Energy cost rises: mitigating the risks

Already faced with tight budgets, it’s essential for public sector organisations to have an energy procurement strategy in place that will help them mitigate the risk of price increases. The recent spike in the price of oil, and the knock-on effect it had on gas and electricity costs, was another reminder of just how volatile, and difficult to manage, commodity energy costs can be. Matt Osborne, principal risk manager at energy consultancy Inenco, discusses the drivers behind the recent rises, and provides some procurement advice.

Oil prices have been on the rise for some time. They have jumped over 60 per cent in the last year alone, due to a rise in demand and restricted supply by the Organization of the Petroleum Exporting Countries (OPEC), and in May this year, spiked to over $80 a barrel for the first time in almost four years, largely a result of a US decision on the Iran nuclear deal.

Iran is the third largest oil producer in OPEC1, and President Trump’s decision to withdraw the US from the Iran nuclear deal and reintroduce sanctions against Iranian oil exports had a significant impact on oil prices – as has the news that Iran is threatening to re-start its nuclear programme in response to President Trump’s actions.

Meanwhile, the economic and political crisis in Venezuela, which has the largest proven oil reserves in the world2, has caused its oil output to decline to its lowest levels in decades.

Another factor behind the steep rise in the cost of oil is the start of the US ‘driving season’. The US accounts for about 10 per cent of global gasoline demand3, and during the spring and summer, when people take to their cars for holidays, the demand for oil increases. Indeed, EIA data reports a 2.2 million barrel drawdown in US stockpiles in the w/c May 7 2018, which is a larger fall than the 0.2m barrels forecast, and the 2018 summer driving looks to be one of the most expensive since 20144.

Spikes in the price of oil feed straight into gas and electricity prices – following the surge in oil prices in May this year we saw winter 2018 prices reaching 60.65pptherm and £58.40/MW respectively. However, other factors affect gas and electricity prices too.

For example, we currently have limited gas storage capacity in the UK because of the closure of the Rough facility. Meanwhile, gas storage facilities in Europe are at a 10-year low for this time of year and reduced production from Groningen (Europe’s largest gas field) over the next few years will also tighten supply. There are also summer maintenance schedules to contend with, which restrict supply, and unplanned outages make the task of restocking storage facilities much harder. The UK’s limited gas storage capacity makes us particularly vulnerable when we experience cold spells, as demonstrated during the ‘Beast from the East’ at the end of February 2018 and the associated gas deficit warning, which sent intraday gas prices to 300p/th. Winter 2018 could potentially be very volatile again, especially if storage facilities are not refilled in time.

Meanwhile, maintenance at the Hunterston nuclear reactor uncovered cracks in the reactor core, resulting in it being taken off the grid for six months, and the LNG schedule remains light. The Pound has continued to fall, following poor GDP figures and ongoing concerns over Brexit negotiations, increasing the relative cost of fuel imports.

Rises in energy prices are difficult for any organisation to manage, but the public sector has very limited budgets, and in recent years has had to withstand severe spending cuts. In addition, the sector has sizeable energy costs; the annual energy bill across all public sector buildings in England and Wales is estimated to be around £2 billion5.

It’s therefore essential for public sector organisations to have an appropriate procurement strategy in place to manage and mitigate the risk of rising energy costs. This can help to save organisations significant amounts of money on their energy bills – in turn releasing funds for frontline services.

In a bullish market, where prices keep going up and up, it is risky to wait and see what happens, as it’s likely that energy will ultimately cost more. With higher energy costs on the horizon, we hedged our clients some time ago – advising them to secure their energy prices in advance.

Taking action now and fixing energy prices can mitigate the risks, but it’s important to have some flexibility too, in case the market changes. While the majority of indicators suggest the curve will continue to rise during the short to medium term, wholesale energy costs are affected by many unpredictable factors, so the opposite could happen.

In fact, some signs suggest that the price of oil could soften. Several events may influence this further – for example, if the other signatories to the Iran nuclear deal remain committed, the Iranian supply could remain in the global marketplace. We also have to consider that US production continues to outstrip increases in demand, and, where gas storage is concerned, we are seeing record summer flows from Russia into Europe, which are helping continental storage facilities re-stock ahead of winter. There could also be a significant increase of Russian gas into Europe following the opening of the Nord Stream 2 pipeline in 2019.

Working with an energy consultancy that offers flexible energy procurement – where there is an opportunity to purchase in advance if necessary, yet still be able to re-expose (unlock) volume back to the market to re-purchase at a lower price should the outlook change at a later date – is therefore key. The strategy taken will normally depend on the organisation’s appetite for risk and budget certainty, but an experienced consultancy will take these factors into consideration and will recommend an approach that best meets the agreed objectives.

Energy prices have strengthened significantly recently, and, bearing in mind the continued instability surrounding Iran and Venezuela, and the issues we are facing with low gas storage stocks, there is plenty of opportunity for them to continue to rise. Our advice is to take out, or extend, contracts now to protect against any further volatility, but to ensure they offer flexibility.

It is also essential for organisations to manage their non-commodity costs, which are also on the rise. In fact, we recently carried out some research that revealed that UK organisations combined can expect to have paid an extra £7.42 billion on their energy costs by 2019 if energy management strategies aren’t implemented. Organisations can use our interactive Non-Commodity Cost Dashboard to calculate their exposure to incremental non-commodity costs over the coming years.

1https://www.reuters.com/article/us-india-oil/india-says-too-early-to-predict-sanctions-impact-on-iran-imports-idUSKCN1ID0C2

2www.bbc.co.uk/news/world-latin-america-36319877

3http://www.poten.com/u-s-driving-seasonality

4www.foxnews.com/us/2018/04/30/get-ready-for-most-expensive-driving-season-in-years.html

5Taken from the Clean Growth Strategy