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What makes logical sense? A critical look at ‘fixed’ and ‘flexible’ energy contracts

A Foundry Trade Journal report prepared by LG Energy Group (www.lgegroup.com)
Price volatility within energy markets is a complex issue, which affects a wide variety of stakeholders. Unfortunately, throughout mainstream media, price volatility has been poorly defined, with no consistent frame of reference. Ultimately, the media has focused on one facet of energy price volatility, seemingly choosing to overlook the fact that the issue of energy price volatility is multi-faceted.
Due to the singular narrative currently occupying mainstream media, the volatility of energy prices, at present, evoke an air of uncertainty and financial risk. However, the consideration that the fall and rise in energy prices present the perfect opportunity to purchase and sell back portions of an energy manager’s energy exposure is often overlooked. Ultimately, this proactive approach to energy purchasing could culminate in significantly lower energy expenditures for many companies. 

FIXED PROCUREMENT
Ultimately, a ‘fixed’ supply contract allows energy managers to agree a set price for their electricity or gas supplies. Prices displayed within such a contract are reflective of energy prices on a specified day (i.e. the day the contract is signed); therefore they are ‘fixed’ throughout the contract covered duration. Overall the ‘fixed’ procurement approach to energy procurement affords the buyer in question the opportunity to accurately forecast budgets and effectively manage cost.
The benefit of budget certainty is derived from the fixing of price for the duration of the supply period (which could be one, two, or three years), however such a strategy only holds credence/utility in a rallying market - where prices are steadily heading northbound. One can now see how an energy manager signing such a ‘fixed’ contract for budget certainty is actually also engaging in a speculative activity which bets that the price of natural gas or electricity will continue to rise throughout the duration of their agreed supply contracts.
Due to the multifaceted nature the role of an energy manager occupies, they are entrusted with a myriad of responsibilities, which can create the need for haste and convenience over future price optimisation. Therefore, in an attempt at avoiding detraction from their core responsibilities, it may appear easier and less risky to sign an energy contract fixing the cost of energy and not have to consider the issue until the next time it comes up for renewal.
In this instance, the signing of a ‘fixed’ supply contract and the hedging of a client’s requisite volume on this date would have resulted in a clear financial disadvantage (see figs.1 and 2).

Limitations of ‘fixed’ energy procurement
The very fact that an energy supplier is affording an organisation the opportunity to fix energy prices throughout the term of a contract must also imply a level of precautionary measure may have been adopted by that energy supplier to factor-in future risks (added risk-premium). 
Additionally, the increase of non-commodity costs - such as higher green levies and transport costs - can be passed onto the consumer unless otherwise stipulated in the supply contract. Due to the unpredictable nature of non-commodity costs, longer-term supply contracts tend to carry heavier risk-premium amidst the varying view on where non-commodity costs may be heading in the future (suppliers protecting their profit-margins). 
Additionally, if an energy manager chooses ‘fixed’ energy prices on a chosen day where the price of natural gas or electricity is uncharacteristically high, then the energy manager in question would have committed his organisation to unnaturally high energy prices for the duration of that contract. 
Now… at what point will the limitation of unnaturally high prices outweigh the benefit of secured budget certainty?

GAS AND ELECTRICITY MARKET VOLATILITY
The common understanding of volatility points to the sharp and regular fluctuation of energy prices throughout any given period. Over the last five years, price volatility has become the most significant issue facing the natural gas, electricity industry and large energy end-users (the clients).
A strong point to take home would be that the volatility in the natural gas and electricity markets has increased dramatically - more than that of other commodities in the stated time period i.e. increased optimisation opportunities via ‘unlock’ operations.

The influence of weather on the price of natural gas and electricity 
Energy markets are increasingly susceptible to volatile prices as changes in the country’s weather hold great influence over demand for the commodity in question, for example, a warmer than average winter in the UK (i.e. last three winters since 2012/13) would most likely lead to less implied demand levels for the commodity as heating demand remains tamed due to the mild-weather impact(1).
In due course, there will be a build-up in gas supplies which would eventually apply downside pressure to the price of natural gas, an expectation led by the upcoming global oversupply of liquefied natural gas (LNG) flows come 2018(2).
Currency fluctuations also have a role to play within natural gas and electricity markets where a stronger Euro against a weaker Pound Sterling (EURGBP) encourages flows out of the UK and into the Continent via The Interconnector (Ireland and France), consequently reducing available domestic supplies.
From a supply-side perspective, the potential risk of interruption in flows destined for the UK via the Easington Langled pipeline (due to routine maintenance or an unprecedented outage) typically implies the level of available gas supply in the UK is limited, thereby intensifying competition amongst UK market participants, ultimately resulting in higher natural gas prices.
Despite the rise in volatility over the years, many industrial and corporate consumers of natural gas and electricity still adopt old-traditional energy hedging techniques to limit price-risks as part of an overall portfolio management strategy rather than explore the available suite of intelligent and sophisticated procurement options (flexible contracts).

