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.

A decade of low energy prices?

Written by Benedict De Meulemeester

In March / April of this year, energy prices across the globe hit historical lows. The Brent oil price dropped to 27,88 dollar per barrel, WTI to 26,21. The price of coal for the world markets dropped to 36,55 dollar per ton. Natural gas in the US (Henry Hub 12-month forward strip) traded down to 2,11 dollar per MMBTU, European gas for next year (TTF) dropped to 13,02 euro per MWh. With fuel prices that low, it’s not surprising that power prices hit historical lows as well. The German baseload electricity price for next year dropped to 20,85 euro per MWh. Pricing in the US is very scattered, but the price for Northern Illinois as an example, traded as low as 25,30 dollar per MWh. Since then, prices have rebounded, but they remain at very low levels. Oil is currently trading just below 50 dollar per barrel, less than 11,8 % of the prices seen in the last ten years were better than that.

For buyers of energy this opens up important questions of course. Should you take this historical chance and make long-term fixings? Or are the supply and demand fundamentals supporting this bearishness so strong that we are heading for a decade of low energy prices, so it’s better to stay in the spot market? Some insight into what has been driving prices in the past decade, will teach us that giving a definitive answer to this question is impossible. Hence, the best bet is to prepare for both scenarios.

What on earth happened to peak oil? In the period 2000 – 2008, prices of energy and other commodities increased steadily to reach peaks in the first six months of 2008. An old theory that was popular in the 1970’s was revived. It assumes that production of energy resources follows the path of a bell-shaped curve whereas demand just continues to increase. Once the right-hand side of the bell-shaped curve has been reached, there is an inevitable supply crunch (peak oil). The maker of this theory, M. King Hubbert, was relatively successful in predicting the moment of the crunch in US oil supplies, giving him some credibility. An increasing number of energy market analysts interpreted the energy price bullishness as proof that peaks were occurring (Peak oil! Peak gas! Peak coal!). 8 years later, with prices at these historical lows, the declarations of the peak theorists seem ridiculous. A quick visit to the website of their association http://peak-oil.org/ will make most of us smile, or worse, get annoyed at the lack of empirical backing of what is said, e.g. that the production of oil has been almost flat since 2005, whereas in reality we’ve seen an increase of almost 12%.

Nevertheless, way back in 2008, the peak oil idea had a huge following. Goldman Sachs forecasted an increase of the oil price to 200 dollar per barrel. Many energy buyers fixed prices at the high levels of the first six months of 2008 as they believed the scary stories of ever increasing energy prices. I remember a meeting with the CEO of a big company that said: “we all agree that energy prices can only increase, don’t we”. Why were business people so easily scared into thinking that energy prices could know only one direction: up? First of all, I think that most of us have a hard time not to think in trends. It takes a lot of guts to believe in a decline when for months and months, even years and years, prices have continuously increased. Secondly, when it comes to energy pricing, many of us tend to be pessimist, energy is always too expensive, never cheap. Thirdly, the idea of scarcity was nurtured by environmentalists. When you can’t motivate people to reduce energy consumption for the sake of the environment only, fear of higher prices might be quite helpful. Eight years down the road, and on the other side of the price ranges, it might be tempting to think the other way around, to believe that the decline can only continue. Thinking back about 2008 can be a powerful reminder always to expect the unexpected, to run an energy buying strategy that is ready for the changes in the trends.

If we look at the long term developments in energy markets, we see a pattern of continuously low prices, temporarily interrupted by sharp upticks. This is caused by the way elasticity, the adaptation of supply and demand to price evolutions, works in energy markets. On both sides there is elasticity, but it works slowly, with significant delays. And the delays tend to be longer on the supply than on the demand side.

On the demand side, short term reactions to prices can occur in the shape of fuel switches, e.g. an industrial using fuel oil instead of gas for producing steam. Mid-term, consumers can lower their consumption when prices increase with behavioral efficiency gains, e.g. driving less kilometers with the car or decrease the temperature in one’s house. On the other hand, if prices are low, consumers will become more profligate. Long-term changes in energy demand due to periods of high or low prices can be caused by investments in structural energy efficiency improvements and by the effects of high or low energy prices on the economy. It would be far-fetched to say that the economic crisis that started in 2008 was caused by high energy prices, but it is clear that there was a link. Another example of this can be found in the 1980’s when the high prices of the 1970’s resulted in a sharp economic crisis resulting in much lower energy demand and two decades of low prices.

On the supply side, short term reactions occur in the shape of marginal cost decisions not to produce when prices have dropped below production costs. These reactions cause a continuous rebalancing but no structural price movements, as the capacities come back online as soon as prices increase above the production costs. More structural adaptations can be found on the mid-long term when installations are shut down when prices are too low. However, due to the high stranded costs of energy production installations, this shutdown is often rather temporary (the installation is “moth-balled”) and can be undone as soon as prices increase again. In the same fashion, we often see a supply side correction when prices are very high in the shape of bringing very old installations back online. The real structural adaptations of supply to price occur in the shape of production capacity adaptations by investments or lack of it in new production facilities. And the terms can be very long. The construction of a new power station, an LNG export terminal, ships for transporting coal, the development of an oil or gas field, etc., they can take more than a decade before the first energy is available to the market.

Having these elasticities in mind, we can perfectly understand what has happened in the energy markets in the last two decades. The strong global economic growth of the late 1990’s and early 2000’s with the exponential growth of emerging economies and China caused a voracious growth of demand for energy and other commodities. As of the mid 2000s this started to result in supply shortages causing prices to increase rapidly. Many decisions to invest in new production capacities were taken, but most of them only hit the market as of 2010. In the meantime, mid-term demand adaptations started to occur, we saw e.g. Americans choosing more fuel-efficient cars, causing a slow-down in demand growth. As of the second half of 2008, demand was slashed by the economic crisis which, as I’ve said before, was partly linked to the higher energy prices. This resulted in a sharp reduction of prices. When as of 2010 demand started to pick up again, supply extended more rapidly, resulting in a new supply glut that ended in the historically low prices of the beginning of this year. The recent bullish correction can be explained by higher demand and the mothballing of older production capacities.

It is however too early to say whether this is the definitive turnaround. It is clear that investments in new energy production capacities are slowing down, as we can see in this graph from the IEA with figures until 2013:

Source: Special Report: World Energy Investment Outlook, International Energy Agency, 2014, p. 20.

At some point, this slowdown in investment will result in a supply crunch such as the one that we have seen in 2005 – 2008. Whether that will be next year or whether we will see a decade of low energy prices is impossible to say. A lot will depend on how demand evolves in the meantime. Will we see another period of rapid economic growth or not? Moreover, we are seeing an increasing drive towards higher energy efficiency on a worldwide basis, meaning that more economic growth means less energy demand growth. This efficiency drive in the framework of climate policy started in Europe that has seen its primary energy demand drop by more than 10% since 2006 (although in 2015 it increased again for the first time in nine years). It is now being copied in more and more parts of the world. Will this keep down demand growth sufficiently for prices to remain low?

Slow elasticity sometimes leads some observers to the reasoning that the normal laws of economics (Adam Smith’s invisible hand) don’t work in the energy markets. They are wrong. Trends such as the sharp decrease of energy prices seen in the last five years do end at some point. Whether the recent turnaround is just temporary or the beginning of a longer period is impossible to forecast. Therefore, as an energy buyer you better prepare for all scenarios.

Go long or go short?

Written by Bart Verest

“I think we should buy all of our electricity and gas needs for next year’s delivery because I’m risk averse and don’t want to miss this opportunity”. It’s a statement I’ve heard quite often in the past few years. Sometimes, it’s followed by the reaction of another stakeholder who, on his end, wants to “take some risk and leave volumes open on the spot market”.
This example brings two important risks to the surface when buying energy.
Sometimes the personal appetite for risk is projected on the company the buyer is working for. In itself this is a natural reflex – people use their personal experiences and vision to perform their job. Nevertheless, it is important to keep a clear line between your personal preference and the interest of the business. Only then will you be able to set up a successful procurement strategy that aligns with the risks and interests of your company. If due diligence matters to you, then you should focus on the interests of your company rather than on your own personal beliefs or risk appetite. Putting your agenda ahead of that of your company can harm both you and the business in a personal and financial way.

