Dealing with unpredictability in energy trading

When buying energy, you inevitably have to take energy trading decisions. In deregulated electricity and natural gas markets, the commodity value of the energy is linked to the underlying wholesale markets. On these over-the-counter (OTC) and exchange traded markets, the price of energy moves up and down. Buying energy means taking decisions on whether to fix the price or not and if you fix, whether to do it today or tomorrow. In volatile markets, these decisions can cause large variations in your energy costs.

Most buyers of large volumes of energy have clearly understood that the timing of your price fixings is the most important factor determining how much you will pay. They have put in place contracts with suppliers that offer them flexibility for the fixing of the wholesale value, contracts that allow you to fix in different moments on the different forward products and/or leave volumes open for spot indexation.

In most mature deregulated energy markets, the users are well accustomed to working with such products. But in countries where the deregulation is more recent, we still find that many industrial consumers have resistance towards this energy trading activity. They call it “speculative”, confusing trading with speculation. Energy trading is an inevitable component of buying energy in a deregulated market. You have to take decisions on whether you fix your prices or not in a market that moves up and down. That’s trading, whether you like it or not.

As trading is not a natural environment for industrials, we see many of them struggling to find the right approach to it. This struggle has a lot to do with people’s attitude to unpredictability.  Energy markets are unpredictable. 95% of the energy buyers that we talk with acknowledge that.

5% of the buyers: you can predict energy prices

5% don’t. They think that you can ‘crack the code’, that there are mathematical laws determining the movements of energy markets. That you can unveil these laws and use that mathematical information to take decisions on whether to fix or not.

The popular argument for debunking that illusion of predictability is simple. If you would have cracked the code for predicting energy prices, why would you be an energy buyer? You would much better become a real trader, buy and sell speculative volumes and earn yourself a villa in the Bahamas. And any consultant or portfolio manager that has a forecasting that actually works would be very stupid if he or she sells it to an industrial client for a few thousand euros or dollars.

Energy markets are unpredictable. The supply and demand equation is extremely complex. The number of variables is very high and the interactions between them are not simple causal relationships. Most forecasting models are based on mathematic wizardry that unveils correlations. However, analysis shows that these correlations change over time, so a current correlation cannot be used to predict the future. Moreover, even if a correlation would be constant, e.g. between the price of electricity and natural gas, this knowledge doesn’t help you very much. It just tells you that one unknown factor (the future electricity price) is correlated to another unknown factor (the future gas price).

On top of this, energy markets can be shaken by unexpected events. Some of those noticed in the recent past: the shutdown of nuclear power stations in France due to security issues, the impact on worldwide energy markets of the Fukushima nuclear disaster or the shale gas revolution in the US. Anyone claiming that she/he can predict energy markets, is claiming that she/he can predict such events.

Best case, forecasts are right 50% of the time. Therefore, they are not a solid basis for taking your energy trading decisions. And if your energy buyer believes in forecasting, she or he is a danger to the financial health of your company. One day, she or he will take a decision based on a wrong forecast that makes your company buy energy on the wrong side of the market.

10% of the buyers: you can’t predict energy prices, so you shouldn’t trade energy

10% of the energy consumers accept the full consequences of this unpredictability. They choose to delete deliberate trading decisions from their energy procurement practices. They link their energy prices to the spot price, to an average forward price or buy at randomly chosen moments to produce an average price. We have a client, for example, that fixes the price for 1/24^th of the expected consumption in each of the next twelve months on every 10^th and every 21^st of the month.

You will find this hands-off approach most often with very large consumers. If you are consuming Terrawatthours of electricity and/or gas, every decision to fix or not is a matter of millions of dollars or euros. Many companies decide that the energy buyer is not the appropriate person to do that. So they either set up a real trading desk, or they go for automated buying. We also observe that hands-off is much more popular among US companies.

E&C supports clients that want to set up a system for price averaging or automated buying decisions. The main challenge for them is to find an average that is in line with their risk exposure. Are they a budget risk customer that is mainly affected by large year-on-year cost increases? Then they should set up a system of automated buying for three or even more years in the future. Are they a company that can see its competitiveness affected by having a higher energy cost than competitors? Then they should find out how rapidly the prices of their products adapt to energy price changes and set up automated buying in line with it.

