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How to tackle the high prices

By Merlijn Mertens

By Merlijn Mertens on 7/09/2022

We’re over halfway through 2022, a year to which future history books will add the word “energy crisis”. The likelihood of a shortage of natural gas supply this winter has increased now that Russian supplies have been cut down further and Germany has upped its alert status one step closer to the emergency level. On top of this, buying natural gas and electricity in Europe continues to cost many times more than anything we’ve seen before. This also has an upward pull on many other markets across the globe. Our consultants are busier than ever helping their customers deal with the consequences of this crisis. But they´re still willing to give us a bit of time to share their views on the issues large energy buyers have to deal with.

This series includes:

  1. How to tackle the high prices
  2. Understanding the security of supply risks
  3. How to assess the counterparty risk of your energy supplier(s)

Prices for buying natural gas and electricity on both a spot and forward basis continue to trade at record high levels. We speak to Merlijn Mertens, one of our Energy Traders, a Doctor in Nuclear Fusion Science and Engineering who made a remarkable career-switch to become our expert on hedging, to understand the steps you can take to mitigate your risk during these times.

Is there a worse-case situation large energy users should prepare for?

While the current high energy prices are very worrisome and put certain industries at severe risk, we see that many energy users have become accustomed to this situation and are no longer panicking. In general, I’m currently seeing energy buyers being more down-to-earth and disciplined than ever in making hedging decisions. They understand now that we are in uncharted territory and that there is no predefined limit to energy prices. A probable worst-case scenario would be a complete cut from Russian coal, oil and gas supplies, most likely as a result of Western sanctions. Not only would this cause energy prices to continue to surge, we would probably also see government-imposed demand side management, with major non-essential energy users being cut off from gas and/or power in case of a shortage in fossil fuels. It is very important for companies to have contingency plans in place for such a scenario, but my colleague Bart Verest sheds more light on this in his interview on Security of supply.

Can large energy users expect government help in this matter?

Ideally, a deregulated market should remain as untouched as possible from governmental interventions. That being said, the situation we are currently in is unprecedented and if there is a time for governments to intervene in the deregulated European energy markets, it is probably now. Not doing so might result in hundreds of bankruptcies of companies struggling with these high market prices and having a hard time competing with, for example, companies in the US where gas prices, although having increased as well, are still many times lower. What helps to ease this risk slightly is the fact that – due to the globalization of energy markets – this energy crisis is wide-spread, meaning other regions (i.e., Asia) are not able to simply outprice European competitors.

We have already seen several smaller measures aimed at bringing some relief to companies in trouble, such as:

  • additional ARENH volume being allocated in France;
  • the EC proposing a Temporary Crisis Framework for State Aid, giving member states a bit more flexibility in the state aid they provide which allows them to focus on companies in trouble; and
  • a price cap on gas for power generation in Iberia.

Given the high cost of any significant government intervention, it makes sense for governments to focus state aid on companies fully exposed to the currently high spot prices – those in deeper trouble than companies that might have hedged rationally and are therefore facing less of a budget shock. The problem here is that market participants with a lack of strategic hedging practices are actively rewarded, while those with these practices in place are penalized. On the other hand, supporting all businesses and households equally would create debt for many future generations to come. Due to these reasons, coming up with interventions or price caps in a deregulated market which are both effective and fair to all market participants is not straightforward. The EU energy regulatory agency, Acer, has urged national governments to carefully consider the medium- and long-term impacts of any emergency intervention, stating that interventions should be aimed at tackling the current exceptionally high gas prices rather than touching the fundaments of the power market design as the latter could deter the investments needed for the EU to meet its long-term climate and energy security goals. As a result, the EU leaders are urging the EC to explore an EU-wide price cap on gas imports from Russia. This is however more likely to be decided on a G7 level.

Should large energy users hedge or not?

Yes of course, no doubt about it. Hedging is a container term that people use to designate many different things. But we look at hedging and risk management at E&C as a procurement practice where you make sure that the P&L of your company is protected against events in the wholesale energy markets. This means that with hedging you can even protect yourself against extreme events such as the one we are currently seeing. This has been a stress-test of hedging practices and we can say with pride that what we’ve set up with our clients in the past years has stood the test with glory. Depending on the size of their overall spend, clients are spending tens or hundreds of millions less than if they wouldn’t have done any hedges. For the largest users, we’re even talking in billions.