We often see that the personal definition of risk is equated with the definition of risk for the company. On one hand, you will have people who see volumes floating on the spot market as a risk because of the unpredictability of spot pricing. On the other hand, you will have people who argue that hedging forward volumes is a speculation on the future price evolution and that a buyer shouldn’t speculate on this. In themselves, both statements are incorrect. Whether or not hedging volumes / leaving volumes open on the spot market constitutes a risk depends on the business model of the company. To explain this a bit further, I can take extremes on both sides of the spectrum as an example. On one side you have company A that makes long-term pricing arrangements with its clients. In order to do this, they look some three years ahead and estimate all costs to determine the final product price they will agree on. Their energy cost is naturally included as part of their calculations and therefore has to remain stable for the next years. If they end up with a price that is higher than the one they agreed upon, they lose margin. In this case, leaving (too much) volumes open on the spot market is rightfully considered a risk because it represents a mismatch between their pricing model and their business model. On the other side you have company B that meets every quarter with their clients to agree on a product price for the next quarter. In these quarterly agreements they have clauses where they pass-through the energy cost. If they fix prices for the next three years and the energy markets drop, they will lose margin as their clients force them to lower the prices they charge for their products. In this case, it’s buying (too much) volumes on the forward market that represents a mismatch between their business and pricing model.

Therefore, answering the question “go long or short” should have nothing to do with the personal convictions of the energy buyer regarding future prices or his/her appetite for risk. It should be based on a long-term energy buying strategy that aims to reduce the impact of energy market volatility on a company’s bottom line. In my presentation at this year’s “Transatlantic Energy Conference”, I will give practical examples of how companies from many different industries managed to take control over their energy costs by setting up such a strategy.

Click here to register for Amsterdam: https://www.eventbrite.com/e/transatlantic-energy-conference
Click here to register for Chicago: https://www.eventbrite.com/e/transatlantic-energy-conference-2-united-states-tickets-21030478728

 

Price transparency, the key to more effective energy price management in the US

Not all large U.S. energy consumers manage their natural gas and power prices in the same way. For natural gas, many have adopted a more advanced approach, buying with contracts that allow for advanced price management techniques such as layered purchasing. For power, most U.S. customers take a different approach – taking either a fixed price or a spot price, and limiting their ability to actively manage their budget through price fixings in the process. Why even opt for this second approach? One major factor is the lower degree of price transparency in U.S. wholesale power markets compared to Henry Hub for gas. That said, there is no logical or economic reason for approaching power price fixing differently. As one client remarked recently: “We’re spending twice as much money on power than on natgas, and 80% of the time we spend on energy pricing, we’re talking about the gas bills”.

How U.S. industrial energy consumers can improve their natural gas price fixing practices

Deregulated natural gas prices in the U.S. are almost always linked to Henry Hub pricing. Those industrials opting for fixed prices contract can simply follow the ups and downs of Henry Hub forward prices on NYMEX. For those gas consumers that want a more managed approach, contracts can be set up whereby prices are layered-in – in other words, consumers can lock-in a certain percentage of their volume – for a certain period – at NYMEX-traded prices for those periods.

Buying natural gas is a tricky business because it involves a double moving target. Not only do you have to deal with the volatility of Henry Hub pricing, but you also have basis pricing to worry about. Your end price depends on the pricing differential between your local hub and Henry Hub. Depending on where your gas is produced or imported, supply / demand dynamics will be more or less favorable compared to the conditions at Henry Hub, resulting in a lower or higher price for the gas. This differential is then reflected in the basis price.

In recent years, for example, we’ve seen basis pricing for West-Pennsylvania and Ohio drop to negative levels due to the shale gas production. Moreover, gas marketers need to book the physical capacities on the network to bring the gas from the production site and these costs are added to the basis pricing. This gives rise to important differences in regional gas prices that change over time. During the Polar Vortex, for example, the increase in Henry Hub commodity pricing was amplified by huge increases in basis pricing in certain regions.

Many US gas consumers are only vaguely aware of the impact of basis pricing on their natural gas spend. All their attention goes to hedging their Henry Hub price and they completely neglect basis pricing. But as you can see from the graph above, basis pricing adds as much volatility risk to your final price as the Henry Hub component.  A sound natural gas price management strategy will therefore take into account basis pricing as well as Henry Hub. It can take some time, but you can often find wholesale market information that gives you a good indication of what basis pricing you should expect. This can help you to select different moments for hedging your basis risk, which often doesn’t coincide with a good moment to layer in hedges on Henry Hub. Moreover, suppliers offer solutions where you can hedge basis in layers, in the same way you spread your commodity buying decision to reduce risk. With some efforts, both of the double moving targets involved in gas pricing can be effectively managed.

How power can be managed in the same way as natgas

Whereas natgas has a pricing system with one reference price for the whole country and basis pricing for different locations, power pricing is based on different wholesale price references. In the State of Texas, for example, there are no less than 4,000 different spot prices. Many of the consumers we speak to have no clue to what specific wholesale price reference their power price is linked to. They are equally unaware of the myriad of forward pricing products suppliers base their fixed price offers on. Many of them are also oblivious to the fact that, just as for natgas, suppliers offer the possibility of layering in power prices, allowing for more active price management.

By managing basis pricing for natural gas and using advanced price management techniques for power, U.S. companies can optimize the way they manage their budgets. While it’s true that floating with the market has often been the better choice given the bearishness of energy markets these past few years, it should always be kept in mind that going on index doesn’t offer any protection when markets turn around. Many customers were reminded of that during the Polar Vortex, when their monthly energy bills exploded. This is especially harmful for so-called ‘budget risk’ clients, businesses that do not have the option of passing on higher energy costs to their customers. For them, it’s a good idea to have contracts with layered forward purchasing features in place for when markets turn bullish. At historically low prices and with the US self-confidently increasing its production year after year, it is tempting to believe that low prices are here to stay. They will not – what comes down must go up. And if they do, many US customers will feel sorry that they didn’t lock-in some of the current low prices for future years.

 

 

How to deal with the volatility in the oil markets

Written by Frederic Grillet

These last few months we’ve seen oil prices bouncing up and down. Intraday movements between 5 and 10% were not uncommon. Current price levels, which are approximately 70% lower than their peak levels in june 2014 and are the lowest that we have seen in 10 years, seem to cause investors to overreact to every rumour in the market.

Brent front-month prices started January at a price level of 37.28 $/barrel and dropped 34% to 27,88 $/barrel on 20 January, only to rebound 25% by the end of the month. The main causes of the price surge were a vague statement by ECB-President Mario Draghi hinting on potential monetary measures to boost the EU economy and a rumour that OPEC & Russia were discussing a potential production cut.

Despite the fact that oil markets have always been quite susceptible to speculation, which amplifies any trend in financial markets, this volatility seems to edge on irrationality. The oil market has a structural problem of oversupply, with production having exceeded demand with 1 to 2 million barrels per day (depending on the source) over the past years. The US Energy Information Agency has indicated that it expects an average oversupply of 1.75 million barrels/day for the first half of 2016 as well, while crude inventories in the US are at record highs above 500 million barrels. An agreement amongst global oil producers, which is looking very difficult due to a variety of reasons, could of course address the issue from the supply side, but the demand outlook remains weak with major economies, including China, showing signs of a slowdown.

Although the downward trend in oil prices was strong in the past months and has reached historically low levels, the fundamental issues in the markets have not yet been resolved and no solution seems to be in the making for now. The very strong upward and downward movements despite the lack of changing fundamentals shows that price levels have entered a territory in which trends are mainly caused by speculators hedging their long and short positions.

Impact on other commodities

EU gas & electricity markets are generally shaped by a variety of factors, though for January, the trends showed that the main driver for prices were the oil prices. Markets in all countries have therefore seen a very rocky start of the year. The main question here from a procurement point of view is whether this volatility marks the start of a structural trend change after last year’s general downward trend and whether it is necessary to start taking bigger positions.

