Will the Polish capacity market stimulate new investments?

Read the Polish blog here. Written by Wojciech Nowotnik.

The last couple of weeks there’s been a debate on whether a capacity market needs to be created in Poland. At the beginning of July, the Ministry of Energy published a few suggestions to implement this capacity market. The main question is whether the capacity market as it’s outlined by the Ministry of Energy will stimulate new investments in stable production capacity to increase the energy security in Poland.

Let’s start with a brief recap. Support for investments in conventional power plants in Poland is nothing new. Do you remember how in the early nineties the Polish energy was in need of intensive modernization to reduce greenhouse gas emissions? A relatively simple mechanism was introduced: the long-term contract, called KDT (Kontrakt DługoTerminowy – Long Term Contract). This kind of support was simple and beneficial for the investor. After Poland entered the European Union, the KDT had to be changed because it was seen as unlawful state aid. The KDT became a transition fee as of 2008, a part of the distribution costs.

In August last year, the so-called power stages were introduced to significantly relieve the power system in Poland. This revived the discussion on the promotion of investment in conventional generation sources.

As you can see on the image above, the available capacity and demand are almost at the same level. This is a clear sign that similar problems might occur in the future. Therefore, other solutions need to be introduced in order to have a more stable national power system. Some other European countries are in a similar situation but the risk of supply constraints isn’t that significant as it is in Poland at the moment.

This is exactly why the Ministry of Energy worked on functional solutions for a capacity market in cooperation with experts from PSE SA. The document says they want to ensure the continuity and stability of electricity supplies to all end-users in the country on a long term. The project is largely based on the concept of the capacity market in the UK.

The proposed system assigns one party that is obliged to determine the size of the power demand and needs to organize the purchase of this amount of power based on . The asking price will be gradually lowered and the winner will be the one who offers the lowest rate.

Below you can find the schedule of processes on the capacity market.

Source: Ministry of Energy

Unfortunately, the example of Great Britain shows us that this solution does not guarantee investment in new blocks. According to the blog of Professor Świrski only 5% of the funds will be invested in new gas-fired units and the vast majority will support the old coal-fired plants to continue to be maintained.

In my opinion, it’s a pity that the solutions were only based on the national system without having a look at the opportunities of cross-border trading. As well, solutions providing Demand Side Response are only marginally treated. I also share the opinion of different commentators that point out that the capacity market as currently proposed might be considered as unlawful state aid. My last and most important remark concerns the cost for introducing the capacity market. ClientEarth’s analysis says that the capacity market based on the current proposal would mean an additional cost of 80 to 90 billion polish zloty (20 to 22 billion euro) between 2021 and 2030. The average energy bill would increase by 30%. The project only shows settlement mechanisms without providing any cost simulations. It seems like the Ministry of energy tries to solve the problems of the Polish energy sector by duplicating the mistakes of other EU countries.

In 2014 Benedict De Meulemeester, founder and owner of E&C Consultants, published an article about the capacity market: Capacity payments: expensive solution for a non-existing problem. At the end of the blog article, a more fair, cost-efficient way without unnecessary increases of energy prices for consumers is proposed:

1. Continue the climate policy measures aimed at reducing consumption.
2. Expand cross-border capacities and stimulate cross-border trading initiatives such as market coupling.
3. Continue to support renewable energy, especially now that its investment costs have dropped.
4. Support demand side management where it is realistic.

If you analyse both the project above and other legislation on the energy market in Poland (such as the law on the construction of wind farms) it seems like the actions of Minister Tchórzewski are exclusively focussed on supporting the Polish coal industry.

Prior to signing the “Windmills Act”, the Energy Minister said “there is a need for less of this renewable demagogy”. I would say there’s a need of less of this coal and bureaucratic demagogy.

 

 

Is the world ready to grow its economy without increasing energy demand?

It is a strongly imbedded belief in the world of energy analysis that demand for energy can only grow. In terms of energy procurement, this leads many buyers to bullish biases, making them buy too soon or at high price levels, as they believe increasing demand will make prices rise. However, as commented earlier on this blog, we have recently seen a slowdown of the growth of worldwide energy demand. It’s true of course that the last decade hasn’t excelled in terms of economic growth. However, in many parts of the world now, an extra percentage of GDP doesn’t necessarily mean an extra percentage of energy use. In 2015, the world’s primary energy consumption grew by just 1%, whereas GDP, according to the World Bank, grew by 2,47%. Have we cracked the code and can we – as of now – increase our economies without using ever larger quantities of energy? Or will a next phase of strong economic growth come with an acceleration in energy consumption growth again?

Fig. 1: Primary energy consumption in the world (Source: BP Statistical Review)

The graph on the world’s primary energy consumption is showing us how during 2000 – 2007 strong economic growth came with large extra quantities of energy. The economic crisis of 2008 & 2009 brought that down sharply, only to be followed by a record year-on-year increase in 2010 as particularly China – the world’s largest energy consumer – revived quickly. But then the energy growth started to slow down. Last year, worldwide primary energy consumption grew by just 1%.

