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.

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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.

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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.