So when do you hedge?

Volatile times like these prove the value of the combination of market analysis and a strong purchasing strategy. The market analysis allows us to identify the opportunity moments, i.e. when markets start turning around. However, as the last months have shown, it is never a sure bet whether that is only a temporary or a fundamental turn of the trend. Hence the importance of spreading your hedging decisions and fix in small incremental amounts. In the end, how much you hedge and how far into the future should depend on your strategy. If your main risk is budget variability over the long term, than you can take large positions for many years into the future, although you should always do that in small incremental amounts. If your main risk is having an uncompetitive energy price, you should be much more prudent and make only small opportunistic fixings.

A long downward trend, as we have seen in the EU energy markets, tends to spark an urge to take bigger bets in the markets, e.g. by opting for fixed energy prices for years ahead, Although a bet can sometimes turn positive afterwards, it remains a bet and should have no place in a professional business. Therefore, although it would be a good idea to check whether the current movements in the markets make it necessary to take a position in your portfolio, it remains very important not to be seduced to overreact to an overreacting market.

Looking for more market information? Order free trials over here.

On buying and selling of forwards as an energy price hedging technique

In many countries, energy markets seem to have reached a new level of maturity with buyers looking for new products that allow them to deploy more sophisticated price hedging techniques. One of those is the selling back to the market of forward positions that have been fixed before. This buying and selling of forwards is sometimes presented as a miracle solution that inevitably brings ultra-low energy prices. It is true that adding the selling of the forwards to the hedging toolbox opens up new possibilities. If well applied, it can produce good results. But we don’t see that every client that sells positions as well as buying them pays much better prices than clients that don’t do it. It is not a miracle solution. Moreover, we sometimes see it being deployed without appropriate risk management. And that sometimes leads to disaster rather than miracle. Before considering the selling of forward positions, it is key that a buyer understands the ins and outs of this sophisticated hedging technique to the last details. It’s not something that you can explain in a few simple sales slogans.

This hedging technique of buying ánd selling is often confused with portfolio management. If you enter a portfolio management agreement, it means that you mandate somebody outside your organization to take the price hedging decisions for you. That portfolio manager will probably want to use the full scale of hedging tools, including the selling of previously bought forwards. But portfolio management is possible without the selling technique. And you can deploy buying ánd selling without the help of a portfolio manager.

When I talk about this hedging technique of buying ánd selling, many clients debunk it as being too risky, too speculative. On the other hand, most traders find the fact that traditional multi-click or tranche model contracts don’t have the selling option too risky. Both are right. By having the possibility of selling a forward contract if markets start to fall after you’ve fixed your price, you can reduce the price risk. But because it is a more sophisticated hedging technique, the risk of something going wrong is higher. This means that buying ánd selling adds system risk to your energy procurement.

To deal with this higher risk of something going wrong when applying buying ánd selling of forwards, it is essential that you have a good understanding of how it works. The basic principle looks simple. You buy e.g. at 40, you sell that position at 60 and then buy it back at 50. Your ultimate price will be: + 40 – 60 + 50 = 30. You have optimized your original position by the 10 (euro per MWh, e.g.) drop in the market. This is the simple + – + logic of applying buying ánd hedging. From it, you can derive two very simple rules for applying it successfully:

1. Buy in a rising market
2. Sell in a falling market

In theory, it looks dead simple, but in practice I see that even clients that have applied buying ánd selling for years make mistakes against this simple logic. For example, they get sloppy about their original buying positions, forgetting that the better your original price, the better your ultimate price. Or: they don’t want to sell at a price below the original buying price, losing valuable possibilities of improving the price in a downtrend. A third example of a misconception occurs when clients sell as soon as the price has risen above the original buying price, being too eager to cash in the ‘profits’ on the original position, but forgetting that they will have to buy back. To avoid such pitfalls, it is essential that everybody involved in the decision-making understand the basic + – + logic of this hedging tool.

Another misconception that I often hear is that people think that buying ánd selling is an energy procurement strategy in itself. It’s not a strategy, it’s a hedging tool. And how you apply that tool depends on your broader strategy that should be based on a thorough analysis of the type of risk that you’re exposed to in the volatile energy markets. Buying ánd selling can be used to optimize price results within the broader strategic goal of stabilizing energy budgets. But it can also be used by clients that have the opposite strategic goal of wanting to safeguard that they have competitive energy prices. Defining your risk limits and applying risk monitoring tools such as value-at-risk should help you in deploying buying ánd selling without excessive risk-taking.

If markets would move in straight lines, it would be very simple to be successful in buying ánd selling forwards. You would just buy everything if the straight line up starts and sell everything if the straight line down starts. But that’s not the reality of the markets. The price goes down for two days, then increases again, down again, etc. It’s this unpredictability of the markets that makes the application of hedging techniques so difficult. Some clients try to get around this by applying machine gun tactics, buying and selling at every first sign of an up-, resp. downtrend. That often results in big losses. I believe that it’s much safer to apply the piecemeal tactics, building up and down your positions in small steps, using your value-at-risk calculations to avoid excessive losses. I also recommend buyers to have patience. The real big gains are made in the big up- en downtrends. These don’t occur every year. If you trade too frantically in and out of every small intermediary trend, you’ll start piling up losses.

Operationally, the most important recommendation I can make is: apply the four eyes principle. Make sure there is at least one other person in your organization that completely understands the hedging technique to avoid disaster. Consultants such as E&C can also have an important role in deploying this sophisticated manner of hedging prices. I recommend to avoid black box solutions and to only use consultants that share all their information with you. Consultants should act as risk management consultants in the first place. The same is true with portfolio managers. Make sure that they are not taking excessive amounts of risk on your behalf by putting the necessary risk management practices in place.

Buying ánd selling of forwards is a powerful energy price hedging technique. It reduces the energy price risk by giving you the chance to reverse buying decisions. And it optimizes your chances of making really good prices as it allows you to benefit from downtrends in the market, and not only uptrends. However, it is also adds a next level of complexity to your energy price hedging. And because of this complexity, things can go wrong. If you want to adopt this hedging technique, I recommend the following steps:

• Make sure that all the people in your organization involved in the energy price decision-making process understand how it works. Don’t use an instrument that you don’t understand. Don’t outsource because you don’t understand.
• Hire a consultant to help you understand the technique completely and at least check that you have no misconceptions.
• If you hire a portfolio manager, make sure you are capable of checking his operations as a risk manager should do.
• Set up a good energy procurement strategy based on a good qualification of your energy market risk exposure.
• Develop good monitoring tools that everybody involved in the energy procurement understands.
• Be patient. Go for the long term trends and not for the short term gains.
• Develop your buying or selling positions piecemeal.
• Use value-at-risk calculations to manage the risk.

Good consultancy is based on an open and free exchange of knowledge. In this perspective, I have written a whitepaper on this topic of buying ánd selling of forwards as an energy price hedging technique. This blog article is a summary of that whitepaper. Send an e-mail to Joke at joke@eecc.eu to get the full version.

Why spot contracts are not immune to volume risk

Readers of my previous blog article (in Dutch) will have remarked that I was quite agitated by misleading sales of spot contracts to end consumers. I would want to come back on a specific issue, the volume risk, and write a separate blog article in English on.

 

“No volume risk” is often cited as one of the advantages of a spot energy contract. And indeed, these contracts don’t have “volume conditions” in the sense of minimum or maximum volumes that have to be / can be consumed. Many buyers of energy have gone through agonizing experiences when they ran into the threshold levels of such traditional volume conditions. This was particularly a problem in 2009. Many industrial consumers of energy saw their consumption drop below levels that they hadn’t anticipated even in their worst nightmares. Moreover, many continental European energy contracts at that moment still had minimum volume conditions of a type that we call ‘hard take-or-pay’. It means that any energy that isn’t consumed needs to be paid for anyway at the contract price. But even those consumers that already had ‘soft take-or-pay’ conditions suffered. In a soft take-or-pay settlement, which has become very common, you pay the contract price and get back the spot price. As the reduction of consumption in 2009 struck many consumers, the overall demand for energy was going down. This caused spot prices to drop sharply. Therefore there often was a very big difference between contract prices that had been fixed in the bull markets of 2007 and the first half of 2008 and bearish spot prices for unconsumed levels of 2009. So, even with such soft take-or-pay arrangements, clients still had to pay a lot of money for unconsumed energy.

