Episode 1: The Energy Markets
Any organization that has been in business for the last 15 years with a significant energy spend, and by energy I am talking about electricity, natural gas or other fuels typically used by commercial and industrial consumers, will know very well how market price movements can impact their bottom line.
In 2008 we saw oil prices rocket with predictions of $200 a barrel coming from some quarters and natural gas was over $8 a dekatherm. The energy market is recognized as one of the most volatile traded markets across the globe, so what is going on and what can be done to mitigate the price exposure.
I want to start by going back in time, twenty five years ago in fact to my first experience of market forces affecting energy consumers. At that time, I was in the UK, and the country was beginning to liberalize its energy market. A new regulator was formed, and the nationalized power market was broken up into twelve regional utility companies responsible for the distribution and supply of power to their customers.
Generation plant was hived off into separate companies and a national transmission company was formed to deliver power from generators to the regional companies. A new wholesale market or electricity pool was formed allowing companies to trade power needed for their customers where prices were bid for each of the forty-eight, 30 minute blocks of time consumption was measured every day.
Next it was the turn of the nationalized natural gas company, which rather than being broken into different companies, was simply split in two, a supply business and a transmission business that now had to allow third parties to access the system, again a notional market was formed to allow trades balancing supply and demand and enabling non producing “marketeers” to begin retailing gas they bought on the wholesale market.
Over a very short period of time we saw the effect of competition as new players in the supply market scrambled to gain market share, cutting margins to gain customers at a time when the wholesale market was dropping fast. Natural gas prices hit all-time lows as the big oil producers, for whom natural gas was in many cases a byproduct of production entered the market for the first time, where it saw consumers as natural sink for their production.
The big winners at this time were the large industrial energy consumers who saw prices plummet week after week as the scramble for market dominance began, arguably the big losers were eventually the coal generators, who saw hundreds of new, cheaper, cleaner gas fired generators take advantage of the low wholesale prices and the comparatively large difference between that and the sale price of electricity – known in the industry as the spark spread.
This worsened as legislation on emissions increased forcing plant after plant to close across the country.
Over the next decade the market settled and consolidated. Every regional electricity company was now able to offer their customers natural gas and the gas companies’ could sell electricity, and as the rush for customers receded, prices began to creep up, although now the price drivers were very much the fundamentals of supply and demand.
Recognizing that there was not an endless supply of natural gas to fuel all this new generation, huge connecting pipelines or interconnectors were built between the UK and mainland Europe to allow natural gas to be imported and fix the demand issue.
However, this didn’t quite work out as expected. The European market was very different to the UK, with most, if not all natural gas agreements indexed heavily to oil products, all be-it with a time lag. When global oil prices increased, so did the cost of natural gas, and prices climbed much higher than that of the UK. It wasn’t long before traders were exploiting this price delta and the interconnectors quickly reversed flow and began exporting natural gas and of course it wasn’t long before prices in the UK increased to those of an oil-based Europe.
As companies embraced the liberalizing markets, energy trading moved from a function of balancing physical positions within utilities, to the speculative profit centers of banks and investment houses, where these new players were transacting purely for financial gain. Energy prices could be bid up to artificially high levels, completely disconnected from the market fundamentals. Enron were so good at it they almost bankrupt the California power market, playing games with capacity to drive up cost in a move that saw hundreds of companies shut up shop no longer able to afford the blisteringly high cost of electricity.
As global events unfolded whether it was war in the middle east or hurricanes off the coast of America, it was clear we were in a very different environment and very connected, whether we liked it or not.
These moments left the biggest impression on me as global events began to affect the domestic price end users paid, and at that time, on a very personal level, because I worked with for one of the largest utilities, it was affecting my own customers too, even those in fixed term supply agreements knew that prices would be increasing drastically.
But it wasn’t all the fault of the market, you can no more stop a trader from trading and making money than you can water flowing downhill. Even though they played the victim well, commercial and industrial energy consumers had a good proportion of the blame to shoulder too. Poor procurement practices and speculative behavior opened the door to high prices and incredible levels of volatility time after time.
Consumers were making decisions based purely on market fundamentals, and seeing the market was overvalued, refused to buy forward hoping for a fall. Prices continued to rise driven by speculation and again they would look to the fundamental analysis and decide to hold off hoping they would fall again. The market continued to rocket with end-users now in a desperate place, if they weren’t going to fix when it was 60% lower, why would they fix now?
In most cases the CFO stepped in and closed down the exposure by entering fixed price supply agreements at these incredibly high levels.
When you step back and look at what happened it is somewhat easier to see that the people who had the energy and were controlling the wholesale prices were the banks, investors and traders – for them the price was inelastic. End users must have energy to stay in business, so they are a natural sink and somewhat forced to pay whatever it takes. So while they were holding off buying, the traders could keep pushing up the price and they did, until eventually consumers blinked, fixed all there contracts leaving no where for high priced energy to go – more supply than demand brought wholesale prices crashing down again leaving end-users saddled with high priced supply contracts.
They didn’t learn either, the markets followed several such cycles in price until the global recession hit in 2008.
In the United States, where I have been for almost a decade, the recession was impacting demand at a time when fracking was producing huge volumes of natural gas from some of the biggest reserves of ever seen. The Marcellus Shale Formation is one of the largest shale formations in the United States and underlies parts of New York, Pennsylvania, Ohio, West Virginia, and small portions of Maryland and Virginia. To give an idea of size, According to geologists at Penn State University, the Marcellus could hold up to 500 trillion cubic feet of natural gas, making it potentially the second largest natural gas field in the entire world. 500 trillion cubic feet equates to more than 85 billion barrels of oil, which is more than the proved oil reserves of Russia, and over 4 times as much energy as our own proved reserves.
Low energy prices were just what our economy needed to help us pull out of recession. Manufacturing that had left the US for cheaper production in places like China, now had a great incentive to bring it back home, something that has been further encouraged by the current policies of the Republican party under President Trump, where tariffs and incentives provide the carrot and stick to bring jobs home.
But, what I find most interesting, is what I saw 25 years ago in the UK is starting to happen again here in the US. Low natural gas prices has fueled massive investment in gas fired generation assets, largely at the expense of coal fired plant. While we don’t have an interconnector pipeline as the UK did, we do have several LNG or liquid natural gas plants that are liquifying and shipping our natural gas overseas. I did read somewhere that the US has aspirations to supply 30% of European natural gas demand over the next 10 years.
As the oversupply is slowly removed, natural gas prices have been creeping back up again, from a low in 2016 of 1.64 a dekatherm to today’s levels of 2.26 or a 38% increase. If you were spending $10mm dollars a year on natural gas at wholesale, you now need to generate another $3.8mm in profit to cover that increase, or put another way, if you make a 10% margin, your sales would have to increase $38mm to stand still.
As an end user you might think you have few options to control this market risk, especially when the only tools you are given force you to speculate on future price moves. You can fix prices but if they fall you have lost opportunity and competitor risk. If you float prices on an index you expose yourself to market volatility.
In my next podcast, I will be exploring the supply chain process that keeps energy consumers away from destructive energy buying cycles and allows smarter energy procurement decisions and complete proactive management of their energy agreements.
Do join me, and I look forward to our next conversation. If you want to be kept up to date with our latest podcasts, click subscribe and we will notify you when a new one is released.