In the course of the 17 years that we’ve been in this business, we’ve heard many companies arguing that hedging includes a risk premium which you avoid paying by buying at spot rate. Ahem. Those are the companies that we can now hear complaining in the papers, that have shut down factories and asked governments for financial support. The money you make if you currently have hedges in place is just so large that it would take a hundred years of lower spot markets to make up for the losses you’ve made if you didn’t hedge.

Above all: hedging gives you the possibility to actively manage the prices that you pay for energy; to identify, formulate and achieve pre-set goals. If you don’t hedge, you´re simply a price-taker. A price-taker with a bleeding nose whose reluctance to hedge costs an enormous amount of money. I can’t possibly think of any reasonable arguments left for not hedging after what we‘ve seen here.

What is the best way of executing such hedging then?

There is no single correct answer to this question. Our decisions to hedge or not are always motivated by the central goals of the energy procurement strategy, with these goals closely aligned with how prices are set for the products or services our client is selling. For a large majority of our clients, budget stability is the main goal. For many of these, we were already buying larger chunks of their volumes for many years into the future in 2020 when we had historically low prices due to COVID-19. As prices rose, we continued to buy small parts of the remaining volume on a regular basis in order to spread the risk as much as possible. Currently, many of these clients are well covered for 2–3 years into the future, therefore they have the luxury to delay small remaining hedges for 2023–2024.

An important but smaller group are our so-called market risk clients. They are energy-intensive businesses where passing on changes of energy cost, up and down, to their clients by increasing or decreasing product prices is a well-established commercial practice. Market risk strategies aim for a price that is never high above the market, year ahead, quarter ahead or spot, depending on how the practice of changing product prices when energy costs change works exactly. They are therefore much more prudent in building up large forward positions than budget risk clients. Those market risk clients that are oriented on year or quarter ahead market average buy regularly in that period. In a bullish market, this means they are better off than when they stay on spot. Next to that, most of the strategies we have with market risk clients allow for some small opportunistic hedges when markets are low. Even if this has been done for just a few percentages, the extreme bullishness we’ve seen gives these opportunistic hedges a huge value in absolute euros. Above all that, we recommend market risk clients to focus on their process of passing on the extra cost to customers, which isn’t always easy in today’s crisis of inflation.

We’ve also seen that for some market risk clients, the extreme peaking of prices has laid bare disconnects between the energy procurement practice and the way that sales adapts the prices of the products. With markets going up and down by 10 Euros, such disconnects often pass unnoticed, but if prices increase by 500% to 600%, and your sales prices increase less rapidly than the pace at which your energy costs run up, that hurts. However, that painful experience has been an occasion for these clients to review the alignment of procurement and sales practices.

To make a long story short, we recommend sticking to the strategy as much as possible, even during these extreme times. Doing this, and considering the result over a longer period (not on a single click basis), you will see that you can still manage to achieve your strategic goals. The only reason not to hedge is when we see panic in the market with prices doubling intraday. We have had several of these peaks in the market and they typically only last for a few days. It can be a reason to delay a hedge and avoid these price peaks paralyzing you. Instead, step back and look at the bigger trends.

Blog: Fear of heights in energy procurement

What should these users bear in mind when deciding when and how to hedge?

I think I covered this mostly in my answer to the previous question. But to summarize, there are three things to keep in mind. The first one is the strategy. All hedges being performed should be first and foremost motivated by the strategy rather than any market fundamentals. Sticking to the strategy will allow you to achieve the strategic goals you put forward, even in this extreme market situation. Hedge because you want to reach strategic goals, such as to stabilize cost or to avoid going over a forward market average or to exercise the ability to do a small opportunistic hedge. Not because you think you know where the market is going. This situation has again pointed out the superiority of a rational strategic approach to buying energy over the usage of forecasts. Find me one forecast that didn’t say that prices would come down again when we started to reach the crazy levels. Such forecasts are just simply dangerous as they kept readers from taking the rational strategic decisions and helped them to give in to reluctance to buy at historically high levels, the forecasts that markets would go down again serving as a rationalization mechanism or excuse: the forecast says it will fall.

A second one, which is part of the strategy, but which should be stressed even more in these historically volatile markets, is spreading the risk. Avoid hedging too large portions of your volume in a single buying decision and try to spread that hedge over many buying moments. This allows you to average out the volatility that we see in the market.