FLEXIBLE PROCUREMENT SOLUTIONS
‘Flexible’ energy procurement allows for a more versatile approach to energy purchasing, enabling industrial and corporate (I&C) clients to improve their respective energy positions by using market volatility to their advantage. A ‘flexible’ approach to energy purchasing also provides client with the facility to hedge portions of their energy exposure over a set period of time, a great shift from having to commit to a set price for a specified duration - the casino-styled ‘all-in’ approach to procurement.
By remaining ‘flexible’ with one’s approach to energy procurement, organisations are able to continue hedging their energy exposures through multiple purchases over a specified timeframe whilst also removing a proportion of the risk-premium attached to those curve gas and power contracts when signing up for a ‘fixed’ term contract.
Many I&C clients with extensive financial exposure to the volatility of energy prices question the validity of delaying the purchase of required energy volumes. Often those who contest such a strategy, hold firm that due to the uncertain trajectory of energy prices, postponing purchases is highly risky. While others may evoke the term ‘speculation’ or ‘speculative’ which over the last few years has evoked negative connotations.
On the other hand, others may argue that life in its very essence is speculative, for example, an energy manager who does not subscribe to the ‘active risk management’ school of thought and alternatively chooses a ‘fixed’ supply contract due to convenience is merely reinforcing their belief that the simple and dated approach to energy procurement would outperform intelligent decision making processes as they ‘speculate’ natural gas or electricity prices will only move higher from that point forward - the ‘fingers-crossed’ approach to risk management.
However, if the recent historical energy prices behaviour has taught us anything, it is that energy prices have become increasingly more volatile and the ability to ‘lock’ and ‘unlock’ volumes has become invaluable in achieving even lower wholesale energy prices and better managing the risk of future uncertainties.

TRAVERSING THE CURRENT VOLATILE ENVIRONMENT
Although it may seem easier and less risky to sign a ‘fixed’ energy contract and not have to consider it until the next time it comes up for renewal, a company must evaluate its approach to energy procurement and question whether or not they are actually maximising the opportunities afforded to them by the market?
Due to the multitude of information and key data points affecting the price of both fuels, interpreting energy data and gauging market sentiment has become an increasingly specialised field, hence why the study and examination of price movements are time-consuming, albeit pertinent to the understanding of price ‘inclines and declines’ and the market factors which stimulate such rapid movements in prices.
The energy procurement field has become increasingly specialised and well-placed to guide and advise time constrained energy managers, in matters relating to purchasing strategies and the management of price volatility. 
Segmentation is a primary strategy currently utilised which involves differentiating between clients based on their level of risk tolerance and their need for price stability.

FURTHER OUT ON THE CURVE (FUTURE OUTLOOK)? 

Demand
Through the analysis of fundamental factors (issues pertaining to forecasted supply and implied demand) influencing natural gas and electricity market volatility amidst differing views on future trends and projections of market behaviour, daily demand-volatility in the upcoming years is expected to increase further over the next few years. 
The growth in weather-sensitive demand calculations has heightened price fluctuations over the years as demand has become even more responsive to weather patterns.
In addition, the growth in power generation loads is expected to increase daily demand-volatility throughout continental Europe due to more and more renewable (solar and wind) generators playing larger roles across the region’s power generation mix.

Supply
Will the increase in natural gas power stations decrease energy price volatility and stabilise energy prices (less volatile) amidst the newly available access to supplies?
The majority of the newly built natural gas power stations are to be used to meet peak-demand (demand during hours of heavy electricity use), fulfilling imminent electrical requirements. As a result, these generators will continue to cycle ‘on and off’ to act as marginal sources of electricity supply and in avertedly lead to higher day-to-day swings in natural gas demand.
As a result, energy supplies and demand levels will remain volatile across the region and potentially could result in prolonged/sustained price swings in the price of the underlying commodities.
However, with increased volatility come increased opportunities. With the right tools and mechanisms at their disposal, industrial and corporate clients are well placed to take advantage of the subsequent dips (lower) in energy prices through the effective use of their multi-purchase ability or ‘unlock’ facility afforded to them by ‘flexible’ contracts.
As a concluding note, one must bear in mind that although a ‘fixed’ supply contract removes all options of improving on price in the event of a market collapse, a ‘flexible’ contract affords clients the ‘right’ and NOT the obligation of being tied to their previously achieved energy price, i.e. the ability to adapt to the ever-changing energy market landscape.

REFERENCES

1. Bearish weather. www.reuters.com
2. Platts LNG conference. www.platts.com/events