 

Of course, for anyone that has had to report to his management the payment of a few hundreds of thousands of euros for not consuming energy, the proposal of a contract without any such volume obligations sounds very tempting. And indeed, a spot contract is a ‘you only pay what you consume’ type of contract. Some such contracts really look at what you consume on an hourly basis and multiply that with the spot price for that hour. Most spot contracts look at the monthly consumption and multiply that with the average spot price for that month. So, even if your consumption drops to zero, no problem, no energy will be billed. If your consumption doubles, you’ll pay the spot price for that extra energy. No more thresholds to keep an eye on, just simply pay for what you consume. I can understand why some people call that ‘no volume risk’. But I don’t agree with them. Not at all.

 

First of all, it should be remarked that the zero volume risk proposition only holds as long as you keep everything open for the spot market. Many such spot contracts also have clauses that allow you to forward fix your prices. Such fixings are then always made for capacity blocks. Let’s say you are a client with such a spot contract and you expect you will consume 60.000 MWh next year and you want to fix your price 100%. Your supplier will come back to you with something like ‘OK, your load duration is 6.000 hours on an annual basis, so I’m going to fix a 10 MW Calendar year block for you’. If your contract is then regulated based on monthly consumption times the average spot price for that month, every month that you consume less than 5.000 MWh, you will pay the fix price and get back the spot price for the unconsumed volumes. If your consumption is higher than 5.000 MWh, you will pay the spot price for those extra volumes. If at the end of the year the aggregated volume of the months is 60.000 MWh, the volumes you haven’t consumed and for which you got back the spot price (in certain months) will equal the extra volumes bought at spot price (in certain months). If you’re lucky, you might have consumed less in exactly those months when the spot prices were high and more in the months with low prices. You could actually make some extra money that way. But it could also be the other way around.  The opportunity and risk are even higher when you have a contract that settles on an hourly basis. It should be remarked that in that case, an extra problem occurs of checking such bills based on hourly consumptions, fixed levels and rates.

 

The volume risk of forward fixing a capacity block can be reduced by buying ‘structured blocks’, meaning that you will use calendar, quarter and month products to fix capacities that correspond with your expected monthly volumes. For electricity, such structuring is further complicated by the fact that you have to construct a structure of base and peak-load blocks. However, unless you have a 100% accuracy regarding your volumes forecast, you will never be capable of making a fixing that exactly corresponds with your actual volumes consumed. And it certainly means that you find yourself in real big risk of having a big extra cost due to volume issues when you’ve fixed 100% of your expected volume and your consumption turns out to be structurally lower. If this coincides with a period of low spot prices (like we’ve seen in 2009), you will find your energy costs exceed the fixed price level (at which you probably budgeted) very rapidly. Same thing when a period of larger than expected consumption coincides with high spot prices. In those cases, you will experience that the old contract with its volume conditions wasn’t such a bad idea after all. In such contracts, the volume issue only starts to bite once you’ve hit the threshold volumes. For this reason we recommend any clients that want to have a high degree of certainty over what their future energy prices will be to sign traditional forward fixing contracts, even if they come with volume conditions (nowadays some suppliers offer consumers of smaller volumes forward fixing contracts without volume conditions).  If you want to sign a spot contract, only do it when you are willing to keep the price of at least 20% of your volume unfixed and open for the spot market. And if you have a high volume uncertainty, you should keep the price open for the spot market for even higher parts of the volume.

 

But even if you keep 100% open for the spot markets, this still doesn’t mean that you don’t have volume risk. High prices in the spot market often coincide with high overall consumption of energy, that’s very obvious economic logic. That means that consumers that have typical consumption patterns, e.g. consuming natural gas for heating in the winter or consuming electricity for cooling in the summer, have an increased risk of seeing periods of increased consumption coincide with periods of high prices and vice versa. Moreover, in the electricity markets you should take into account the large differences in hourly pricing. If you have a typical peak-load pattern, for example because you consume the electricity in an office setting, the probability of a large consumption in a particularly expensive hour increases. In a cold winter or a heat-wave summer, the combination of increased consumption and higher spot prices can cause serious derailing of budgets.

 

If you look at it in this perspective, the claim that spot contracts are free of volume risk, actually is true only if you look at it from the suppliers’ perspective. The supplier is sure that he will always get paid for what his clients consume at the exact same price at which he has to buy the energy in the spot market. (Or, if it is a contract settled on a monthly basis, a price very close to it.) No risk of having bought  too much for a client and having to sell it in a bearish spot market. No risk of having to buy more in a bull market. Actually, the volume flexibility conditions of traditional (forward) fix price or tranche model contracts are just that: flexibility, a way of reducing the volume risk. They mean that inside the tunnel or bandwith, you are sure of the price you will pay, regardless of what your exact consumption is. An 80% – 120% volume condition protects you against the negative effects on your prices of unfavorable spot market movements. Forward fixing your prices and accepting volume flexibility on that fixing, protects you against budgetary catastrophe in times of high consumption. In many cases, spot contracts are less expensive than forward fixings with volume flexibility. This clearly illustrates that with a forward fixing contract with volume flexibility, risk is shifted from the client to the supplier and not the other way around. And that makes the claim that spot contracts are less risky absurd.

 

This example clearly shows that as a buyer of energy, you need to be extremely on alert when somebody is proposing you something that has no risk. If I have learned anything in thirteen years in the energy markets, it’s that it is very hard to find ‘no risk at no extra price’. The closest thing to it could be the forward fixing contracts with unlimited volume flexibility that some suppliers currently offer to smaller consumers. But spot contracts aren’t a ‘no volume risk’ solution. Every energy contract negotiation is an act of carefully balancing risks and opportunities between supplier and client. A spot contract means a shift of volume risk from supplier to client. That explains why it often comes at a lower price.

Procurement: generating savings or adding value?

Last week I had some interesting discussions with clients – procurement professionals – on the topic of reporting savings. It raised fundamental questions about the role of a procurement division in a company. We are witnessing some contradictory evolutions in corporate procurement practices nowadays. Some of our clients are still making the first steps in centralizing and professionalizing their procurement activities. Procurement tasks are taken away from local managers and a new corporate procurement team is set up at headquarters. But then we see other clients that have gone through this centralization a decade ago and now start to build down their centralized procurement divisions and push the responsibilities for buying goods and services back towards local site (procurement) managers. Is this a normal ‘ebb and tide’ phenomenon inherent to corporate life? Or is there something more going on? I believe that putting too much emphasis on the ‘savings’ made by procurement teams is responsible for this.

As a centralized team takes over the buying of certain categories of goods and services, they start to grab the ‘low hanging fruits’. The volume effects, the synergies and the professionalism of buying centralized often cause massive savings for different categories. It is obviously very tempting for procurement managers to make a lot of noise, “look how much money we have made for the company”. Moreover, setting up a large team of corporate buyers is very challenging in many industrial organizations. Especially when CEO’s have a background in production, they tend to be very skeptic about the value of large teams at headquarters, far from where the real value is created in the industrial processes. It is of course very tempting for the procurement manager to validate the decision that has just been taken to set up a corporate buying team by reporting the large savings made by the initial round of grabbing the low hanging fruit.

As energy procurement consultants, I recognize this temptation. One of the most gratifying aspects of our job is precisely this possibility of making cost reductions. Especially the savings that result from negotiations of contracts can give quite a kick. Last week, one of my colleagues was walking around with that recognizable big smile. He had reviewed the energy contract situation of a client with a large cogeneration unit and saved over a million euro per year with the negotiation of new contracts. It is of course very tempting to broadly “boast” about such savings. They obviously justify our consultancy fees. However, we try to resist that temptation, for a double reason. First of all, it is impossible to perpetuate such savings. They typically occur in the first year of working together with a client when the injection of energy market knowledge allows us to cure what went wrong in buying energy (the low hanging fruit). Secondly, however exciting they are, such savings by negotiations are just one aspect of the added value that we can create for our clients. Therefore, we have always preferred not to put too much emphasis on them. We don’t want to create the wrong expectation that we will make such savings every year and we want our clients to understand that buying energy is not just about making savings by negotiation.