Nevertheless, giving up the taking of deliberate decisions to fix or not, is a bit of a pity. The large majority of E&C’s customers have a hands-on approach in which they take decisions based on energy risk management instead of forecasting. We see a lot of business value in that approach.

10% of the buyers: you can’t predict energy prices, but you can create business value by actively managing your prices

Active energy price management means that you adopt the following approach:

1. You analyze the impact of energy market volatility on your business and implement a strategy that mitigates the risks. This strategy will not determine when you buy, but it will determine how much you buy how far into the future. If your main risk is a large increase of energy costs (i.e. budget risk), you buy larger volumes for many years into the future. If your main risk is a loss of competitiveness by having fixed at a higher level than the market (i.e. market risk), you buy very regularly and buy only small extra portions in opportunity moments. How far you buy in the future is determined by the pace at which prices for your products adapt to changes in energy costs. This approach can be further finetuned with budget-at-risk calculations and price fixing tables with minimum and maximum levels up to which you should / can fix before certain dates.

2. To determine when you buy, you follow the markets. This market analysis is not aimed at forecasting. You don’t look at fundamental and technical information to try and forecast what the price will do in the future, you are only interested in what it is doing now. When the markets are falling, you don’t do anything. You only buy when the market has turned around after a period of falling prices. We call this “buying the dips”.

3. But of course, markets don’t fall and rise in straight lines, they go down a few days, have a little uptick, than fall again, rise again, etc. This means you are constantly confronted with a dilemma: is this the definitive turnaround of the market or just a temporary uptick? Most buyers are solving this dilemma with forecasting. They look for information that predicts whether the market will continue to rise or whether it will fall again. Sometimes (best case: 50% of the time), they will get it right. But in all other cases, they will either buy too much on a temporary uptick or miss the definitive turnaround.

An energy risk management approach to buying energy means a totally different approach to the uptick versus turnaround dilemma. When making a price fixing decision, you should adopt a 50/50 approach. The chances that markets fall again the next day are exactly as high as the chances that they will continue to increase. This will inspire you to fix prices prudently, step by step. Let’s say that your energy risk management policy allows you to fix up to 50% of an annual volume in a certain moment. You could carve this up in four 12,5% tranches. When the market turns around, you fix a first 12,5% tranche. If it continues to go up, you fix another 12,5% tranche, and so on until 50%. If it drops again, you don’t fix anything and you have only 12,5% fixed on a temporary uptick.

This active energy price management approach produces excellent results. It allows a company to achieve pre-defined energy risk management goals. And because you make your fixings when markets turn around and not in the middle of downtrends, you’ll produce good results versus the market. A disciplined application of energy risk management, always spreading decisions and never make too large fixings because you think you know where the market is heading, will avoid energy trading disasters.

Hands-on active energy price management is definitely a great solution for budget risk customers. They can visualize their commodity costs for energy in the next years and then take the price fixing decisions based on goals, e.g. in a rising market: don’t let your cost increase by more than 10%. Or in an opportunity moment: cement a budget reduction by buying forward. For a budget risk client, this is a better approach than hands-off as you take your future costs in your own hands rather than let them randomly depend on how the market average prices you are buying are moving.

You can take your energy trading to a next level by adding an extra tool to your active energy price management toolbox: the selling of previously bought forward positions. If well-executed, this can definitely lead to great results, but it’s not the miracle solution that many consultants and portfolio managers try to sell you. Moreover, if you adopt the buying and selling approach with forecasting, you are doubling the financial impact of the 50% cases in which the forecasts are wrong (best case).

For market risk customers, the hands-off approach is excellent for achieving the main energy risk management goal, i.e. never have a price high above the market average. Active energy price management for them means the buying and selling of small extra volumes in opportunity moments in an attempt to do better than those market averages. It’s up to every company to decide whether to go that extra mile or not.

