Proceed with Caution
Over the past few weeks electricity prices have taken a bit of a nudge northward. Despite the current over-abundance of natural gas supply in storage, gas prices have increased 25% over the past month. The recent jump in gas prices can be attributed to some producers announcing that they are cutting back on drilling plans until prices firm up. And it’s just not talk – the active gas drilling rig count continues its eight-month decline, even for the all-important shale gas formations. As natural gas is fast becoming the sole energy input to electricity generation on the margin (especially with the retirement announcement of more coal-fired generating plants), as gas prices move up, electricity prices follow the upward trend.
In the never-ending quest to reduce electricity expenses, many of our clients are comparing the cost of current real-time prices (LMP or day-ahead) to the prices imbedded in future contracts for one, two or three years. Apparently, historically low electricity prices weren’t enough to entice them into making a long-term commitment. Now that they are seeing future prices move up, it is causing end users to rethink their energy procurement plans. But what options are available and, more importantly, what are the risks associated with some non-fixed price plans?
Most everyone understands that being 100% invested in an hourly product is extremely risky – while trying to make annual budget numbers. For most customers trying to satisfy their annual budget, real-time pricing isn’t (and shouldn’t be) a consideration. But what about procurement strategies that are a hybrid of fixed pricing and real-time pricing, with the level of exposure to the real-time market commensurate with the level of risk you wish to assume? That way you have the best of both worlds. Well, maybe.
There are several different types of hybrid procurement models. One that has been around the longest is block & index. For block & index the end user determines the size of a block of electricity (usually a quantity that the user is almost 100+% sure he will consume) to be covered by future contracts and any additional consumption on the margin will be purchased at the real-time rate. (Note: You may or may not realize this, but this is how you are probably purchasing natural gas for heating.) Another hybrid model is “fixed price for percentage of load.” For this option, you determine what percentage of load in any half-hour (or hour) you want to be on a fixed rate with the remainder of the load priced at a real-time rate. For both of these options, making the decision seems easy – sophisticated analytical models exist that utilize volatility and price history for electricity, producing graphs and charts, which indicate in some manner either the expected value of your decision or the probability you will make your budget. The output of these models is used to determine how much of your future electricity consumption will be put at risk in the real-time market.
Things to Consider:
There are several things to consider when you make a decision to assume price risk for energy supply:
- The models use historic information in projecting future price variation. Admittedly, this is the best information available, but it doesn’t provide perfect correlation with future performance. If you have any questions about this, just read the disclaimer that accompanies the models’ output.
- Models can be the best method for mitigating price risk, but what you really want to mitigate is business risk. For most organizations, all business risk cannot be captured by an electricity procurement program. In fact, you may have other business risk that varies inversely with electricity prices. If that is the case, then mitigating electricity risk actually increases business risk – instead of decreasing business risk as one may assume.
- Taking some proactive measures makes one feel more in control of the situation, even if the data show that the action doesn’t always generate a positive outcome. This can provide a false sense of security.
- Assessing your “Risk Appetite” (how much risk you should assume) is a very difficult task. According to Dylan Evans, in his book Risk Intelligence – How to Live with Uncertainty, risk appetite is an emotional response – a gauge of how comfortable people are with taking risks. When you assess your risk appetite, think about how your management views a 10% negative variance on your energy budget versus a 10% positive variance. I bet they aren’t valued the same.
What to do?
Risk isn’t necessarily bad. It has made some people very rich; but it has caused many others to lose their jobs. I’m not saying that you shouldn’t use one of these risk models – but before doing so you should understand their limitations and yours. If you cannot adequately assess your risk appetite, then any model’s output is not very meaningful.
There are a few things you can do to improve the outcome of any program you pursue:
- Implement a program that allows you to respond operationally to electricity consumption. Most end users don’t have the ability to alter electricity load; however, the folks at Clean Urban Energy ( HYPERLINK “http://www.cleanurbanenergy.com” http://www.cleanurbanenergy.com) have such a product.
- Continually monitor the market so you always know when the expected value of converting to a fixed price contract starts to exceed your projected expense.
- Make sure your management understands what you are doing. If things go south in a big way, there will be a witch hunt.
Risk is not very well understood. Just look at JP Morgan Chase if you need any reminders. If you decide to participate in a program, make sure you do your research and understand all you can before you make a commitment.