I can only recommend corporate procurement managers to do the same thing. Making a big show of the initial ‘low hanging fruit’ savings round will create a pattern of expectation. The performance of the procurement division will be measured on measurable cost reductions only. You will find yourself struggling with an increasingly complex savings calculus. You will lose a lot of time in discussions with your buyers and with the financial manager over the realism of the reported savings. And especially if the savings reporting system is pushed all the way through to a bonus calculation for buyers, you will find out that it starts to live a life of its own. That your buyers are no longer doing what is best for the company, they do what is best in the (abstract) framework of the savings calculus. I have spent a large part of my professional life in the presence of corporate buyers. And at several occasions I witnessed buyers that “conspired” with the sales people to fake a saving. (For example: savings calculations that are based on differentials between initial, second best, average prices offered and the final price. Buyers ask the sales guy to make a first bid that is high enough. Don’t laugh, I’ve seen this happening before my eyes at least ten times.)

Too much emphasis on the savings reporting inevitably ends in the situation one of the clients I was discussing with this week told me about. He said: “a new CEO walked in and said, ‘I’m tired of procurement reporting astronomic savings of which I’ve never seen a penny in my bottom line’”. The client also told me that procurement in his company was now decentralized again and the corporate procurement team was scaled down. It happens too often that corporate buying teams are restructured because “the savings they generate are no longer justifying the costs”. As my client pointed out rightly: “why are they never asking the same questions about the corporate finance team?”, or corporate marketing? HRM? Because everybody acknowledges the value of doing such activities on a corporate level even if this value cannot be measured in exact ‘euros or dollars saved’.
Everybody will acknowledge that it is impossible to squeeze a lemon indefinitely. At some point, the low hanging fruit is gone. Reported savings inevitably decline (or they become increasingly ‘artificial’). That doesn’t mean that a central procurement team loses its added value for the company at that moment. Looking at procurement from the point of view of one category, namely energy, I see that in large international organizations, corporate buying generates the following added value:

1. Because of the smaller size of what they buy, site buyers will often buy a large number of categories. Corporate buyers can focus on one or more categories and become specialists in them. This inevitably leads to better decisions.

2. Companies shouldn’t just aim at making savings, they should aim at making savings “where possible”. That means that the buyers do all they can to “make the best possible deal, taking into account the market situation”. Professional buyers that are specialized in one or just a few categories are better at that. I observe again and again that local buyers or site managers sign sub-optimal contracts because they lack market knowledge.

3. Negotiating contracts is just one (albeit important) aspect of the procurement job. As they become specialists, corporate buyers can develop other aspects of their job and generate considerable added value with that. When they buy commodities, the procurement specialists can develop and implement the risk management and risk analysis tools that are necessary to protect the company against price volatility. And in products as well as services, buyers’ market knowledge can be an essential component of corporate supply chain management and quality control.

4. Even if cutting away the corporate procurement team is a direct cost saving, this will be compensated by the fact that buyers or site managers have to spend more time on procurement activities.

I recognize the need for metrics to judge a procurement division’s performance. But procurement professionals should avoid that the evaluation of their performance is reduced to savings reporting. They shouldn’t neglect the crucial role they play in the risk management, supply chain management and quality assurance of their company. Too much eye for savings is a dead end street. And moreover, too much emphasis on savings causes a regrettable neglect of other added values created by professional procurement, added values that are more difficult to measure. Everybody knows that reducing the role of the buyer to “the guy that comes in at the end to squeeze the lemon” is a farce. There are much more intelligent ways to do a procurement job and create a sustainable added value for the company. Management should judge their procurement teams on that broader added value.

A risk manager’s approach to buying energy

A few years ago, we used to enjoy the delight of being one of the first companies talking about “the next new thing”. E&C started proposing risk management oriented solutions for buying energy to its clients as early as 2006. We would then often hear clients comment: “you are the first consultants that ever talked to us about such an approach”. This obviously was a key factor to our early days’ success. However, the fate of the innovator is that he will be copied. And, as I’ve noticed again, whilst participating in last week’s energy procurement conference in Berlin, a Unipower conference, it is probably very hard these days to find an energy procurement consultant that is not talking about risk management. Still, I did observe that we still have quite a different take on it. In this blog article, I want to give a summary of my speech last Friday in Berlin, and I hope that it will give you some food for thought on the energy price risk management practices in your organization.

What is risk management? 

Evident as it might sound, from the different presentations during the conference, it became clear that energy buyers have a variety of answers to this question. To start with, people have a different apprehension of what type of risk the subject “energy” is creating for their organizations. I saw some pretty impressive schemes on risk typologies. Some companies selling products to end consumers, might focus their attention on the risk of being perceived as an unclean company because of the burning of fossil fuel. In large companies, the procurement staff might be facing legitimacy risks if they fail to produce energy contracts that are in line with overall expectations of those contracts’ internal stakeholders. A company that is operating on a global scale might focus on the regulatory risk. As each country has its own set of regulations, regional differences can produce risk of delocalization.

As energy procurement consultants we tend to focus on the pure market price risk, the risk created by the volatility of the wholesale energy markets. This is also what I did in the conference and what I will do again in this blog article. This doesn’t mean that we are blind to these other risks, you will find my interest in them expressed in other articles on this blog. I focus on market risk for clarity and shortness’ sake. Regarding other risks of buying energy, and before starting my article, I want to briefly point out the financing risk that is now created by energy procurement. Energy suppliers are increasingly acting as a financial services company for their clients. They procure energy for their clients in the wholesale market. They hedge this energy and they take the financial derivatives for these hedges (futures, forwards, swaps, options) in their own books. They pay the margin calls when these instruments move out-of-the-market. They often pre-finance non-commodity components of the bills: grid fees and taxes. And they deliver all this financial service in the knowledge that in case of a client going broke, they will end up with – best case – three months of unpaid bills. You have to consider that the energy business is one of the few where the supplier cannot shut down the supply in case of non-payment. It is no coincidence that energy companies implement ever more strict credit policies. Most consumers have contracts that stipulate that their energy suppliers are entitled to demand pre-payments, shorten payment terms or demand a three-month bank guarantee if their credit situation worsens. This means that a company in financial distress is now under the added risk of seeing its cash flow position further affected by an energy company exercising this right to cover its payment risk.

However, as I said, I will focus on the market price risk of buying energy. As energy prices have seen 200% volatilities in the past five years, it has become clear that buying energy at the wrong moment can severely impact the financial solidity of a company. Hence the importance of adopting solid risk management practices. But then, even the presentations during the conference made clear that different companies and/or consultants have different views on what risk management means. I know it’s not the most sympathetic way of doing it, but still, I want to start with a negative definition, making clear what, according to me, risk management is not:

• Risk management does not equal market analysis. Obviously, if you are not aware what the markets you buy energy in are doing, you are running a serious risk. But contrary to what many companies think, just knowing what the market is doing is not enough to manage your energy market price risk. I am always surprised when presentations on risk management are for the largest part made up of slides with market information.
• Which brings me to my favorite topic of risk management vs. forecasting. Some companies and consultants take their market analysis a step further and pretend that they can figure out what prices will be in the future. This knowledge is supposed to protect you. However, this is false protection as even the most fanatic energy market forecaster will at the end of his presentation always show a fat disclaimer saying that you shouldn’t believe anything of what he just said.
• Risk management is not about managing your contract. We still get that question regularly: “we have just signed a multi-click or tranche model contract, can you help us with doing the risk management for this contract”. That’s not the right way, it is the other way around. The contracts you sign are the tools to execute your risk management.
• Risk management is not just about applying hedging techniques. Caps, floors, collars, straddles, etc., they sound very impressive. But just applying them is not managing your risk. Like contracts, hedging techniques are tools to execute the risk management, nothing more.
• Which brings us to an aspect that is often over-looked. Risk management does not equal trading. On the contrary, one of the main things you need to do if you want to avoid the risk of an energy trading catastrophe is separating your risk management from your trading. Edouard Chevalier, the speaker of GdF-Suez during the conference used an interesting image in that perspective. He described the GdF-Suez trading floor, explaining about the traders in the middle and the risk management people by the side. Do you remember Nick Leeson? The rogue trader that brought down British reputed financial institution Barings Bank by making wrong bets on the Tokyo stock exchange? One of the reasons that this could happen was the fact that Leeson was both trader and risk manager. If I look at many of the portfolio management solutions that are currently presented to buyers of energy, they suffer from precisely this problem. The portfolio manager is trading and gets paid based on the performance of his trading. And he is also handling the valves of the risk management … As companies take their energy buying to a next level of sophistication by not only buying tranches or clicks but also selling them, and as they often outsource this, we might be waiting for a few disasters.

