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.

Calculating procurement savings when buying energy

Procurement savings are often the measure of the performance of procurement professionals. In an earlier blog we commented on the risks inherent to this narrow view on procurement. But reporting procurement savings is an inevitable part of a buyers’ job, and why should it be avoided? There is nothing dishonorable about saving money for your employer.

However, when procurement savings are used to measure a buyer’s (or a consultant’s) performance, you better get the metrics right. And in a complex knowledge environment like energy markets, it’s not always easy to be sure that the cost reduction is indeed the result of an individual’s good work. In the past few years, wholesale prices for natural gas and electricity have dropped dramatically. Many buyers have enthusiastically reported the resulting cost reduction compared to the previous year as a cost saving. Now that markets have stopped falling, many are feeling cold sweat about how to report the year-to-year evolutions. Here’s our vision on how purchasing cost savings due to energy buying should be reported (and how not).

It starts with an analysis of what an energy buyer is doing and what procurement savings he can generate with those activities:

1. Energy contracting,
2. Energy trading activities (forward fixing or not fixing & unfixing activities),
3. Energy controlling,
4. Special projects.

1. Energy contracting

Generating savings by negotiating better contractual conditions is a traditional activity of professional buyers. It is important to get a clear view on what improvements have actually been made thanks to the buyers’ activities. The energy price consists of three components:

1. The wholesale value of the gas or electricity, or the price at which the energy is secured by your price fixing actions,
2. The retail add-on, which is the add-on cost added by the supplier to go from the wholesale products, which are flat capacity blocks, to the specific load profile consumed by you as a client with its ups and downs,
3. The grid fees and taxes.

What your wholesale value will be is not decided by your negotiation skills, but purely by the moment at which you are closing it. And grid fees and taxes are in most cases charged on a pass-through basis, meaning that you pay the amount at which they have been set by the regulator and not what you negotiated. Therefore, the only part of the energy bill that you can influence during the contract negotiations is the retail add-on.

Now, if we look at the kind of simple TTF or other Hubs plus add-on contracts that are often negotiated in today’s gas markets, we can easily explain how a saving can be reported. Let’s say that you currently have a contract with a formula TTF + 0,7 euro per MWh and that you negotiate a new contract for 2017 with a formula TTF + 0,4. Then it becomes clear that thanks to your negotiation, your company will save 0,3 euro with every MWh that it consumes in 2017.

However, the calculation isn’t always that simple. In a country like Belgium, suppliers are not charging transportation costs on a pass-through basis but apply reductions to the official tariff. In that case the reduction on transportation should be part of the savings calculation. And for electricity, the retail cost is often based on a complicated formula to go from wholesale to retail price. However, by plugging the same wholesale values in the different formulas, the implied add-on costs can be calculated and compared. In the same way, the implied add-on cost of a fix price contract can be calculated by comparing the retail price that was signed to the wholesale value for the relevant period on the day that the fix price contract was signed.

2. Energy trading

Unfortunately, the performance of buyers regarding their decisions to fix, not fix or unfix forward pricing is often judged based on a year-to-year comparison.  In the past years, with markets going down, that worked out favorably. But what will buyers report in a bull market?

Moreover, if you acknowledge that the savings metrics should reflect the positive results of a buyer’s work, than you should not report every drop in the wholesale value of your energy as a saving. You can be a very good buyer, but you’re not the one that determines whether the market goes up or down. Moreover, if the wholesale price goes down from 40 to 20 and you fix at 35, you might report a saving, but you’re not doing a very good job. In any case, a worse job than someone who fixes at 25 when the market goes up from 20 to 40.

Some organizations might conclude that no added value can be created with energy trading. That is not true. When we look into the performance of companies that we haven’t advised, we see remarkable differences in the quality of the wholesale price management. You’re doing a good job if you:

• Spread your fixing decisions, so that you don’t fix too much when you’re completely on the wrong side of the market. If you fix a lot in one moment, you might also do this at a very good moment, but that is more due to luck than skill, as markets are unpredictable. Moreover, by fixing too much in one moment you are taking too much risk.
• Don’t fix in a falling market, don’t unfix in a rising market. It sounds simple but most energy buyers completely ignore this basic rule and end up with having fixed too much too soon in a downtrend.
• Follow up the market actively, so that you make small fixings every time when a low has been reached and markets start to increase again. Equally, unfix in small portions when markets have reached a peak and start to fall again.
• Have an efficient decision-making process, so that you don’t lose opportunities because it takes you days to make a fixing or unfixing.