It should be clear that not all parts of the world are equally contributing to this reduction in energy voraciousness. As can be seen from the graphs below, the traditional economies in Europe and Northern-America have been in the lead. In the European Union, we even see a clearly declining trend that started in 2006, which is before the striking of the economic crisis. This is the moment that many energy efficiency programs devised in the framework of Europe’s climate policy have come into effect and I believe that there is a clear causal relationship here. In North-America, energy consumption in 2015 was at the same level as in 2000. US primary energy consumption in 2015 dropped 0,9% compared to 2014, despite a 2,4% increase in GDP.

(Regarding Europe, critical observers might remark that there has been an increase in EU consumption in 2015 – to which I would respond that this was a year with cold winter weather.)

Fig. 2: Primary energy consumption in different parts of the world (Source: BP Statistical Review)

The lines on the right hand side don’t show much slowing-down of the hunger for more energy in the emerging economies. However, in China e.g., energy consumption grew by just 1,5% last year, which is far below the 16,6% and 17% that we saw in 2003 and 2004. On the one hand, this slowdown in hunger for ever more energy can be explained by the mechanics of economic development itself. In the first phase of its economic development, growth in a country like China came from the growth of basic, energy-intensive industries such as steel production, causing energy demand to go up quickly. On top of that, the growing middle classes started to enjoy energy-consuming luxuries such as cars, a larger house, air-conditioning, frozen foods, etc. However, once a certain level is reached, further economic growth comes from less energy-intensive industries and services and the middle class stops to grow, causing the growth of energy consumption to slow down. But could it be a deeper trend, and is the world starting to copy Europe’s example of consciously improving its energy efficiency?

When I talk to people around me, I observe that most of them don’t realize at all what a revolution they’ve gone through in their daily lives in terms of energy efficiency. To just name a few examples:

• Cars have drastically improved their fuel efficiencies,
• In lighting, we’ve moved from the lighting bulb to energy-saving lighting bulbs to LED-lighting, meaning that we now have the same amount of light using less than 10% of the energy that we used 15 years ago,
• Insulation regulation has reduced the amount of energy that we use to cool or heat our houses,
• Walking into electro shops, we are now looking at the energy efficiency labels, inspiring us to buy new fridges, microwaves, vacuum cleaners, etc. that use much less than the ones we throw away,
• The boilers that we use to heat our houses are now super-efficient top technology,
• …

And not just households have reduced their energy consumption. If I look at our clients, mostly large industrial users, all of them are running energy efficiency programs, inspired by government regulations, demands by clients and other stakeholders or just environmental consciousness. Implementing more efficient technology and practices, they have all reduced the energy-intensity of their production. And many of them are not only reducing energy consumption in relative (MWh per ton) terms, but also in absolute MWh per year terms.

It is true that the effects of more efficient technology, appliances using less energy every time we use them, has partly been undone by the fact that we use them a lot more. We drive our cars more often, take more flights, light up every building with LED’s, etc. This leads pessimists to disbelieve that technological improvements are not a solution to our energy problems. What has happened in the EU in the last decade, has proven them wrong. We can grow our economies and enjoy the luxury of a well-lit building or smoothly-driving car without increasing the overall amount of energy that we use. The next years should show whether this can be imitated and turn the slow-down of energy demand growth in other parts of the world into a decline as well.

You can still subscribe for the second leg of our Transatlantic Energy Conference 2016 in Chicago over here: http://bit.ly/TEC2_US 

Are we approaching an age of energy abundance?

Do you remember the first months of 2008? Every week, prices increased. Oil prices rose near an all-time high of 150 dollar per barrel and some analysts “predicted” that they would soon reach 300. That was obviously a disaster every time you had to fill the car. But European buyers of natural gas were also affected as back then almost all the gas contracts were pegged to oil prices. Natural gas prices rose above 40 euro per MWh. And if you were impressed by the tripling of oil prices, what to say of coal that rose from a level around 50 dollar per ton to more than 200. Electricity prices were obviously affected by these increases in combustible prices and in many countries baseload prices rose to a level near 100 euro per MWh. For buyers of energy these were terrifying times. Every delay in price fixing decisions caused a frightening increase in energy costs. We had several emergency meetings with companies in those days that were desperately looking for ways to avoid dramatic increases of their energy budgets.