A third one would be: keep calm and don’t panic. Over the last few months, we have seen several price spikes in the market; prices doubling or sometimes even tripling in a matter of hours or days. One example is the price spike that we saw at the start of March when the EU was considering a Russian oil embargo and when President Putin warned of a cut in gas flows as retaliation for such an embargo. Prices rose lightning fast to unseen levels, with front month gas prices more than tripling in a few days. However, when the EU agreed not to impose a Russian oil embargo for now, prices dropped equally fast. I would recommend not taking part in such panic moves. At the same time, you should not let it paralyse you. Allow some flexibility in your buying decisions to delay planned hedges by a few days to allow the market to settle, but not by weeks!

What about unfixing prices?

At price levels like the ones we are currently witnessing or that we witnessed over the last few months, energy users that have hedged well in the past are becoming more and more eager on unfixing positions. We saw this desire grow already several months back but have so far decided to always push back against any opportunistic selling. In the current market environment, the upward risk and volatility is simply too high to make a case for it. Very often when selling, you set a stop-loss limit at which you would force yourself to refix to limit the loss. On the other hand, a profit-taking trigger is rarely set or if set, rarely respected as people so easily get greedy when things are going in the right direction. The result is that – with the current volatility – even if you might be in-the-money at a given time, a sudden price jump can easily push the market price above the stop-loss limit, forcing you to refix at a loss.

At this point, there are only two reasons to unfix:

  1. if you (accidently) overhedged in the past; and
  2. if a drop in activity is expected due to issues in the supply chain of raw materials you need for production. If you need to unfix volumes on the near-term due to this reason, you could try to exploit the discussed price peaks caused by panic. If the overhedged position is expected to occur further out and is not too big in size, we recommend holding on to that position as long as we continue to see the upward trend in market prices and to spread the unfixing decisions if possible.

Once we see market fundaments turn more bearish and the geopolitical crisis situation ease slightly, that is when energy users could start to unwind some of their positions as they see the start of (what could be) a longer-lasting downtrend in the market. Also here, spreading unfixing decisions and unfixing small volumes at a time is essential as there is no way to differentiate between a long-lasting bear market and a temporary downtick, except in hindsight. Just as for buying, we recommend focusing on the bigger trends rather than getting caught in speculative behaviour aimed at exploiting day-to-day volatility. And of course, with prices at such high levels, if this ever corrects and prices go back to ‘normal’ levels, selling off positions and riding that long ride down could result in some pretty spectacular price optimizations. Our fingers are itching to get that done, but with so much uncertainty, we need to be very careful not to pull that trigger too soon.

Can anything be done for unhedged volumes?

There are indeed many energy users that were caught by surprise by this unseen bull run. A problem we often encounter is market participants too focused on current prices where they begin to consider them the new standard. In 2020, COVID-19 made energy prices drop to all-time lows. Some energy users saw this as an eye-opener and an argument not to hedge too eagerly going forward, instead keeping a larger exposure to spot to optimally enjoy such sudden price drops. It is true that for energy users neatly following their energy procurement strategy pre-COVID, this sudden price drop could have been painful to witness if large volumes were hedged on the short-term. However, their strategic goals were not compromised by this drop, whether those goals were to avoid large y-o-y increases in energy costs or to achieve a price close to certain averages.

In fact, it is these energy users that also continued to neatly follow their strategy while we were deep in the COVID-19 crisis that managed to optimally make use of the low prices that could be hedged also on futures. Over the past few years, some energy users have learned the hard way that there is more risk in leaving large portions of volumes open to spot than there is benefit. These companies find themselves today with large volumes exposed to the high market prices, desperately hoping prices will come down.

The advice from me would be to never assume that prices cannot go higher than current prices. It is a phrase I heard when Cal-22 gas prices topped 25 Euros/MWh and continued to increase – doubling, tripling, quadrupling… A first important step would be to get out of the paralysis that has stopped you from hedging in the past year. Define a catch-up strategy for volumes exposed on the near-term to limit any possible further losses if prices continue to go up. Also, for consumption volumes further out, I would recommend starting to gradually build up your position to progressively protect yourself against further price increases, but not to fix too aggressively either. Spread your risk over the full remaining period you have, thus making sure you still have some volume open to benefit from any downward trend in prices.

In any case, the main advice here is to stay calm, define realistic goals and set up a (catch-up) strategy aiming to achieve those, and most importantly, show discipline and stick to it.

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