Looking for a positive definition, this is what I found on the internet:

Risk management is the identification, assessment, and prioritization of risks followed by the coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.

Hubbard, Douglas in The Failure of Risk Management: Why It’s Broken and How to Fix It (2009)

I was intrigued by the title and date of publication of the book (which, I have to admit, I haven’t read (yet?)). Back in 2009, right after the debacle of Lehman Brothers, people in the financial sector must have suffered a huge hangover of the risk management party that they had engaged in during the previous decades. They had spent fortunes in developing software systems, building up data center capacity, hiring “quants”, prodigies in mathematics with impressive academic credentials (Chicago!) that helped them to implement the sophisticated statistics necessary for risk management of diversified asset portfolios. Now, despite all these billions of dollars and euros spent, their industry had just suffered the worst systemic crisis in almost a century. And not a million Monte Carlo simulations had helped them avoiding that. (We cannot help but remark the irony of having banks refer to one of the world’s most famous casinos when they describe their risk management methodology.)

Mister Hubbard’s definition makes clear why it will always continue to go seriously wrong from time to time in financial markets. Even in 2009, he could not avoid using the maximization of opportunities in a definition of risk management. Risk management is involved in everything we do in life. When we cross a street, we balance the risk of getting run over by a car with the opportunity of getting to the other side without losing too much time. When we marry, we balance the opportunity of building a happy family with the risk of our partner running of, etc. The overly prudent end up poor and unhappy as their risk-aversion keeps them from realizing opportunities. The overly audacious end up poor and unhappy because they hunt an opportunity that ends up in a nightmare. Success in life depends on our capacity to balance risk and opportunity. Just read one of Warren Buffet’s books and you will notice.

People hate unpredictability. When we step on board of an airplane, we like to have the certainty that there is a 99,99999…% chance that we will actually get to our destination. Human life is supported by an impressive technological system that is completely based on the prevalence of predictability. Science is all about reading future outcomes in present datasets. Therefore, when we enter into markets, we try to find the same degree of reassuring predictability. However, markets are completely unpredictable. Just think about what happened in April 2011. Energy markets were quiet. And then we saw a sequence of events: an earthquake in Japan, a Tsunami striking the Japanese coast, an election in Baden-Württemberg won by the Green Party and a German chancellor shutting down eight nuclear power plants over the weekend in a knee-jerk reaction. Markets for electricity and gas in North-Western Europe were up 20% in less than a week. Anyone that says that he can forecast the energy markets is somebody pretending that he can forecast natural disasters, election results and reactions of politicians …

For E&C, a risk managers’ approach to buying energy is all about radically accepting this unpredictability of the market. When people take a price fixing decision, they want to be reassured that prices will (continue to) go up the next day. Well, nobody can say that for sure, not even the most sophisticated market guru. When you take your decision to fix (or unfix) your price, you know only one thing for sure. The chances that the price will go down the next day are equal to the chances that it will go up. If you adopt this 50/50 approach to your energy buying decisions, you will start adopting the necessary degree of prudence to avoid that you take too much risk. Grasping the opportunities is about carefully observing the markets to find the opportunity moments (now, in the present). Risk management is about determining how much you buy in one moment to avoid the risk of potential future market movements.

Energy market price risk assessment 

During the conference, there were some animated discussions among the participant end consumers. The companies that presented their approach to risk management all made the case for buying energy in the spot markets. Other participants thought that this was too risky. This made clear that energy market price risk is not the same for every company. Each company has its own specific risk exposure, meaning that each of them will apply their own specific approach to managing that risk. Comparing approaches is pointless, as what is good for company A isn’t necessarily right for company B. Yes, it is true, as some of the speakers have argued, that in the past five years, the spot markets traded some 5% below the average forward market prices. The “Forward premium”, the premium for buying energy upfront, is not just a theory but in the past five years also an empirical fact. However, for a company that aims at stabilizing its energy budgets, buying all your energy in the spot markets isn’t a good choice of strategy.

Five years ago, E&C designed a very basis categorization scheme for energy market risk exposure. On the one hand, we have the budget risk clients. These are for example companies that have to put products in the market in a very stable pricing environment. Think about the automotive industry. Or companies producing premium price consumer goods. Or many pharmaceutical companies. They don’t want to see a sudden increase in energy budget as such budget increases eat directly into the profitability of the company. With such companies we design energy buying strategies that aim at stabilizing the energy budget. We apply strict stop loss limits that we watch very closely. When opportunity moments occur, we click prices for several years into the future. Even if there are such phenomenons as backwardation and contango, still we see that at any given moment, the prices for the next calendar products are always close to each other. By fixing the price at the same moment over several of these calendar products, you get a stabilization effect. Ideally with such clients, you can just move from dip to dip and end up having a stable budget below market average. However, this is only possible if you have a market without strong bull runs that oblige you to make stop loss price fixings to avoid budget derailing.

On the other side of the spectrum, we have the category of market risk clients. Such clients put products in markets with strong price competition. Cost decreases because of lower energy costs will immediately be used by some of their competitors to lower the product prices. Although this is often the subject of tough negotiations, such clients manage to raise their prices to a certain extent when energy prices increase. The worst thing that can happen to such a company in the energy market is having bought too much at the peak of the market. In that case, they will see their competitors lower the prices of their products as the energy markets fall. In the case of energy intensive businesses, they will eventually observe that their competitors sell their products at prices below the cost that they have for producing the product. The main pre-occupation of market risk clients is that they don’t pay too high above the prices of their competitors. Of course, there is no information available on what competitors pay. However, if you consider that in the end all the energy is bought according to the same benchmark, namely the underlying power or gas market, the wholesale prices can be considered as the best proxy of what your competitors actually pay. We will therefore click on a very regular basis on this wholesale value to make sure that prices don’t deviate too much from the average value. Of course, the question pops up: which average? In a very commoditized business (I’m talking about the markets the clients sell their products in again), this could be the spot price. In businesses with yearly contracts (e.g. the food industry), this could be the average year ahead price.  Through skilful price fixing and unfixing we will then try to manoeuvre the price below market average.

There is a last category of clients that we call – and I know that the choice of word isn’t very sympathetic – the survival risk clients. These are companies that have to operate in markets with over-supply. In such markets, there are always competitors ready to sell products below marginal production costs to protect or gain market share. This means that in case of falling energy markets, such companies immediately feel the pressure of competitors lowering their product prices. On the other hand, when energy markets rise, it is impossible to negotiate a price increase with clients. This is obviously a very tough condition to buy energy in. Basically, we advise such clients to buy their energy very much the same way as market risk clients do. Don’t be the unfortunate company that has to shut down because you gambled and ended up buying too much energy at the wrong moment. We also add to this the advise to ‘lock in a margin if possible’. If prices have reached a level where you are saying, “we can make profits with such low energy prices”, than you shouldn’t hesitate and fix.