Most analysts agreed on the root cause of this unprecedented bull-run. As countries like China and other emerging economies grew at exponential rates, the planet just wasn’t capable of producing enough commodities to fuel that growth. The developed economies had already depleted the world’s geological reserves so much, that there wasn’t enough left now that the developing economies joined the race. We were just plainly running out of oil, coal and natural gas. That was the simple logic behind the 300 dollar per barrel prediction of a Goldman Sachs analyst that forced many buyers of energy into panic decisions. And the fact that other commodities such as copper were also rising to historical highs proved the point. The peak oil theory became wildly popular. This was a calculus introduced decades ago by a Shell geologist called M. King Hubbert. According to Mr. Hubbert, production of oil reserves followed the elegant path of a bell-shaped curve. At some point the peak was reached and after that ever declining production rates were inevitable. Mr. Hubbert had applied his bell-shaped calculus to the US oil production and produced a reasonably accurate forecast of the peaking moment. As oil prices increased exponentially, more and more observers became convinced that we had reached or were at least near the peak of the curve of worldwide oil production. Some were even convinced that we were on the right side of the bell shaped curves of coal and natural gas production as well …

Open-minded people will acknowledge that reality is in most cases way too complicated to fit elegantly bell-shaped curves. But I have to admit, that as prices just kept on rising, even I was tempted into some Hubbert-style thinking. What explains the attractiveness of the peak theory? I believe it is our instinctive scarcity scare. Most of the people reading this blog article can satisfy their basic needs without much trouble, just like me. Just consider the most essential needs, warmth and food. Heating myself and my family means the occasional phone call to the plumber to fix my gas-fired boiler and checking gas bills and contracts from time to time. And the struggle for daily food means phone calls with my wife in which we discuss food variety and who will take the ten minutes to stop by a shop on the way back home. However, thinking about it, I have to return just two generations to find ancestors for whom the struggle for essentials was much harder. I remember a story told by my grandfather in which he scattered white flower on his coal reserves in the shed to check whether his suspicions of a coal-stealing neighbor were true. Less than a century ago, people still had to fight daily to get their share of the scarce energy and food. Unless you are born in some old aristocratic family, you carry in yourself the genes of people that survived due to their scarcity scare. This explains why perfectly civilized societies start the completely irrational hoarding behavior or even worse, looting, as soon as the first signs of scarcity are on the horizon. Slightly ashamed of our luxurious contemporary life styles, the idea of increasingly scarce energy supplies fascinates as well as scares us. The horror picture of 300 dollar oil fascinated us, because we are silently scared of having to return to the harsh daily struggle for the scarce commodities for keeping your family warm.

Some economists kept their cool and displayed a ‘what goes up must come down’ mentality. They remarked that this wasn’t the first peak in oil prices, and that previous peaks had been followed by deep decreases. They argued that high prices would put the laws of supply and demand at work, leading to corrections. Only, as the lead times for adaptation in energy are very long, this takes some time. As the bull-run extended in time, some renegade economists started to declare that energy was a basic good and hence not price-elastic. Whatever its price, consumers would continue to consume ever more energy. And accepting the ‘inevitable’ truth of M. King Hubbert’s peak theory, even if producers wanted to increase supply, they couldn’t. The cooler economists responded that energy supply and demand are price-elastic, but it is slow elasticity. Investing in more energy-efficient equipment and in new production isn’t done overnight. These delays explain the ‘boom-and-bust’ cycle of energy prices. Cool-headed economics has proven to be right again. In the second half of 2008, the energy prices corrected sharply and dropped back to their pre-peak levels. Peak oil (and other energy) theorists used the economic crisis as an excuse. As soon as that crisis would pass, the plain logic of the bell curves would kick in again. But isn’t the economic crisis in itself a sign of the elasticity of energy demand? If energy prices rise too high, this pushes the world into a recession, causing demand to drop sharply. The 2008 crisis (which still isn’t over, at least not in Europe) has a complicated web of causes. But high energy prices are definitely part of that. The increasing impact on their budgets of high fuel prices was one of the reasons why so many Americans couldn’t pay back their mortgages. So, even if 300 dollar oil prices and equivalent prices of other energies are possible, they would very probably be extremely short-lived, as they would push the world in a deep recession. That draws a bleak picture of life in a perpetual economic crisis on the other side of Hubbert’s peak. The last five years have learned that economic stagnation isn’t fun, so we all have a moral duty to avoid ever ending up there.

As the economy has recovered, specifically in the commodity-devouring developing economies, energy prices on the world markets have increased again, but they haven’t hit the previous highs (yet?). Electricity in many countries of Europe is currently even trading at its lowest level since 2005. And we are clearly seeing that energy demand and supply are impacted by more fundamental phenomena than just the economic crisis:

DEMAND SIDE:

– Combined with climate policy measures, the high prices of 2008 have caused renewed enthusiasm for energy efficiency improvements. This seems to have caused a sustainable downtrend in energy consumption in the developed world (both the EU and the USA). However, the effect of this is largely undone by continuing growth in energy demand in the developing world.

