Sometimes, you don’t even get a clear view on what the current position is. If a risk management policy is applied, this is being monitored by the portfolio manager himself, not by somebody else (your portfolio manager is in Nick Leeson’s place). We have seen examples of clients ending up paying performance fees based on fake savings (the reference for calculating the saving was adapted by the portfolio manager according to need). Often, the decision to hire a portfolio manager is based on greed rather than strategic consistency. Somebody in the organization believed that the “proven track record” graphs shown by the salesman of the portfolio management company was based on facts and that it is (was) a guarantee for future success. In the Netherlands, every commercial mentioning past performance of an investment vehicle is obliged to end with the very wise words: “Be careful, performance of the past is not a guarantee for the future”.
It is important that you are aware of where your organization is, to choose the right contract type. For example, don’t choose a market average only because somebody messed up the fixing decisions due to a lack of strategic discipline. Don’t move to full scale trading if you haven’t mastered working with a clicking contract yet, as it adds complexity for which you might not be ready yet.
Which brings us to the subject of people management. Organizations that choose one person to take all the price fixing decisions are running the risk that this person messes up. You need some other people involved to check this. On the other hand, if too many people are involved, you run the risk of ending up in decision paralysis. Seven years ago, a client of ours had created a “steering committee” that was to decide on every fixing. Every time that there was a moment in the market, we were called in front of that committee and we had to bring a presentation on the markets. In the following hour, these people would start a massive discussion on the state of the world economy and the impact they thought this would have on the energy markets. At one moment, one of the people in the committee took a firm position and pushed through the decision to make a large electricity price fixing. And then came the crash of electricity prices in the spring of 2006 … In the next steering committee meetings, the person that had pushed the fixing decision was again and again blamed for his wrong view on the market. This created a very tense situation in which everyone was extremely reluctant to decide on a price fixing. As a consultant, I found myself in a very difficult position. As long as I was giving arguments why this might be good moment for fixing the price, everybody was “watching the tips of his shoes” and avoiding the sort of eye contact that obliges you to take a position. When I uttered just a hint of an argument why it could be good to wait a bit longer, a massive sigh of relief was heard around the table and a decision was taken … to fix a date for the next meeting. This is just one of those client experiences that taught us how to approach price fixing decisions in companies. And one thing is clear: joint-decision making doesn’t work for decisions in unpredictable markets. You need to designate one person that makes the calls, at most you can have him sparring with one superior, but don’t get more people involved. Get as many people involved as possible in setting up the strategy. But then these people need to trust (and monitor) that the person that makes the fixing calls will realize the strategic targets by applying the targets correctly.
Applying risk management doesn’t mean that you will try to get the best possible price out of the market. Many energy procurement consultants have sold “savings” for such a long time to their clients that they now try to sell risk management as something that makes you save money, something that helps you winning money by getting a better price. Well, risk management is not at all about saving or wining money, it is all about avoiding that you loose money. Sounds similar, but if you think well about it, it is not exactly the same. Just think about the difference between entering the casino with the aim to win money and entering the casino with the aim not to lose money. When markets were liberalized, industrial consumers entered them with the conviction that they would win money, that they would make big cost reductions. I think we now have experience enough to acknowledge that our first concern should be not to lose too much money. The first target of any energy buyer should be: “make sure that you don’t jeopardize the financial security of your company by fixing too much energy at the wrong moment”. By applying a strategic approach to managing energy market price risk, companies can successfully mitigate the risk of volatile energy markets to their businesses. However volatile the markets are, by applying what I described in this article, companies get budgets that they can live with. They are managing their budgets instead of being thrown about by the market movements. I am happy when a client never has to say again: “now I can only hope that the market will move up”, or “now I can only hope that the market will move down”. A risk manager’s approach to buying energy is all about excluding hope and managing your budgets instead. And if you manage your budgets successfully, you will also start making better use of the opportunity moments.
Successfully implementing a risk management strategy when buying energy isn’t a very easy task. Here are some of the main obstacles that I have observed over the years of advising clients on it:
- Many clients find it very hard to accept the idea that forecasting the market is impossible. Somebody in the organization gets convinced that this is a super price level and that it can’t get any better than that and forces a decision to fix too much too soon, for example. The belief in a forecast makes you put aside the strategy, you no longer care about risk management. That is logic. Forecasting and risk management exclude each other. What risk is there to manage if you no where the price is heading? The funny thing is, the closer you are to the markets, the more easily it is to get convinced of its unpredictability. Often, it is people that only occasionally look at the energy markets that have the strongest convictions that they know where it is moving. The deeper you get involved in the energy market, the more proof you get of its unpredictability.
