The COVID-19 outbreak has had a significant impact on every aspect of global business and the energy sector is no exception. An unprecedented slump in demand has seen prices plummet; coal has been the hardest hit, with worldwide demand tumbling by almost 8% in the first quarter of 2020 compared with the same period last year.
So how can organisations guard against market volatility while unprecedented uncertainty persists in energy market?
A good strategy is vital
A demand shock on this scale may be followed by a consequential change shock impacting supply going forward, with energy producers reducing production or shutting down altogether. If, or when, this happens, it is difficult to predict prices and increased volatility and uncertainty of the market direction often occurs as a result.
Businesses may consider whether, in the wake of significant price fluctuations, it is more beneficial to fix energy costs long-term or to buy in the short-term market, also known as spot buying.
There is no ‘one size fits all’ answer. Every business is unique, with its own individual tolerance to price fluctuation and supply risk. Formulating a long-term dynamic energy strategy will enable organisations to become more resilient to market changes. Important elements of such a strategy involve factoring in price trends and developing a hedging plan.
Price fluctuation – albeit on a smaller scale than during the pandemic – is nothing new to the energy sector. Over the years, we have seen energy markets exposed to extreme market conditions and price changes, and we expect this to happen in the near future.
Levels of demand for energy are greatly influenced by external factors such as the weather, climate change, competition and changing regulations. Therefore, the possibility of extreme price swings within the energy market will continue to exist long after the current crisis is over.
Experience shows that the best way to combat price fluctuation and to safeguard supply is to have an efficient, robust risk management strategy in place.
What is a price risk management?
Protecting your organisation against energy price volatility is important to avoid risks to your business. Simply settling for the daily market prices might not necessarily be the most cost-effective option, particularly if your business is a large-scale consumer of natural gas, electricity, or fuels.
Having a comprehensive price risk management strategy in place can mitigate such volatility and enable users to manage budgets more effectively. It will also help to protect margins, minimise price swings and enable you to stay competitive.
The first step is to understand how your business is affected by unexpected price fluctuation; and whether rising or falling prices have the biggest impact.
This requires a thorough analysis of both external and internal factors, to determine your organisation’s objectives and unique tolerance to price fluctuation.
While external factors such as the industry in which you operate, the competition and the weather may be beyond your control, it is important to understand how these known risks affect the market and to evaluate your business’s tolerance to market volatility.
Various internal factors must also be considered, such as protecting margins, securing budgets and other financial requirements.
In addition to helping you manage projected budgets and costs, this analysis will enable evaluation of suppliers and utility infrastructure, capacity and storage while monitoring price and aiding the credit process.
This comprehensive risk assessment, used alongside in-depth market insight and daily monitoring, will establish short and long-term goals that will ensure your business has the right information to buy better and buy smarter energy.
Energy price hedging is another integral element of your risk management strategy. Energy hedging solutions will benefit from market intelligence and your organisation’s data. Using hedging tools such as fixed-forward pricing, caps, and collars, depending on your business’s needs will help you take advantage of the rise and fall of energy prices.
Including sell back or unfixing forward prices in your strategy will also enable you to benefit from a falling market price trend, as well as the possibility to take spot in delivery for part or the whole portfolio. Sell back has been particularly well-received in recent years, as the renewable share of the energy production market increases.
There is no definitive time to hedge energy; it can be done monthly, quarterly or when the time feels right to help your organisation meet its targets and protect profit margins. Always consult an energy expert before making any significant changes to your contract to avoid potential penalties or being forced to unwind hedges.
An eye on the market
Crucial to making informed decisions is keeping a close eye on the energy market. Tracking energy prices, market trends, carbon positions and regulatory changes will give you the most up to date market intelligence and pinpoint the risks and opportunities in the market at any given time – essential if you are to make informed decisions on energy procurement.
Monitoring the markets effectively will not only help you to understand prices and identify opportune moments, it will enable you to avoid fixing at a moment when prices are at a peak.
It is also important to keep abreast of any changes to regulation that may impact your business or sector, whether it is relating to energy consumption, such as ESOS or Contracts for Difference (CfD), or energy supply – for example, IMO 2020.
Monitoring the markets and legislation can be a time-consuming and somewhat overwhelming process if you are unsure what to look out for and what fluctuations could benefit or impact your business. The rapidly changing nature of energy markets can make tracking energy prices problematic, particularly if organisations lack the in-house expertise to monitor prices on a global scale.
Future-proof your energy procurement
The ongoing global COVID-19 pandemichas led to significant changes in demand for many businesses around their energy consumption, as well as price and cost uncertainty.
While events such as this are thankfully few and far between, it is still important to always have an eye on the market to mitigate risks and maximise opportunities as you never know what might be around the corner.
It is good practice to review your energy portfolio regularly and consider the contract tenure. Markets can rise and fall but being ahead of the game can reduce potential risks and open up opportunities to make savings in the long-term. Explore whether your current contract gives you the option to extend, capture and lock in historically low prices or request a longer hedging horizon should the market dynamics change.
Make sure you understand your payment and credit terms on your contracts, through appropriate due diligence. Communicating regularly with your suppliers will help minimise the impact of financial or commercial risk to your business.
The success of an energy price risk management strategy is how you manage it. Once in place it needs to be monitored and regularly reviewed, either by an internal team or outsourced to a third party. What might be a risk today, might not be tomorrow.
Rolf-Helge Sørensen is Head of Risk and Trading, EMEA, at World Kinect Energy Services. Managing a team of 10 portfolio managers and analysts based in Norway, Rolf-Helge is responsible for price risk management and trading activity within power, gas and EUA in the EMEA region.