SUPPLY SIDE:

– Oil production in 2011 was 1,5% higher than in 2008. So, we are not on the right side of the bell-shaped curve yet. It should be remarked that these extra barrels are increasingly expensive to produce, causing oil prices to remain high. But it looks like we still have enough oil left. Thanks to shale oil, US oil production was 16,44% higher in 2011 than in 2008 and some are optimistic that these unconventional resources could ultimately mean an end of oil imports in the US. So, Mr. King Hubbert, the tail end of the US oil production curve is not bell-shaped …

– Peak theorists that simplistically extended the peak oil theory to coal and natural gas, were ignoring the fact that undeveloped reserves of those fossil fuels were much higher than those of oil. As oil prices remain high, the world has tapped into its coal and gas reserves. Coal production in 2011 was 12,8% higher than in 2008, gas consumption grew 7,5%. This clearly shows that the peaks in coal and natural gas were nothing more than an expression of slow elasticity. Natural gas production has been boosted by conventional and unconventional gas production. I have extensively written about the shale gas revolution on this blog. If it can spread across the globe, gas abundance could become a reality.

– The prices of wind and solar power production have dropped to a level that necessitates only limited subsidies to stimulate their growth. Therefore, the growth of the share of energy produced from these renewable sources seems unstoppable.

The previous energy crisis (the 1970’s) was followed by a long period of energy abundance and historically low prices. Are the trends above sufficient for the world to be entering an age of energy abundance again? The hunger for energy of the developing economies is continuing to put pressure on the world’s energy markets. But if shale gas becomes a worldwide reality, energy abundance could become a fact, especially if it is combined with an adoption of more energy-efficient and more renewable technology by the developing economies.

There are many obstacles on the road to energy abundance. And the legendary unpredictability of energy markets makes it impossible to say if we are heading for it or not. So please don’t interpret this blog as a forecast of low energy prices. The important message is that abundance is not unthinkable. Still, we see many energy buyers that continue to be driven by scarcity scare in their price fixing decision. This is partly due to the fact that abundance stories don’t get much political and press attention. Many conservative politicians prefer the peak energy theories because they fit within their energy independence policies that are supportive of their hawkish geopolitical position. Do you really think that the American public would have allowed the sacrifice of American blood and money in the Iraq War if back in 2003 they would have known that they were heading for the abundance of homegrown shale gas and oil? On the liberal side, the scarcity scare fits within the anxiousness to do something about climate change. This seems to be the predominant policy of Europe. We need to be very careful as we are approaching a possible age of energy abundance. If Europe unilaterally choses for more efficiency and renewable rather than more (unconventional) oil and gas, we might end up with a much higher bill than the rest of the world. Can we really afford that?

Benedict is giving a presentation on this topic on our (Central) European Energy Procurement Conference on the 16th of May in Warsaw. Send an e-mail to info@eecc.eu if you want to attend or click here.

Power supply for next winter in Belgium

Written by Bart Verest, Kobe Cannaerts & Benedict De Meulemeester

For many weeks now, a heavy debate is raging in Belgium over the possibility of power outages next winter. It looks like the culminating point of an ongoing debate over security of supply. With the rapid growth of renewable energy production, experts worry over the availability of flexible power supply to make up for the intermittency of renewables. Add to this the fact that in Belgium investment in new large-scale power stations has been very limited in the past decade, and you understand the worries over Belgium’s power supply situation. When earlier this year, the energy minister Wathelet put plans on the table to shut down Belgium’s two oldest nuclear power stations, the security of supply debate rekindled. And as two other nuclear plants were shut down during the summer over safety issues, the discussion found its route into the mainstream media. Everybody, from ministers and experts to our barber, is worrying that there will be outages next winter.

Ministers Wathelet and Vande Lanotte hurried to appease the population. “No problem”, was their devise. With heavily contested local elections on the 14^th of October, they don’t want to be held responsible for a power supply fiasco. They are right of course in blaming the media for unnecessarily spreading panic by using the “blackout” word. Worst case, we will see a coordinated shutdown of power in some (countryside) areas of Belgium. But the lights will not go out in the whole country. We are confident that our power grid operators are capable of organizing a well-managed local shutdown. However, crying that there is no problem when more than 10% of the country’s tight power production capacity is shut down, cannot be taken very seriously. Fortunately, it is also clear that Mr. Wathelet is working on contingency plans behind the screens. This highlights how deeply political the “no problem” statements are.

Regulator Creg has been quite vocal in voicing worries over the power outages, which caused the Minister to launch a violent counter-attack. This discussion should be viewed in an ongoing conflict between regulator and their political paymasters over technical versus political management of an energy market regulator. The discussion is also due to a difference in analysis methodology applied by both parties. On the one hand, the Creg has adopted a theoretical approach. They have added up the available production capacities and compare these to the real production at the moment of the demand year-peak. On the other hand, the minister is referring to a study by grid operator Elia adopting a statistical approach. They have modeled the conditions determining supply and demand. They launch a Monte Carlo analysis with this model and calculate the probability of a shortage. Between the lines, you can read that the Minister estimates this probability to be low enough to call “no problem”. But it is unclear about which probability we are speaking. It definitely was high enough to start up the development of a contingency plan.