75% of the buyers: you can’t predict energy prices, but I want a forecast when I take an energy trading decision

 Like we’ve said, there is only a very small fraction of the energy buyers that we talk to that believes you can predict future energy prices. However, a large majority of them cannot imagine that they take decisions to fix, not fix or unfix without some kind of forecast. This makes no sense. Why would you base your decision-making on a technique of which you acknowledge yourself that it doesn’t work?

The use of forecasts is deeply embedded in the business world. It has its roots in deterministic economics. Economists try to upgrade their science by making it look as exact as physics or mathematics with laws that produce correct predictions again and again. This branch of economics is often taught in business schools. And it is sold to businesses by consultants in the shape of forecasting services. They are either based on the guru status of the consultant or on a sophisticated-looking mathematical model.

Albert Einstein taught us that even in physics forecasting will not always work (I’m not going into the details of quantum physics to explain this). And in mathematics, we have chaos theory. It still believes in a deterministic physical reality, there is a set of initial conditions that determines the outcome. But this reality is so complex that it is impossible to trace that chain of causal effects. The butterfly effect describes how a small change that is impossible to trace can have large consequences. A butterfly flapping its wings in the forest in Brazil can cause a tornado in Texas.

The butterfly is an excellent metaphor to illustrate the complex, chaotic environment of energy markets. Forecasting systems will invariably over-simplify this, leading to wrong forecasts. But as human beings, we are so allergic to the uncertainty of unpredictable chaotic environments like energy markets that we keep buying the false certainty of forecasting.

I think about a recent meeting with the energy buyer of an international food company. He told how every month their board had a presentation by a professor that gave his vision on the world economy and how it would affect pricing of diverse commodities. Decisions to hedge were then based on that vision. So, we commented: “if the professor gets it wrong, the economic health of a company with thousands of employees will be affected”. “He is very clever, he gets it right most of the time”, was the energy buyers’ answer …

I also think about other meetings during which energy buyers’ acknowledge that forecasting doesn’t work. However, they buy forecasting services and base their energy trading decisions on it, because then they know why they took wrong decisions … Some even said: “we then have a consultant to whom we can transfer the blame” … I’m sorry, I’m a consultant that respects his job and I will never sell myself as a scapegoat.

It’s all the more sad that so many energy buyers keep holding on to forecasting even if they know that it doesn’t work, because they don’t need it. The active energy price management approach described above produces excellent energy trading results. It is simply a much more rational approach to buying energy than holding on to the false certainty of forecasting. It’s E&C’s mission to convince large energy consumers of that and help them to implement an energy trading practice that is not based on false forecasting.

More information on how to deploy buying and selling can be found here or contact benedict@eecc.eu for receiving our whitepaper on this topic.

US LNG: a long expected arrival for the European energy markets

In the last months, we have seen an important increase in the number of ships bringing US LNG to Europe.  8 ships unloaded US natural gas in Europe in the first two months, compared to 5 in the whole of 2016.

European energy markets have been eagerly awaiting the arrival of US LNG. In 2010 – 2012 the Henry Hub prices were pushed lower and lower towards 2 dollars per MMBTU. Seeing how they paid more than twice that amount for consuming gas in Europe, European energy consumers had a hard time grasping what was going on.

“Shale gas”, all of a sudden the magic word was pronounced in all corners. The perfection of the technology to produce gas from shale rock layers, the so-called hydraulic fracturing or fracking, caused US gas production to rise significantly. At first, Europe was hopeful that it could imitate that energy production miracle. Countries like Poland and UK started to explore the possibilities of producing shale gas from their soils. However, we haven’t seen much of European shale gas yet. Most projects faltered in a combination of geological and bureaucratic challenges.

And then the US started to talk about exporting gas as liquid gas, LNG. A strange turn of events, as a few years earlier, the US had started to construct terminals to import gas. Now, these projects were turned around and export terminals were planned, permitted and construction started. This sparked hopes in Europe that this US LNG could bring prices down to a level that is more in line with the US. Sabine Pass in Louisiana was the export project that made the most rapid progress.