As you can notice from what we have discussed above, making up a good energy buying strategy not only demands in-depth knowledge of the energy markets. What is mostly needed is a good knowledge of the markets that the client is operating in. This also means that as an energy buyer, you might lack the information for making up the strategy. You have to imply other people in this strategy assessment, your top management to start with, as they are the ones that bring the information regarding procurement and sales together. Depending on how energy intensive your company is, this can be the CEO and/or CFO. Key stakeholders of the energy budget, such as business unit or production managers can also get involved. It might even be a good idea to talk to the sales and/or business development managers to get a better view on how the markets work. If companies operate in different markets, it might even be necessary to differentiate strategies for different business units. As you can see from the above, the strategy depends heavily on the particularities of a client’s own business. This means that no two clients have the same strategy. When energy buyers explain the strategy that they apply at conferences such as the one I attended in Berlin, they always try to explain why theirs is the best strategy. This provokes protest from the buyers in the audience that come up with comments why theirs is better. This obviously doesn’t make much sense. The question is not “who has the best energy buying strategy?” (probably meaning: leading to the lowest price). In the framework of risk management, the question is: “who has the energy buying strategy that is best fitted to mitigate their specific risk exposure in the energy markets?” Each company has its own best strategy.

Implementing your energy buying risk management strategy 

Do you remember the strategy – tactics – operations sequence from (business) school? For the successful implementation of an energy buying strategy, this is quite crucial. Once you have your strategy set out and the strategy note written, it is important that you implement the right operational practices to get the desired results. In your day-to-day operations, you can also use a few tactical principles to increase the success of your price-fixing decisions. The most important tactical principle, which we have applied with great success in many cases is: “let the profits run”. Don’t fix a price in a falling market, don’t unfix in a rising market. Wait for the turning point of a downtrend before you start fixing. If you apply this, it is of course not always possible to distinguish between a turning point and a short-lived uptick. Therefore, we recommend again to adopt a risk management approach to this decision. If you want to fix 25%, fix 12,5% the first day that it turns around and 12,5% if it continues to rise the next day.

In terms of operations, it is obviously extremely important that you adequately monitor your portfolio position. Especially in large organizations with many sites, just keeping track of your different contracts for your different sites might already be a huge challenge. On top of that, you need to keep track of all your price fixings. To take good price fixing decisions, you need to know your portfolio values: “what will I pay next year, if I fix everything now, taking into account what I have fixed already and what the market price is now?” Your management will probably also be interested in mark-to-market values: “what would we pay, if we hadn’t fixed anything yet?” You will be asked to keep track of your clicking performance: how are you performing against the market (average)? If you have minimum and maximum percentages to be fixed by certain dates, you will have to make sure that you know how much you have fixed at any point. If you have stop loss limits to watch, you need to monitor them, and you will have to roll out some sort of value-at-risk calculations to make sure that you make (partial) fixings in time to avoid going over your stop loss level. If you are having one production plant, with one simple four-clicks on the Calendar products contract, this might still be relatively easy. But what if you have to monitor 30 sites with 6 contracts and fixings on Cals, Q’s, M’s, volumes left open for the spot market, etc? How will you keep track of your unfixing decisions if you take them? How do you keep track of future volume changes? Of course, your energy supplier can help you with portfolio monitoring. However, you have to be careful that depending on your supplier for your monitoring needs is not necessarily good for your position in contract negotiations. As an energy procurement consultant, we have invested a lot in setting up portfolio monitoring tools, because we see that many organizations struggle with this. You wouldn’t be the first company that loses an opportunity or is confronted with a surprise budget increase because you didn’t have a timely and correct view on your portfolio positions.

Once you have your monitoring under control, you need an important instrument to execute the strategy: the right energy contracts. At this moment, we see the current approaches to energy price fixing:

• Many clients still go for the fix price contracts, fixing the price for a few years into the future. Need I say that these are mostly budget risk clients. There are also some regional differences. German clients, for example, are always very tempted by proposals to just fix the price. Fixing the price for a few years obviously gives you budget stability for the period during which you fixed the price. But this also gives you a false sense of security. Many companies with fix price contracts are surprised by big budget shocks as they go from one contract to the next one. Making clicking contracts for the next three years and than fix the price for parts of the volume for each of these years at the same time, builds a much more sustainable long-term budget stability. On top of this, from a risk management perspective, the fix price contract is always the worst choice possible. It’s the win all – lose all solution. If you are lucky to have fixed at the lowest point, you will be wearing a very big smile for the duration of your contract. And in the past years, we have met with some smiling people that managed to move from dip to dip with three year contracts. But we also met with some very sad people who ran out of luck and had to fix at the worst moment possible.

• That is why most clients these days have multi-click contracts. The chances are big that as you read this, this is exactly the contract that you have. You try to avoid risks by fixing in a few moments. If you are budget-risk oriented, you will fix large tranches for many years into the future. If you are market-risk oriented, you will have adopted a more prudent approach and fix smaller tranches, not too many years ahead and with smaller intervals between two fixing moments. If you are unhappy with the outcome of your price clicks, don’t blame this on the multi-click contract. Ask yourself questions like these:

• Are you aware that zero risk / 100% opportunity is impossible in markets (as in life in general)? Are you not expecting too much (of your energy buyer)? Are you willing to sacrifice the possibility that you will fix everything at the lowest point possible by spreading your fixing decisions?
• Are you sure that your approach to the price fixing fits with the risk exposure that you have in the energy markets? Are you applying strict stop loss limits while you are a market risk client? Are you too prudent in fixing and does this make you loose chances of building more stable energy budgets, as you are a budget risk client?
• Have you lost opportunities because your monitoring of your portfolio failed? Did you lose track of your positions?
• Have you exercised strategic discipline? Or did you give in to the colleague (higher in the ranks of your company) that forced you to fix everything because he believed a bullish forecast? I’ll come back on this topic of strategic discipline in the conclusions of this article.

• Sooner or later, market risk oriented clients find out that if you make a lot of price clicks, it becomes very challenging to “beat the average”. The gains in terms of difference to market average are often not in line with the efforts of doing all these clicks, again and again. Therefore, we see more and more of these market risk clients choosing averaging contracts, which can be contracts indexed to the spot market or the average year ahead, or quarter ahead price. Obviously, if you are indeed subject to market risk, this is an excellent choice of contract. However, you need to be aware that you are subject to the systemic risk of choosing the wrong average. What if you are on the average spot price and all your competitors are on the average year ahead price? Moreover, you will find out that sooner or later, the feeling of loss of opportunity will pop up. Just imagine that the markets (and your average price) are running up after a moment of very low prices (think about the first months of 2009). Are you sure that nobody will say: “why didn’t we fix more in those good moments?”

• A growing number of clients start to develop something close to full trading activities. Trading means that you will not only close positions but that you will also give yourself the chance of opening the positions in a falling market. By fixing and unfixing your prices, you reduce the market price risk, that is for sure. However, you get a lot of system risk in return. I’ve already said above that you need even better monitoring capacities to make sure you don’t loose track of what your portfolio position is. And are you sure that you completely understand how it works? Many clients are therefore hesitant to develop the in-house capabilities for managing such trading contracts. They prefer to hire a portfolio manager. However, we often see that these are proposing black box solutions. You get no insight into the details of the strategy that is being followed (this is supposed to be top secret, it’s the million dollar, always market-beating wizardry). Sometimes, you don’t even get a clear view on what the current position is. If a risk management policy is applied, this is being monitored by the portfolio manager himself, not by somebody else (your portfolio manager is in Nick Leeson’s place). We have seen examples of clients ending up paying performance fees based on fake savings (the reference for calculating the saving was adapted by the portfolio manager according to need). Often, the decision to hire a portfolio manager is based on greed rather than strategic consistency. Somebody in the organization believed that the “proven track record” graphs shown by the salesman of the portfolio management company was based on facts and that it is (was) a guarantee for future success. In the Netherlands, every commercial mentioning past performance of an investment vehicle is obliged to end with the very wise words: “Be careful, performance of the past is not a guarantee for the future”.

It is important that you are aware of where your organization is, to choose the right contract type. For example, don’t choose a market average only because somebody messed up the fixing decisions due to a lack of strategic discipline. Don’t move to full scale trading if you haven’t mastered working with a clicking contract yet, as it adds complexity for which you might not be ready yet.