Our analyst Bart studied the data and soon came to a startling first conclusion. There are issues with the data regarding energy supply and demand that Elia publishes on its website. To begin with, normally the total available production should equal the sum of the available production of the different types. Well, it doesn’t fit. Elia told us it is researching what went wrong with their published data.  Moreover, for every 15 minutes, the total demand should at least equal production + imports – exports. That was not the case for certain moments. This would suggest that in the past shortages should have occurred already, which isn’t the case. No satisfying explanation was given. My question is: have Elia and/or Creg based their analyses on wrong data? Or are they using some secret data file that is not made available to the public?

We have made a simple calculation, using the historic available capacity data and then deducting the 2.014 MW of the nuclear power stations that have been shut down.  We compared these to the historical production data at the peak demand moment. The conclusion is very clear. With the nuclear outages, we are seeing several moments during the winter months when the available production would not be able to supply the load demanded. The available capacity margin just wasn’t 2.000 MW during several moments in the past year. Even if renewable energy production continues to expand, it doesn’t look like we will have a lot of extra production capacities available any time soon. Rather to the contrary, if we consider the announcements of shutdowns of power plants in Ruien, Tessenderlo and Vilvoorde. On top of that, we have to consider the possibility that a peak in demand occurs at a moment of limited availability of wind and/or solar power. Minister Wathelet is planning measures to create a reserve capacity of old power stations, but will this be sufficient and will they be available soon enough?

Fortunately, the Belgian power grid system is well embedded in the larger North-West-European market, with cross-border connections with the Netherlands and France. This brings us to an interesting dilemma. As we worry over a shortage of production capacity in our own country, the problem in the North-West-European market seems rather to be that there is too much capacity. There has been a spectacular expansion of renewable energy production in Germany, and Belgium and France are following. Moreover, there was a lot of investment in gas-fired power production in the Netherlands, a market that is now clearly over-supplied. European power production giants E-On and RWE have announced that they will stop investment in large-scale power production in the North-West-European market because it is over-supplied. The spark spread and the peakload – baseload spread are both trading at historical lows, which is a clear sign of over-supply. Therefore, at first sight it looks like the Belgians are worrying over a non-problem. If they have a supply gap next winter, cross-border power, and more specifically gas-fired power from the Netherlands will solve the problem.

Unfortunately, there is a complicating factor here. The available capacity at the Dutch-Belgian border is constant at 1401 MW, at the Belgian-French border it ranges between 2500 and 3200 MW. This means that in case of a shortage or just a high price in France, all of the electricity that is coming in from the Netherlands could be exported to France. This is exactly what happened in most of February 2012, when the Belgian power demand peaked at a yearly high. During the Belgian demand peak of February 7th, Belgium was importing at the Northern border almost at full capacity and exporting at the Southern border at full throttle. So the use of the import capacity is very conditional. Production in Belgium was just 4% short of its available capacity. When Creg pointed out this problem, Minister Vande Lanotte reacted by saying: “we’ll shut down the French border then”. We hope that by now he is realizing the complete absurdity of that suggestion. From a legal point of view, keeping electricity that was sold by a Dutch party to a French party in Belgium is “theft”. And as Belgium is now more than ever depending on free cross-border trade of electricity, will we be the first ones to fire the protectionism shots? There is a more simple solution, mister Vande Lanotte: in case of a shortage, the power will stay in Belgium, if the Belgians are prepared to pay more than the French. Dutchmen are Dutchmen, they’ll sell at the highest bidder.

There is high probability that a peak in Belgian winter demand will coincide with a peak in French demand. This peak is related to the climate, electrical heating for industrial and residential heating purposes increases as the weather gets cold. The strain on North-West-European winter power demand is aggravated by the fact that so many French houses have electric heating systems. Due to the geographic proximity, it is very likely that cold weather will cause demand to spike in both Belgium and France. Even if  the 2.014 MW of the Belgian nuclear power stations is just 2% of the overall production capacity in North-West-Europe, the fact that it is higher than the capacities on both borders points out, that its outage is a serious issue in the balance of getting that market supplied.

There is something which the government can do in the short term to reduce the strain on the system. There are some signals that the total capacity on the Dutch border that is available for exports is higher than the limitation of 1401 MW. The Belgian government should push all it can to increase this availability. The Dutch might be quite willing to do this, as their power producers are hungry to get rid of their excess gas-fired power capacities. On top of that, we should also increase the incentives for industrial consumers to scale down their capacity off-take at peak moments. And we need to train the procedures for making sure that in case of a shortage, those areas are put in the dark where the outages have the lowest economic impact. (We have warned the people in our office that live in the countryside to buy extra candles.)