As European energy companies signed contracts with US counterparts to import gas and the construction of Sabine Pass progressed smoothly, European forward gas prices turned euphoric. By the 7^th of April 2016 the year ahead price on the benchmark TTF Hub dropped as low as 13,02 euro per MWh, their lowest level since December 2009. However, as of April, the bull trend seen in other energy markets hit the European gas markets as well, with a peak of 18,505 euro per MWh for year ahead TTF on the 30^th of December.

What had happened? On the 24^th of February, the first boat with LNG left Sabine Pass, to sail to Brazil rather than Europe. In hindsight, it makes geographical and economic sense for LNG ships leaving in Louisiana to sail to South-America rather than Europe. And so did most of them. Of the 45 cargoes that embarked from Sabine Pass in 2016, 26 had Latin-America as their destination, compared to only 5 for Europe (Source: Timera). The expected flood of shale gas hitting the European market didn’t materialize.

However, we see a remarkable reverse of this trend in 2017. In January & February, we already saw 8 ships with US gas. All in all we see an important increase in the total number of shipments, with a total of 30 in the first two months of the year. We clearly see the effect here of the fact that a second and third train are now available for exports. With 7 ships, Latin-American imports of US gas remain stable. The biggest winner of the larger amounts of gas in Sabine Pass is Asia with 12 cargoes coming their way.

The TTF forward price is dropping again, with 16,145 euro per MWh on the 21^st of March. It’s always dangerous to pinpoint cause and effect in energy markets though. The gas market is dropping in line with other energy markets. However, it should be remarked that pricing in gas markets is made ‘on the margin’, a few boats of gas more or less can mean the difference between excess or shortage that has a heavy impact on the prices. It’s too early to call “Hurray”, but it definitely is a good thing that more US LNG is finding its way to Europe, if only from a diversification of supply point of view.

It should be remarked that further expansion of US LNG export capacity is planned, in Sabine Pass and other places. A total of 89 billion cubic meters (bcm) is due by 2021, compare that to the 4,2 bcm that the US exported in 2016. Will that drive prices in Europe lower? That’s obviously impossible to say. The LNG market has proven to be very versatile. Shippers easily adapt their routes when prices on another continent are more favorable.

And how about politics under the new Trump administration? It looks like Mr. Trump’s main economic policy goal is to restore the US trade balance. Producing large amounts of energy and exporting it, would be a great step towards that goal. His decisions regarding permits to produce seem to support that. However, how will protectionist Donald Trump react if increased exports towards the higher priced markets in Europe pushes up prices for US gas consumers?

 

Green energy supply: source or invest?

A growing number of companies adopts renewable energy goals and commits to green energy supply. Top of the bill might be Ikea, that has committed to produce as much renewable electricity as it consumes in its industrial sites, storage sites and shops by 2020. Apple is approaching the 100% renewable electricity supply rapidly, and was already at 93% in 2015. And here’s just a handful of famous company names that have committed to the symbolic 100% renewable electricity supply by 2020 target:

Swiss RE, Bank of America, BMW, British Telecom, Coca Cola, Goldman Sachs, ING, La Poste, Phillips Lighting, Sky Entertainment, UBS, Unilever

(These names and much more information on corporate renewable energy efforts can be found on the RE100 website.)

With a climate change denying Trump administration in the US, one could easily be pessimistic about the prospects of greening the world’s energy supply. However, I believe that the renewable energy revolution is a train that is rolling and can’t be stopped in its tracks:

1. A large part of the public is convinced that climate change is a real problem. Companies feel a pressure to present green energy credentials to clients, current and future employees, investors, or they just go green because of an inborn sense of social responsibility.

2. The costs of building renewable energy generation has dropped spectacularly. Energy from windmills now costs between 52 and 110 euro per MWh, according to Wind Europe. That is 48 to 102 dollars at the current exchange rate. Electricity from photovoltaics looks even more spectacular. According to the International Renewable Energy Agency, a project in Dubai that was commissioned in May 2016 will produce power from the sun for a cost as low as 30 dollar per MWh.