Which brings us to the subject of people management. Organizations that choose one person to take all the price fixing decisions are running the risk that this person messes up. You need some other people involved to check this. On the other hand, if too many people are involved, you run the risk of ending up in decision paralysis. Seven years ago, a client of ours had created a “steering committee” that was to decide on every fixing. Every time that there was a moment in the market, we were called in front of that committee and we had to bring a presentation on the markets. In the following hour, these people would start a massive discussion on the state of the world economy and the impact they thought this would have on the energy markets. At one moment, one of the people in the committee took a firm position and pushed through the decision to make a large electricity price fixing. And then came the crash of electricity prices in the spring of 2006 … In the next steering committee meetings, the person that had pushed the fixing decision was again and again blamed for his wrong view on the market. This created a very tense situation in which everyone was extremely reluctant to decide on a price fixing. As a consultant, I found myself in a very difficult position. As long as I was giving arguments why this might be good moment for fixing the price, everybody was “watching the tips of his shoes” and avoiding the sort of eye contact that obliges you to take a position. When I uttered just a hint of an argument why it could be good to wait a bit longer, a massive sigh of relief was heard around the table and a decision was taken … to fix a date for the next meeting. This is just one of those client experiences that taught us how to approach price fixing decisions in companies. And one thing is clear: joint-decision making doesn’t work for decisions in unpredictable markets. You need to designate one person that makes the calls, at most you can have him sparring with one superior, but don’t get more people involved. Get as many people involved as possible in setting up the strategy. But then these people need to trust (and monitor) that the person that makes the fixing calls will realize the strategic targets by applying the targets correctly.

Conclusions 

Applying risk management doesn’t mean that you will try to get the best possible price out of the market. Many energy procurement consultants have sold “savings” for such a long time to their clients that they now try to sell risk management as something that makes you save money, something that helps you winning money by getting a better price. Well, risk management is not at all about saving or wining money, it is all about avoiding that you loose money. Sounds similar, but if you think well about it, it is not exactly the same. Just think about the difference between entering the casino with the aim to win money and entering the casino with the aim not to lose money. When markets were liberalized, industrial consumers entered them with the conviction that they would win money, that they would make big cost reductions. I think we now have experience enough to acknowledge that our first concern should be not to lose too much money. The first target of any energy buyer should be: “make sure that you don’t jeopardize the financial security of your company by fixing too much energy at the wrong moment”. By applying a strategic approach to managing energy market price risk, companies can successfully mitigate the risk of volatile energy markets to their businesses. However volatile the markets are, by applying what I described in this article, companies get budgets that they can live with. They are managing their budgets instead of being thrown about by the market movements. I am happy when a client never has to say again: “now I can only hope that the market will move up”, or “now I can only hope that the market will move down”. A risk manager’s approach to buying energy is all about excluding hope and managing your budgets instead. And if you manage your budgets successfully, you will also start making better use of the opportunity moments.

Successfully implementing a risk management strategy when buying energy isn’t a very easy task. Here are some of the main obstacles that I have observed over the years of advising clients on it:

• Many clients find it very hard to accept the idea that forecasting the market is impossible. Somebody in the organization gets convinced that this is a super price level and that it can’t get any better than that and forces a decision to fix too much too soon, for example. The belief in a forecast makes you put aside the strategy, you no longer care about risk management. That is logic. Forecasting and risk management exclude each other. What risk is there to manage if you no where the price is heading? The funny thing is, the closer you are to the markets, the more easily it is to get convinced of its unpredictability. Often, it is people that only occasionally look at the energy markets that have the strongest convictions that they know where it is moving. The deeper you get involved in the energy market, the more proof you get of its unpredictability.

• Setting up an energy buying strategy and an implementation structure, is obviously all about taking the subjective element out of energy fixing decisions. You no longer decide to buy because somebody in the organization is convinced that the price will go up. You do it because it helps you to reduce your budget for 2014 compared to 2013 (budget risk client). Or because you haven’t made any fixings since two months (market risk or survival risk client). Sometimes, clients want to take this a step further and want to implement a full-blown mathematical decision-taking model. We seriously advise them not to do it. There is no model that consistently beats the market. So if you want to go for automated decisions, than it’s better to go for an average price contract. When we back-test mathematical models (I love doing that) we can always conclude: it works well in these market conditions, it fails in these. Often, the volatility of the market is the main factor that makes a model fail or not. But a mathematical buying model is in our opinion very similar to forecasting. You presume that certain market conditions will occur in the future. Determining a good energy buying strategy is about implementing just enough objective decision criteria to make sure that your subjectivity never makes you take too much risk. It’s building in the safety belts, the airbags, the ABS, the automatic breaking systems. But it’s not about putting a robot at the steering wheel. Somebody needs to continue to take the decisions: “I buy now, I don’t buy”. The objective element will keep his decisions inside the limits of the energy buying strategy so that no totally unwanted results pop up.

• When designing strategies, some clients tend to lose themselves in unnecessary details. I am a great adept of the KISS-principle in this perspective: keep it short and simple (which is not stupid, like some people add).  Large organizations, especially public authorities, are often surprised by the shortness of our strategy notes. They want more text to document why they are making such strategic choices. I always ask them the following question. “It is 16:45 on a Friday afternoon, the energy exchange has just published it’s closing value and it’s up after several days of falling. You have to communicate your price fixing decision to your supplier before 17:15. What do you prefer? Having to browse through a ten-page strategy note? Or through a two-pager?” If you want more explanation, fine, make a separate explanatory note. But keep your strategy note short. I also see some companies applying very advanced stuff (collars with options, e.g., or price optimizations in within-day markets) while they are not controlling the basic stuff, such as setting stop loss limits. Look for the simplest road to realizing your strategic, risk-mitigating targets. The more complicated your strategy, the bigger the risk that you will fail to implement it.

• Something which I have observed again and again in discussions with potential clients. We discuss our approach to managing energy price risk. The client gets interested. We want to get down to the facts: how are they buying energy now? And then the client spends the next half hour trying to find out what he has clicked at which moment. Like I have argued above, getting your data management under control is key to a successful implementation of your risk management strategy.

• You have made your strategy assessment. Before, you were fixing prices every year for the next year. It went well for a few years but then disaster struck, you had to buy at the peak of the market and the market dropped right after your buying decision. The alarm calls of your sales people and the negative result at the end of the year have learned you that you are subject to market risk. You decide to buy on the average spot price and then the spot markets start to rise. People in the organization start to ask questions: “OK, we had a bad experience, but wasn’t it better in the old days when we fixed the prices? At least we knew what we were paying, even if it was too much”. Are you sure that your organization has the discipline to stick with its strategy? So many times people tell us: “we are running behind on our strategy”. What is that supposed to mean? That you are taking risks that you previously agreed on that you wouldn’t take? Or another example of a lack of strategic discipline. There is an opportunity moment in the market. You have a contract ready to be signed so that you can make the clicks that your strategy is telling you that you should take. But at a reception, the sales manager of an energy supplier told your vice-president procurement that in a few months time, they will have a new contract proposal that will be super for your organization. The decision to sign the contract gets postponed, the opportunity moment gets lost and you run behind on strategy as your prices start to rise above the stop loss levels.

• The main reason why clients fail to implement their strategy is that they don’t get their contracts signed in time. In some cases this can be due to market circumstances. The government is redesigning the system for calculating green energy add-ons and suppliers are unwilling to sign long term contracts, for example. In these shaky economic times, volume uncertainty is also making it difficult for some companies to get the contracts in place in time. Everything is ready to be signed, but production managers fail to commit to contractual volumes.

• The uncertain economy can also make it difficult to find suppliers willing to offer price fixing services on a long term. Large consumers are now getting more and more difficulties in this perspective. When they want to fix prices for the Cal+2 or Cal+3, the suppliers ask for bank guarantees, which is quite logic, as they will have to pay the margin calls if the mark-to-markets on those far-in-the-future price fixings move into negative territory.

Applying a risk manager’s approach to buying energy can help you in getting control over your energy budget. I hope you have understood from this lengthy blog article that it’s all about applying simple logic. However, implementing it you will run into many difficulties. But I have a busload full of success stories to show you that it can work.