Fear of heights in energy procurement

By Benedict De Meulemeester

By Benedict De Meulemeester on 25/01/2018

Topics: Energy Trading

As described in our energy report, the yearly market analysis, 2017 was another bullish year in Europe’s energy markets. Energy prices reached historical lows in March – April 2016 and then saw the start of a bull run that hasn’t come to an end yet. Before that, we had five bearish years, with prices dropping month after month.

Being an energy buyer during such long stretches of falling energy markets as in 2011 - 2016 is an easy job. With every new gas or electricity contract or price fixing, gas and electricity prices are lower than previously.

What contractual possibilities do I have? 

As most of your stakeholders tend to look only at “do we pay less than previously”, you’re always the hero if you succeeded in energy savings. Even if you’re not doing the best job and e.g. negotiate your energy contract a bit too late, this results in lower pricing, so who’s going to blame you?

Buying at 35 when the market goes up from 30 to 50 is doing a better job than buying at 45 when the market goes down from 50 to 30. Nevertheless, the second buyer will probably get praise for “making a saving”, whereas the first one needs to explain why costs are going up.

More on different price hedging techniques

Many of you procuring energy have probably had to make those explanations in the last months. Best case, you operated in the framework of a well-defined energy procurement strategy so you can perfectly explain the situation and justify that your actions were in line with well-defined strategic goals, such as “avoid that electricity or gas prices increase too much” or “stay in line with the market”. Worst case you are confronted with stakeholders that refuse to understand that the wholesale energy markets move up and down independent of your performance as an energy purchaser. They consider your buyers’ job to be making savings regardless of what happens.

Bullish energy markets are also pitiless. For example, being late with putting a electricity or gas contract in place due to uncertainty over contractual volumes, will immediately cost you a few euros or dollars per MWh. Hesitation over a fixing can be likely costly. If anything, then the past two years have shown the importance of putting good practices of buying energy in place. But even with the best energy sourcing strategy, buying when markets go down is more fun than buying in bullish markets.

The main characteristic of buyer's psychology: savings!

When we hammered out E&C’s approach to energy risk management in 2005 - 2008, we actively explored the field of behavioural finance. Because after all, behind that curve of energy market prices going up and down, there are people, showing human reactions and emotions. Psychology is at play in the markets. The problem with a typical buyers’ psychology, is that is often biased towards cost reduction. Companies see the procurement department as the people responsible for cutting costs. And buyers’ choose a career in procurement because they love to make a bargain.

There’s nothing wrong with that of course. I wouldn’t want my procurement professionals to be notorious big spenders. And an emphasis on cost reduction is necessary to create added value for your company in e.g. energy contract negotiations (tempered by good insights into quality & service requirements and total cost of ownership). But it creates problems when energy buyers need to take decisions regarding gas price fixings in wholesale energy markets. We have identified three main dangerous mechanisms:

  1. The fear of fixing prices when markets go up. A buyer wants to make better gas or power prices. This makes her / him often very reluctant to make price fixings in a bullish market. Every day, she / he sees a price that is worse than the price of the previous day. Leading buyers to literally tell us on the phone: “my boss doesn’t pay me for making a price that is worse than the price I could have made yesterday”. If markets continue to go up, this fear of heights of the energy buyer can be an expensive affair. Decisions not to buy in a rising market are often rationalized by a buyer that finds a myriad of reasons or so-called market analysis why “prices will go down again”. But such forecasts are often just wishful thinking. And if markets continue to be bullish for a longer period, not buying inevitably ends in a catastrophe of unexpected high cost increases.
  2. Fixing too soon in a falling market. When markets drop, the buyers’ psychology plays against her / him in the opposite direction. Every day, the price is better than the price the previous day. The buyer sees this as a bargain and wants to fix it quickly before the opportunity is lost. But if markets continue to go down, this leads to big losses against the much better prices that occur later in the bear run.
  3. Not fixing enough in a good moment. Markets have dropped to historical lows. But a buyer doesn’t want to fix, because she / he is convinced that prices will drop even lower. Greed is at work. The buyer has grown addicted to the adrenaline of seeing ever lower prices and future energy budgets and cannot believe that every bear market inevitably comes to an end.

In the past two years, we have seen again how the fear of higher prices can be paralyzing. Almost every client needs a push in the back to make the stop loss decisions that help to avoid cost excesses in bullish markets. Some 15 to 20% of our clients don’t manage to overcome their reluctance to fixing in bullish markets. Sometimes it is the buyer her / himself that has the problem, sometimes it’s another internal decision-maker that is stopping the decision.

Don't fear fixing in a rising energy market

Energy hedging strategies can help a buyer and his organization to overcome the fear of fixing in a rising market. Some 70% of our clients are what we call “budget risk clients”. For such clients, there is no possibility of passing on a higher energy cost to customers by increasing product prices. It’s very simple: every euro or dollar that is to be paid extra is a euro or dollar less profits. They are particularly affected by bullish moments in the markets.

To mitigate such energy budget risk, we put in place energy strategies with a strict risk stop loss mechanism, e.g., if the price increases by more than 10% compared to the previous year, we buy everything to stop the resulting increases of our global energy budget. With a value-at-risk calculation generating worst case scenarios that indicate early warnings in a rising market, you can gradually hedge energy to avoid that you have to make the 100% fixing when the risk limit has been reached.

Nevertheless, we have seen in the last months that for some clients making such stop loss fixings is impossible. They should be aware that this is like driving a car without breaks and that it will inevitably lead to disastrous energy cost excesses in case of long periods of rising prices. Therefore, managing your fear of higher prices is one of the most important things that you should do to source energy successfully.

Having the possibility of not just fixing but also unfixing positions can be helpful. You know then that if markets start to fall again after you’ve taken your stop loss decisions, you can limit the damages by selling those positions again. However, good unfixing starts with good energy fixing. And a buyer that cannot control the fear of buying in a high market is not ready for the more complicated hedging approach of buying and selling. Moreover, the decision on whether selling is allowed or not depends on corporate decisions that are often outside of a buyers’ control. So, control your fear of heights and you will definitely be more successful in energy procurement.

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