In many places in the world, the all-in cost of consuming electricity from the grid is higher, making it profitable to generate on-site green electricity rather than buying from the grid.

For feeding the green electricity into the grid, the 110 euro per MWh needed for some windmill projects, might still be too high for the investment to make business sense. Subsidies and governments willing to grant them to windmills and solar panels might still be needed for the time being. But then the energy industry has always been subsidized. The UK will pay EdF 92,50 pound sterling per MWh for building a nuclear power plant at Hinkley Point, that’s a 107,54 euro per MWh. Isn’t that money more wisely spend on windmills?

Renewable energy is also playing a crucial role in bringing electricity to poor countries. Access to green electricity in remote regions, isolated from reliable grids, can be crucial for those regions’ development. The recent acceleration of growth of renewables in developing countries is likely to continue.

If Donald Trump thinks that his skeptic approach to greening energy supply is part of his businessman’s attitude to the presidency, then he is mistaken. A 21^st century businessman integrates green energy supply goals in his corporate strategy, because they make business sense. As an energy buyer, the chances that you will be asked to buy green energy are increasing and they will continue to do so, whether Mr. Trump is in the White House or not.

Getting that question on greening the energy supply confronts the energy buyer with an important dilemma:

Will you go green by sourcing green electricity from the grid or by investing in your own green electricity production? To give an answer to this question, we have to make some considerations:

1. The physics and logistics of electricity supply make it difficult to label

Many years ago, we researched the green energy options of a client of ours. One of their team members kept insisting that he wanted proof that the green electricity was coming from a particular windmill near their factory. Due to the physics of electricity it’s impossible to do this. You cannot produce MWh’s in your windmill and attach a label to them saying: “Electricity from windmill so-and-so, to be delivered to company so-and-so”.

Electricity supply works by keeping the tension on the grid at a constant level by injecting as much electricity into the grid as the end-consumers are collectively consuming. But there is nothing that is physically being moved from place A to B. Therefore, it is impossible to say where the MWh’s that you consume were produced.

To deal with this, systems such as the European ‘certificates of origin’, have introduced a double marketing system. Producers of green electricity in Europe receive a certificate of origin. This is a piece of paper that says that a MWh of electricity was produced by a windmill, solar panel, by hydro, geothermal, biomass, etc.

The green electricity producer will sell electricity twice. The product itself (often called the “grey electricity”) goes to the grid at market prices. Next to that, the producer will make some extra income by selling the certificates of origin in a separate market.

Energy suppliers buy these certificates and bundle them with the physical MWh’s that they supply in green electricity products. That doesn’t mean that the power you consume comes from a particular windmill or solar panel. It means that as a consumer you have made an extra investment to support renewable energy. Some consumers have taken the labeling logic a step further by buying certificates of origin themselves in quantities equal to their physical consumption.

2. Green comes in many shades

More than 20 years ago, I read a book of which I vaguely remembered the title to be “Grass instead of atoms”. It envisioned a future in which all of the world’s energy would be supplied by biomass. The theory was that biomass is carbon-neutral, as the carbon dioxide produced by burning the plant material would be compensated by the CO2 sucked from the air by the growing plants. Green activists embraced the biomass idea heartily.

Twenty years later, the world and definitely the green movement has grown much less enthusiast about biomass:

1. Due to its low calorific content, you need a lot of plant material to produce a reasonable amount of energy. This causes huge logistic problems.
2. Not the least of it being the huge amounts of land that you need to produce sufficient biomass for supplying the world with energy. Land that in many cases could be used better to grow food. And land that was sometimes won by cutting down valuable, bio-diverse and more carbon-sucking rain forest. Next to that there are the environmental issues caused by monoculture. Very rapidly, we discovered that the world would not be better off if the whole equatorial zone was transformed into a massive palm oil plantation.
3. The theory of the carbon-neutrality of biomass can be challenged, especially if you cut rain-forest to plant palm oil and when you ship your biomass halfway across the globe.

Many well-intentioned biomass projects have ended in a public relations nightmare due to the questionable environmental credits of burning plant material. To investors’ horror the environmental groups that push for more green energy are often the first ones to raise protest against specific projects. Think about the many times local green activists have raised protests against the construction of a windmill.

