Energy procurement can be a significant competitive advantage for an organization when it is viewed as a portfolio with risk to be measured and managed instead of a simple transactional process. Energy markets are complex and dynamic with an extensive list of outside technical and fundamental forces influencing prices. Successful energy buying programs involve defining and prioritizing several types of risk, developing a strategy based on market outlook and a statistical analysis of potential outcomes, and ultimately being able to measure the results of the strategy.
A common misconception in energy procurement is that when all forecasted consumption has been locked in to a fixed price, 100 percent of the risk has been eliminated. The reality is there are several types of risk that impact an energy spend. Each of these risks must be managed in concert to best enhance an organization’s energy program.
1. Budgetary risk is the most commonly managed type of energy risk. It is encountered in situations where the forward market and cash/index market prices rise. This can impact an organization’s ability to maintain budget commitments if not enough of the anticipated consumption is locked in at a fixed price.
2. Opportunity risk is the inverse of budgetary risk. If much or all of the anticipated consumption is locked in at a fixed price, an organization cannot benefit from a bearish move in the forward market or soft cash/index market prices.
3. Consumption risk comes into play as organizations look to predict future consumption. Mergers, acquisitions, divestitures, demand management, and sustainability are at the forefront of many strategic plans. All of these significantly impact energy consumption and associated costs.
4. Term risk is managed when the term of energy contracts align with other commitments within an organization. Additionally, term risk contemplates the current forward market to evaluate market opportunity.
Establishing an organization’s risk tolerance requires thoughtful contemplation and prioritization of each type of risk. For example, a business with slim profit margins and multi-year sales contracts should prioritize budgetary and term risk, building a strategy with higher fixed positions and longer tenors to mitigate the margin at risk associated with a bullish run in energy. Industrial clients with high swings in demand from day-to-day and flexible operational behavior would be best suited by first managing opportunity and consumption risk. The intentional cash/index exposure will allow for flexibility to shift operations from a higher price time period to a more favorable pricing condition and eliminate potential sell-backs into an unfavorable market.
The next step after establishing a risk tolerance is developing a strategy based on market fundamental influences, technical influences, and outlook. The strategy development stage involves answering three common questions.
1. When is the right time to buy?
Traditional approaches will look at the period immediately before the existing contract end date, which can lead to missed opportunities or being forced to choose between the lesser of two evils (no fixed positions or a buy in an unfavorable market). A managed portfolio should always have a three- to five-year view into the forward markets, allowing for a full reciprocal historical trend analysis. This changes the deciding factor from “what is the lowest price today?” to “how does today’s price compare to the minimum, maximum, and average price over the last five years?”
2. What is the right term to buy?
Sometimes company policy dictates minimum or maximum contract term. In the absence of that (or when an existing policy should be reevaluated), the three- to five-year view into the forward markets will highlight opportune tenors. Sometimes technical or fundamental shifts in the market can cause a backwardated condition, where a three-year fixed price is lower than a one- or two-year price. Also, the forward market has periods where the forward spreads (price difference between each future year’s prices) collapse, making the difference between a 12-month and a 60-month price negligible.
3. What is the right portion of forecasted consumption to buy?
An energy program that is built on risk management will first look at the range of potential outcomes to understand the current market value of the portfolio as well as the cost and opportunity at risk. An industry-leading risk management platform metric will contemplate the thousands of potential outcomes, given the full exposure to the volatile index/cash markets, and convey best-case and worst-case scenarios. Alongside this, the current market value of the forecasted consumption is calculated. The difference between the current market value and the worst-case outcome is the cost at risk. The spread between the current market value and the best-case outcome is the potential opportunity. A company must then decide how much of the cost at risk they are willing to accept in order to retain some or all of the potential opportunity. For every megawatt hour or one million British thermal unit that is locked in at a fixed price, the cost at risk is constrained, but so is the potential opportunity.
To take it one step further, each market for natural gas and electricity is comprised of periods of relatively high volatility and prices (e.g., electricity for summer months during peak hours in Texas or natural gas for winter months in New England) and relatively low prices and volatility (e.g., electricity for late spring during off-peak hours in the Pacific Northwest). The decision of when to place fixed positions – which months and hour blocks – is arguably more important than how much to purchase. A thorough risk management analysis will allow a company to understand the potential impact of a fixed price position to both the cost at risk and potential opportunity, essentially test-driving a strategy before executing it.
Once a strategy has been developed, the next step is to document it so it can be communicated internally for consensus among in-house stakeholders as well as benchmarked to be evaluated later. A record should be made of the market conditions at the time of execution, the full analysis of cost at risk and opportunity – with and without the chosen strategy – and the details of the chosen strategy including volumes to be fixed and associated price(s). The biggest measure of success for an energy portfolio management program is how well it performed relative to expectation.
Due to the in-depth analysis in the preparation stages of the process, a company will be able to tell (at any stage of their contract life):
• how much cost at risk was eliminated as a result of the fixed price positions;
• how much potential opportunity remains in the portfolio with fixed price positions;
• what the market value of the portfolio was at the time of contract or strategy execution; and
• what is the realized price inclusive of any fixed and index/cash market positions.
Comparing the realized price to the market value of the portfolio when the strategy was finalized allows a company to say, definitively, “This was the value of my strategic management.”
There are many forces impacting natural gas and electricity markets. Regulatory changes, supply/demand balance, weather shocks, geopolitical influences, sustainability initiatives, environmental legislation, innovation, and overall macroeconomic conditions will all influence the volatility, overall price movement, and liquidity of energy markets.
Energy procurement will ensure a company has the gas and power needed for operations. A successful portfolio risk management program allows a company to know when to buy, how long to buy, how much to buy, and how well the strategy performed.
December 2017 RENDER | back