If you apply these principles, your price fixing will have good results. These results can be evaluated by measuring them against a market benchmark. Let’s say for example that you are fixing prices in different moments during the year prior to the year of consumption. You could always choose to just buy the average year ahead price, meaning that if your price is higher than that average, the results of your price fixings are negative. You could have better not done any fixings and take the average year ahead price. On the other hand, a price below the average means that you have added value that can be expressed as a procurement saving of the market average minus the price.

You can fine-tune your market average that serves as a benchmark with your global energy strategy goals. Let’s take the example of a client of ours that is a producer of energy-intensive chemical commodities and the pricing of its products is going up and down with spot natural gas markets. Their strategy is to make fixings and unfixings for small volumes, in an attempt to ‘beat the spot market’. In this case we chose the spot market as a benchmark.

Another example is a client in the automotive sector. As prices for its products are fixed for several years, e.g. in seven-year contracts with the car manufacturers, the main goal is to achieve cost stability. Running a diverse portfolio of contracts with car manufacturers, we have chosen to run this cost stabilization strategy in a three-year forward timeframe. When markets reach lows, we make larger fixings for those three years into the future at the same moment. Moreover, we have a strict observance of a maximum year-on-year cost increase of ten percent. In this case, we are using the average three-years ahead price as the benchmark for the performance of this client’s energy trading activities.

The choice of the right benchmark is very important. If the automotive company would choose the spot market as a benchmark, its energy buyers would perform less well. They would be “scared” of making forward fixings, as that jeopardizes the chances of beating that spot market benchmark. Which would mean that they have difficulties achieving the primary goal of cost stability.

You can’t expect to fix prices below market average on every contract for every single year. Sometimes you will fix prices for part of the volume in what was just a temporary uptick, with prices diving even deeper afterwards and your price ending up above the market average. Or you have to take a protective price fixing in a rising market.

The solution for this is to spread your price fixing decisions as much as possible, but that diminishes your chances of having a price well below market average. Therefore, skillful price fixing will strike the right balance between spreading enough to avoid prices high above market average and still make opportunistic (un-)fixings that lead to a price below average.

In a more general sense, in its energy trading efforts a company needs to strike the right balance between managing risk (i.e. spreading fixing and unfixing) and making savings (opportunistic fixing and unfixing) to be successful. A company that puts too much pressure on its buyers to make savings, might end up in the disaster of having taken too much risk. A company that puts all the emphasis risk management only, might forego interesting opportunities to lower its costs.

3. Energy controlling

The involvement of energy buyers in the controlling of energy costs can differ widely. In some companies, the buyer is responsible for setting up budgets, checking cost versus budget and validating bills. In other companies this is done by the financial controlling department. When buyers are involved, management will often want to see results of the energy controlling in terms of savings.

Defining savings through energy controlling is quite simple. For example: the buyer checks the bills of one of his US plants and finds out that the wrong utility rate is applied. He writes a letter, conducts negotiations and in the end a 350.000 dollar refund is granted and paid to the client. This can be reported as a 350.000 dollar saving.

Some companies might have reservations for calling this a saving. It is a rectification of a mistake, a refund of money that the company shouldn’t have paid in the first place. On the other hand, if the energy buyer hadn’t done his job properly, the mistake might have passed undetected and the 350.000 might have never been returned. For the buyer, reporting the 350.000 might be a great success, especially if he has a bonus arrangement based on savings. On the other hand, he needs to realize that such successes depend on being “lucky” that your supplier or utilities send out wrong bills. For the company’s cash flow, receiving a correct bill in the first place and not getting refunds is the better option.

The buyer and his company should also realize that not all mistakes will lead to a refund, they might also lead to an extra bill. From our energy controlling activity, checking thousands of energy bills every month, we can say that 50% of the mistakes in energy bills are to the advantage of the clients. The 350.000 dollar extra bill sent by the utility that has detected its mistake, will obviously never be accepted as a “saving” … However, if the energy buyer detects that mistake, he’s doing a good job, as he can help his company to put aside the money for when the correction comes in.