The certificates of origin are granted to any green electricity project, regardless of its real environmental merits. If you consider going ‘deep green’, you might make some extra investments by buying some higher quality certificates.

3. Buying green electricity is very cheap

In Europe, you can currently buy certificates of origin. That is very cheap. The reason for this low price is simple: demand is lower than supply. Every MWh of green electricity produced in Europe gets a certificate. At this moment, 29% of all electricity produced in Europe is green (2015 data coming from Agora Energiewende). As long as all the citizens, companies, public authorities, etc. that buy green electricity consume collectively less than 29% of all electricity consumed in Europe, the demand for green electricity will be lower than the supply. Hence the low price of buying green electricity.

If your only interest in buying green electricity is “green-washing”, getting the paper on the wall to say that you buy green so that you can satisfy the customers that are asking for it, the low price of green electricity is good news. However, many customers have a more genuine interest, more serious intentions of making a valuable contribution to the environment. For them, just spending a few ten thousands of euros or dollars on certificate-buying will not be very satisfying.

Moreover, a public relations catastrophe is looming again. Environmentalists are increasingly aware of how easy and cheap it is to claim ‘100% renewable electricity’ by buying certificates of origin. Clients that involve NGO’s in their sustainability policy (e.g. through the WWF Climate Savers initiative), already feel that pressure to do something more valuable than buying 15 cent per MWh certificates of origin.

4. Not all green electricity is good for the environment

Certificates of origin don’t work as a tool for putting pressure on energy companies to increase their green electricity production. But it works as a system for having companies with green intentions invest money in greenery. Unfortunately, that money isn’t always effective.

An effective investment in green electricity means that less carbon dioxide is emitted. Very often, the money you pay for certificates of origin goes to an old hydro power station or a windmill, solar panel or biomass power station that have been there already for many years. For hydro, wind and solar, the marginal cost of production is 0, meaning that their owners produce the electricity whenever they can. Bringing us to the startling conclusion:

Whether you pay for the certificate of origin or not, the green electricity would have been produced anyhow.

So, your effort to pay extra for the certificates of origin isn’t keeping a gram of carbon dioxide out of the air. You could solve this by buying higher quality certificates. However, if you invest every euro you spend to source green electricity in your own renewable energy production, you are effectively keeping CO2 out of the air. It will mean that a windmill, solar panel or other project gets built thanks to your efforts that pushes fossil-fuel fired MWh’s from the grid. As the investment costs to produce your own energy are so much larger than what you spend buying certificates, it might be financially impossible to achieve the symbolic 100% renewable goal. But the money is spent so much more wisely and with a net better effect on the environment.

5. Sourcing means spending money without return, contrary to investing

Which brings us to a next observation. Spending money on certificates is just that, spending. Investing money means that you can expect a return on your euros or dollars. On-site renewable energy production is often developed by a third party with a power purchase agreement. In many cases you will receive a fixed amount of money for renting your terrain or rooftop. Next to that, you can buy the electricity at a price far below the price at which you buy from the grid. Such projects always lead to savings, and thanks to such third party arrangements without even having to invest the company’s money.

When you invest in off-site renewable energy projects, the return will depend on the particular set-up, and often on the subsidy arrangement. In many cases, renewable energy is an interesting investment as the return is relatively stable and reliable.

6. What do you want to achieve with your green energy efforts?

As you can read from the observations above, greening your energy takes more reflection than just buying a green power product based on certificates of origin. Investing the money in your own green electricity production is a more valuable approach, both for the environment and for your financial bottom line. However, not every company might be ready to have such large amounts of cash flowing to green power investments.

As an energy buyer, your research of the energy markets can lead to more valuable choices for your company. To determine your approach, it is worthwhile to make a good preliminary analysis of what you want to achieve with your green energy efforts, e.g. through a stakeholder analysis. If you’re just greening to satisfy customers, you might be happy with the certificates of origin. If you also want to prove your green credentials to environmentalists, you might decide to go deeper.