In the mid to long-term, the government faces an important dilemma, due to the combination of a lack of supply in Belgium with excess capacities in the broader North-West-European markets. The most rational thing that we can do is a massive financial and political investment in the further development of a pan-European power market. Building an extra cross-border connection is simply a much cheaper option than building a new (presumably gas-fired) power station. And we are talking about a connection to the Dutch gas-fired power stations, of course. Also, shouldn’t we finally build that connection with Germany that we should have built years ago? We know that Germany has problems of its own, but we think that building a connection between Belgium and Germany can even help to alleviate those internal German problems. The problem in Germany is not a lack of production capacity, it is a lack of capacity to bring the renewable power produced in the North to the consumers in the South. Another bypass through the excellent transportation grids of Belgium and France can help to solve that issue and at the same time it would reduce another stress factor in the North-West-European power market.

However, we are not very hopeful that our policymakers will choose this most rational option. With all the media attention for the “black-out” issue, politicians might be hungry to show some activism on power supply. And stimulating the construction of new production capacity in Belgium will be more appealing to the public at large than constructing an extra cable. Keeping in mind what Minister Wathelet has written in his latest energy plan, this will probably mean some sort of subsidy for capacity payments for gas-fired power stations. Unless there is a radical rupture with past practice, these subsidies will be passed through in end-consumers’ power bills. Moreover, these new power stations will increase the problem of over-capacity in the North-West-European market. On that majority of hours during which no shortages occur, their subsidized presence in the market will further depress spark spreads. Which is a problem for industrial consumers or greenhouse farmers that have invested in cogeneration units. Most analysts seem to lack the capability of viewing power supply and demand issues on a European scale and stay inside their national borders. The policies that ministers base on this analysis are equally myopic. This tendency is further reinforced by the general mistaken perception that power demand is rapidly increasing and that renewable energy is causing severe balancing problems.

The Belgian power market is having a supply capacity problem. This has been wrongly identified as a problem of market failure. The extra capacities have been built, but outside Belgium. Inside Belgium it was as good as impossible to get permits for building large-scale new power stations. The list of rejected projects is very long. This has brought us in this uncomfortable position of having a power production capacity shortage in a North-West-European market that is over-supplied. Which, we repeat, leaves us only one option: fully embrace European power market integration.

The end of ‘speculation spring’?

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

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

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

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

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

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

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

Gas markets Europe 2010 – 2011

The past month has been a bit low in blogging activity, due to my being busy creating a report on the European gas market. Research of supply and demand figures brought me some surprising insights. You can read an extract of the report by clicking on the link below. Please read the executive summary of the report below. Contact me at benedict@eecc.eu if you want to receive a full copy of the report.

Executive summary

• ‘Energy can only get more expensive’, is a common belief among energy buyers. However, we have recently seen that natural gas prices remained relatively low, even when the economic activity picked up. Oil prices rose, so the gas prices on the Hubs became structurally lower than oil-indexed gas prices.

 

• The biggest natural gas reserves in the world are to be found in the Middle-East and not in Russia. However, the Middle-East are currently only the world’s fourth largest producer of natural gas, meaning that huge reserves are untapped. Gas production in gas reserves giants Qatar and Iran has started to rise exponentially in recent years. This explains the presence of excess gas volumes in the world markets.

 

• The US has increased its production of natural gas by 16% due to the development of shale gas. In 2009 they were the world’s biggest producer of natural gas, bigger than Russia. We have always known that beyond conventional gas reserves, a lot of gas was trapped in this shale layer. Only, it was always thought that it was impossible to produce gas from these layers without excessive costs. Recently production techniques have been improved, and the energy companies claim that it is now possible to produce shale gas at a cost that is lower than the production of conventional gas. The possibility to economically produce shale gas boosts the gas reserves of the world.

 

• Shale gas production has already had an impact on gas prices, as it made more LNG available to the European market as less was needed in the US. If the US continues to expand its gas production, it might even start exporting LNG. There is also potential for shale gas production in Europe and in China. If all this shale gas production is developed, the world’s gas supply situation will look completely different. However, this whole shale gas development could be turned back due to environmental impact of the shale gas production. It is too early to decide what the further development will be.

 

• As of 2011, the Nord Stream gas pipeline will bring additional gas from Russia to Germany, 22,5 billion m³ of capacity in 2011 and 45 billion m³ in 2012.

 

• Natural gas demand in Western-Europe peaked in 2004 and then started to fall. This is contrary to popular belief that energy consumption is continuously growing.

 

• Although the growth rate of power consumption is slowing down, it is still growing. Deployment of electric cars would speed up this growth of electricity demand. Most of these extra MWh’s of electricity are now produced from renewable energy sources. But the growth of demand is faster than the growth of renewable. This means that extra power plants will need to be built. Plans to shut down nuclear power plants in countries like Germany, Belgium, the Netherlands and UK have been turned back, meaning that fewer power plants will need to be built. How much of the new power plants will be gas-fired will depend on whether new nuclear and (clean) coal-fired power plants can be developed. Which plants will be built is subject to political decisions. It is therefore madness to try to predict how much extra gas will be needed for new gas-fired power plants.