Putting too much emphasis on savings through the financial controlling activities can also lead to over-opportunistic behavior. This is a particular danger when such controlling services are delivered by a consultant on a no cure – no pay basis. Of the mistakes that we detect in energy bills, some 60% are “differences in interpretation” rather than real “mistakes”. An opportunistic buyer or consultant might hurry into declaring that difference in interpretation a mistake so that she/he can claim the saving. This leads to the reporting of fictitious mistakes and paying of pay for a cure for a problem that wasn’t a problem in the first place. Moreover, aggressive claiming of mistakes can antagonize suppliers without need.

An example will illustrate this. We once took over a client from another consultant that had been working on a no cure – no pay basis. For its French plant, the client had signed a natural gas contract in which it had agreed to pay a fixed amount every month for transportation of the gas. The agreement stated that at the end of the year, the real cost of transportation, based on the official tariff would be calculated and an invoice or credit note to settle the shortage or surplus amount would be sent.

In July, the consultant calculated the amount that was due according to the official tariff, found out that it was lower than the fixed amounts that had been billed, sent a letter to the supplier to claim back the surplus money that had been paid to the supplier and an invoice to the client for the 50% commission on this so-called “saving”. Needless to say that both supplier and client were not very happy with this behavior. However, in a company where the buyer is receiving a bonus when reporting savings by energy controlling, that buyer might be tempted to work together with the consultant in claiming the saving.

4. Special projects

Energy buyers can be involved in many different projects that lead to cost savings, such as:

• The implementation of auto-production, e.g., a CHP unit or a PV-installation.
• Filling in forms to get a reduction of a regulated price component, e.g. the EEG tax in Germany.
• Setting up a demand-response program to benefit from the highs and lows of spot markets.
• Marketing of interruptible load to benefit from a capacity program.

Calculation of the savings caused by such special projects is to be determined on a project-by-project basis. Such calculus will always be based on a “before” and “after” situation. It should be taken into account that the world of energy markets is very dynamic with all factors changing continuously.

To give a – at first sight – simple example, a PV project. The saving might be calculated by simply saying: “last year we paid 1,5 million euro, now, we pay 1 million, so we made a 500.000 euro saving thanks to the solar panels on our roof”. However, it could be that in the current year, the wholesale electricity market dropped, causing the cost of the remaining power that you consume from the grid to drop by 300.000 euro. Therefore, the saving thanks to the solar panels is 200.000 euro rather than 500.000. A better measurement of savings could therefore be to take the amount of energy produced by the solar panels and multiply that by the price that you paid for the remaining off-grid electricity.

And even that isn’t correct. Due to installing the solar panels, what you pay for add-on cost and usage of the grid will have increased. If you’re very good at interpreting energy cost components, you might be capable of calculating that this means you paid 25.000 euro more for the electricity than you would have paid without the solar panels. Meaning that the real saving is 175.000 euro. As you can see from this example, savings metrics in energy buying is never a straightforward matter.

The involvement of the energy buyer in such special projects might be anything from having initiated them, to be involved in all steps to just getting called in when the contract has to be signed. Too much focus on making savings, can lead to this ‘being called in at the last moment’ phenomenon. Too many companies still consider their procurement professionals as the people you call in to squeeze out a price concession. That’s a pity, as involvement of procurement from the very first steps in a project will lead to much more added value, as they can help to:

• Make a better analysis of the needs.
• Have a broader view of the market in which the project can be bought.
• Keep potential suppliers and project partners sharp from the very first moment.
• Tender competitively instead of getting heavily involved with just one potential project partner.
• Have a better view on the structure of energy costs so that the calculation of the savings and payback of a project is more realistic.

Having procurement professionals involved in special projects can increase the savings that they cause. But again, too much emphasis on those savings can lead to sub-optimal results.

Conclusion: be pragmatic when applying procurement savings metrics in the field of energy buying

From the examples given above, it must be clear that the usage of savings in energy procurement is a delicate subject. It is impossible to set up a system for measuring savings that makes sure that every 1 euro savings reported by the buyer results in 1 euro extra for the company’s financial bottom line. Moreover, a good energy buyer will have many added values that are not measurable. Too much emphasis on reporting savings can cause such intangible added values to be neglected.

On the other hand, saving money for their organizations should always be the fundamental driving force of procurement professionals. In this article we have given some ideas of how pragmatic energy procurement savings metrics can be implemented. Applying them will motivate your energy buyers (and consultants!). However, be aware that such measurable savings are not the only added value that they can deliver.