- Setting up an energy buying strategy and an implementation structure, is obviously all about taking the subjective element out of energy fixing decisions. You no longer decide to buy because somebody in the organization is convinced that the price will go up. You do it because it helps you to reduce your budget for 2014 compared to 2013 (budget risk client). Or because you haven’t made any fixings since two months (market risk or survival risk client). Sometimes, clients want to take this a step further and want to implement a full-blown mathematical decision-taking model. We seriously advise them not to do it. There is no model that consistently beats the market. So if you want to go for automated decisions, than it’s better to go for an average price contract. When we back-test mathematical models (I love doing that) we can always conclude: it works well in these market conditions, it fails in these. Often, the volatility of the market is the main factor that makes a model fail or not. But a mathematical buying model is in our opinion very similar to forecasting. You presume that certain market conditions will occur in the future. Determining a good energy buying strategy is about implementing just enough objective decision criteria to make sure that your subjectivity never makes you take too much risk. It’s building in the safety belts, the airbags, the ABS, the automatic breaking systems. But it’s not about putting a robot at the steering wheel. Somebody needs to continue to take the decisions: “I buy now, I don’t buy”. The objective element will keep his decisions inside the limits of the energy buying strategy so that no totally unwanted results pop up.
- When designing strategies, some clients tend to lose themselves in unnecessary details. I am a great adept of the KISS-principle in this perspective: keep it short and simple (which is not stupid, like some people add). Large organizations, especially public authorities, are often surprised by the shortness of our strategy notes. They want more text to document why they are making such strategic choices. I always ask them the following question. “It is 16:45 on a Friday afternoon, the energy exchange has just published it’s closing value and it’s up after several days of falling. You have to communicate your price fixing decision to your supplier before 17:15. What do you prefer? Having to browse through a ten-page strategy note? Or through a two-pager?” If you want more explanation, fine, make a separate explanatory note. But keep your strategy note short. I also see some companies applying very advanced stuff (collars with options, e.g., or price optimizations in within-day markets) while they are not controlling the basic stuff, such as setting stop loss limits. Look for the simplest road to realizing your strategic, risk-mitigating targets. The more complicated your strategy, the bigger the risk that you will fail to implement it.
- Something which I have observed again and again in discussions with potential clients. We discuss our approach to managing energy price risk. The client gets interested. We want to get down to the facts: how are they buying energy now? And then the client spends the next half hour trying to find out what he has clicked at which moment. Like I have argued above, getting your data management under control is key to a successful implementation of your risk management strategy.
- You have made your strategy assessment. Before, you were fixing prices every year for the next year. It went well for a few years but then disaster struck, you had to buy at the peak of the market and the market dropped right after your buying decision. The alarm calls of your sales people and the negative result at the end of the year have learned you that you are subject to market risk. You decide to buy on the average spot price and then the spot markets start to rise. People in the organization start to ask questions: “OK, we had a bad experience, but wasn’t it better in the old days when we fixed the prices? At least we knew what we were paying, even if it was too much”. Are you sure that your organization has the discipline to stick with its strategy? So many times people tell us: “we are running behind on our strategy”. What is that supposed to mean? That you are taking risks that you previously agreed on that you wouldn’t take? Or another example of a lack of strategic discipline. There is an opportunity moment in the market. You have a contract ready to be signed so that you can make the clicks that your strategy is telling you that you should take. But at a reception, the sales manager of an energy supplier told your vice-president procurement that in a few months time, they will have a new contract proposal that will be super for your organization. The decision to sign the contract gets postponed, the opportunity moment gets lost and you run behind on strategy as your prices start to rise above the stop loss levels.
- The main reason why clients fail to implement their strategy is that they don’t get their contracts signed in time. In some cases this can be due to market circumstances. The government is redesigning the system for calculating green energy add-ons and suppliers are unwilling to sign long term contracts, for example. In these shaky economic times, volume uncertainty is also making it difficult for some companies to get the contracts in place in time. Everything is ready to be signed, but production managers fail to commit to contractual volumes.
- The uncertain economy can also make it difficult to find suppliers willing to offer price fixing services on a long term. Large consumers are now getting more and more difficulties in this perspective. When they want to fix prices for the Cal+2 or Cal+3, the suppliers ask for bank guarantees, which is quite logic, as they will have to pay the margin calls if the mark-to-markets on those far-in-the-future price fixings move into negative territory.
Applying a risk manager’s approach to buying energy can help you in getting control over your energy budget. I hope you have understood from this lengthy blog article that it’s all about applying simple logic. However, implementing it you will run into many difficulties. But I have a busload full of success stories to show you that it can work.