 

• A multitude of factors will determine whether gas supply will continue to grow and/or gas demand will continue to fall. Therefore, it is impossible to predict whether the current situation of over-supply will continue or not. The important news is that it is not unthinkable that we might see some decades ahead with abundant natural gas available to our markets, resulting in lower gas and electricity prices. Therefore, corporate energy strategies based on the adagio that energy can only become more expensive, should be adapted. Guidance on how to do this can be found in the conclusion of this report.

Fuel for the dragon

Last month, figures were published that made clear that China has surpassed the US as the world’s largest consumer of energy.  Economic pessimists will probably interpret this as another sign that the Western economies are being surpassed by the Asian economies. It is true that for many years now, the economies of the east have grown faster than our economies. However, you are only surpassed when your competitor is becoming bigger than yours. And if we are discussing economic performance, you should watch for per capita figures rather than absolute figures. If you only watch absolute figures, the tiny country of Belgium that I live in, would never be good in anything. If you look at the energy consumption figures in that perspective, it still means that US energy consumption per capita is four times bigger than the Chinese. So, once again, we should remark that China is catching up rather than surpassing. In the past decades, this economic miracle has lifted 400 million Chinese out of poverty. Who can be against that?

The dragon economy of China has recovered more swiftly than that of any other country from the perils of the 2008 financial crisis. Moreover, it looks like they are managing to reduce the dependency on export (and American credit-based consumption) by stimulating inland demand. As the Chinese become richer (and wages are rising fastly), they buy more and more consumer goods. They also move into higher added value goods, which is a logic step. Being the world’s cheap labor workshop is not a source of sustainable economic growth. The counterside of that economic growth is of course the rise in energy consumption. And this gives rise to some important reflections:

1. Since hitting their lowest point in the beginning of 2009, oil prices have more than doubled again, fueled by the rapid recovery of Chinese oil demand growth. Coal prices didn’t grow as much, as increasing demand was matched by increasing supplies.  However, the evolution of oil prices shows that increasing Chinese demand has an important impact on commodities that are traded on a worldwide scale. This is also obvious in other commodity markets with tight supply such as copper.  What does this mean for natural gas markets, now that they are becoming more and more worldwide markets due to the LNG boom? Will China dash for gas and tap into the reserves of Russia, Southeast Asia and the worldwide LNG markets? And will the newly tapped reserves of shale gas be able to fuel an increase in worldwide gas demand? Will China itself be able to increase its production of gas due to the shale gas evolution?

2. Chinese energy demand growth has a big impact on the global carbon dioxide balance. China is growing fastly in renewable energy and for wind and solar power, it is a key market. But this renewable energy is unable to compensate for the even larger growth of coal-fired power plants. With its newly won status of being the world’s largest consumer of energy, the pressure on China for taking more responsibility in terms of reducing carbon dioxide emissions will be bigger than ever.

3. Even if China is obviously the most important factor in determining oil prices, the market is still looking mostly at the US for its analysis of prices. See this previous entry for more on that. This is due to the lack of good quality data on Chinese oil consumption. In the past two years we have seen the market surprised again and again by unexpected growth in Chinese oil demand. It is clear that an improvement in Chinese energy statistics would make the markets a lot more transparent.

We will have to see in the next years if the Chinese economy can continue its economic success story. Anyhow, it is clear that we will have to look East for information about the energy markets.

Hubbert’s peak or just a bump?

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

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

Meanwhile, what do we observe in the markets?

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

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

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

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

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

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

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

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

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

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

Iraq: the next oil bonanza?

The oil market is buzzing with whispers over the future oil supply from Iraq. The Iraqi government is granting licenses for the giant Iraqi oil fields. The numbers are impressive: Zubair: 4 billion barrels, Majnoon: 12,8 billion barrels, West Qurna 12,9, Halfaya: another 4 billion barrels. As a comparison, Ghawar in Saudi-Arabia, the world’s largest oilfield, is said to have already produced 60 billion barrels. Still, the Iraqi government hopes that the production in these oilfields will allow the country to surpass Saudi-Arabia as the world’s largest producer of oil. They project Iraqi oil production to grow to 11 million barrels per day, five times its current production. Western analysts are more prudent and say that they would be happy if Iraq could grow to 5 million barrels per day.

The most important feature of these oilfields is that they are giant, conventional on-land oilfields at a normal depth and with satisfying pressure and water levels and that they are close to existing oil export infrastructure. This means that production from these oilfields will be cheap. Occidental Petroleum (US), Eni (Italy) and Korea Gas Corp, the three companies that team up for production at Zubair are happy to earn 2 dollars per barrel. They will invest 20 billion dollars in Zubair over the 20 years for which they have won a license. This is a completely different story than the tar sand or deep-sea off-shore oil fields of Canada, Venezuela or Brazil. Oil can be economically produced from these fields only at oil prices far over 50 dollars per barrel.

If the Western oil companies that have now been invited into Iraq manage to produce the oil bonanza for which the Iraqi government is yearning so much, this could mean a huge glut of cheap oil in the markets. The combination of increasing demand and diminishing supply from traditional cheap oil fields like Ghawar or China’s Daqing has produced the peak in oil prices of recent years. The fact that these large cheap oil fields were being replaced by much smaller and more expensive oil fields also caused the extreme volatility of oil prices which made oil prices double again in 2009. Will a glut of cheap Iraqi oil produce more stability and lower prices in the oil market?

The first question is of course whether they are indeed the bonanza that both the Iraqi government and Western oil companies clearly believe they are. After all, these are not newly discovered oilfields. Was it just the crookedness of the Saddam regime that made large-scale oil production from these fields impossible? Or are unexpected technical difficulties awaiting? And if oil production is technically possible, will the political climate in Iraq finally find the stability necessary to allow a stable flow of the oil out and the money in? Will the Sunnis, Shiites and Kurds find peaceful agreement over how to share the booty? Today, the US Marines are leaving Iraq. Is this signaling a final step for the country into a peaceful, prosperous future?

If Iraq could finally come to peace with itself and its oil riches, the question is of course what happens in the rest of the world. The combination of growing oil demand (in China) and declining oil production in other parts of the world like Saudi-Arabia could outstrip the increase in production in Iraq. This is what James DiGeorgia, author of “The global war for oil” believes. If that would happen, that would be excellent news for the Iraqi government. They would cash in the extra dollars between the low price paid to the producers and the much higher price that they would get in a world market characterized by tightness. It’s cynical, but it would be a huge payback for Iraq for all the blood and tears of the past decades. That is, if the oil bonanza doesn’t cause another period of war and terror.

Impossible to see who will prove right, skeptics like mr. DiGeorgia or the Iraqi government. Anyway, with the Iraqi oil bounty looking for its way to the market, a future of rising oil prices looks less certain. In your energy buying strategy, you shouldn’t neglect the possibility of a future of cheaper oil.

2010: bullish or bearish for energy markets?

Energy markets have a terrible habit of rising during the New Year’s period. On the 6th of January of the new year, the oil price ended the day at 81,89 dollar per barrel, well above the 80 dollar barrier that had been a rooftop on the market for the last four months of 2009. In the week before Christmas, the oil prices traded as low as 72,99 dollar per barrel, meaning that we saw a more than 12% price rise during the Holiday period. It looks like some people in the oil market left the table early this year for their trading desk. And it looks like they were in a bullish mood. Such surprise movements at a time when most people are on holiday always feel nasty. It’s like the market not giving you a chance to do something. Fortunately, the bullishness in the oil market didn’t spill over into the other energy markets. And even more fortunately, the bull party was quickly over. At the moment of writing these words, the oil price is back below 80 dollars at 77,22.

What inspired these New Year bulls? I personally believe that it was a clear case of ‘turning the page’ optimism. 2009 was a year of deep economic gloom. But as the end of the year came near, the picture started to look rosier. In their end-of-the year reports, most economists agreed that in 2010 the economy would do better than in 2009. Dubai and Greece were scary, but so far, these issues seem to be brought under control. This ‘things can only go better’ attitude spilled over into the oil market and caused prices to rise. Apparently, this wasn’t supported by fundamentals. The call for extra oil in the physical market wasn’t strong enough to justify oil prices over 80 dollar.

The market of the first weeks of 2010 therefore looks unclear: a rapid bullish start with an equally rapid bearish correction. How will this continue?

For oil markets, the past year has learned us that they are inclined to rise rapidly with the economic outlook. Oil is commodity that is traded worldwide. The improving economy was mostly supported by developments in China, which is doing remarkably well in terms of economic recovery. China consumed record levels of oil in 2009 and this was the main support for higher oil prices. Moreover, the easy-to-produce oilfields have recently been replaced by much more difficult and expensive sources such as tar sands, deep-sea off-shore production or bio-fuels. This causes rapid price rises at even very small increments in oil demand.

For natural gas markets, the outlook is different. Natural gas consumption is much more focused in Northern America and Europe. And these are the regions where the economic recovery and gas demand growth are slow. This has caused an important gap between oil prices and gas prices. Lower gas prices were also supported by reports of expanding gas reserves in the US based on improved recovery techniques for shale gas.

With this jump up and down of oil prices, it looks like 2010 will be another interesting year in the energy markets. The big question on my whiteboard is: will the decoupling of oil and natural gas persist? I’ll keep you informed.