Procurement Category: Energy Energy Market Forces: Friend or Foe?
As dynamic energy pricing becomes more prevalent in the industry, multi-site organizations are presented with new challenges, as well as opportunities, to control and optimize their energy costs. Times are changing today organizations can identify opportunities to leverage new pricing models and rate structures to create a portfolio approach for their energy spend. Like any investment, a portfolio approach requires that organizations align their risk profiles with their strategic business goals. We have worked with clients across a broad spectrum who have come to view their energy spend as a growth lever for their organizations whether the client has a growing enterprise opening or acquiring hundreds of locations each year, or evaluating product lines to make sure energy costs are appropriately included in cost structures. Wherever an organization is along the continuum, it is clear that to make the most of its energy spend, today s businesses need to understand all options, explore new ways of thinking and doing, and take advantage of new pricing products. What has not been as clear in the past is how an organization can take control of its energy spend to create an integrated energy strategy that matches its risk profile with techniques that take maximum advantage of market forces. The following details energy strategies worth considering. Should I fix my energy price or leave it to float? If you have ever purchased a house, you know firsthand the anxiety of choosing a fixed versus variable rate mortgage and trying to time the market to choose the right moment to lock in. Many people think that a fixed rate is the low-risk option. A fixed rate can also be quite risky what if you lock in at the wrong time? For large energy consumers, a more sophisticated, hybrid approach can make the most sense. Similar to individuals who want to ensure they have a diverse mix of investments within an investment portfolio that match risk tolerances with return objectives, it is important to diversify your energy position. To make the most of energy spend, organizations need to understand all options, explore new ways of thinking and doing, and take advantage of new pricing products. 2
How can I diversify my energy position? What will be the benefits? Becoming educated about the energy market in general is the first step. There are multiple options to consider once your organization has agreed upon a risk management strategy. Here are a few strategies to consider: Strategy 1 Block and index One of the more sophisticated strategies that can be employed for deregulated electricity is a block and index product with a multiple layer hedging strategy. This purchasing strategy mirrors the way that energy suppliers procure power themselves, through wholesale blocks or tranches that are sized to fit as closely as possible the purchaser s load shape, as depicted in the graphic below. The block and index strategy provides the ability to partially fix a price at different points in time, limiting your single day execution risk such that you don t have to hope you pick the right day to fix your contract price. This approach also offers additional opportunity to secure a lower price as you approach the actual contract period for energy requirements, providing more value to your organization. Aside from supply/demand, weather, and other market disruptions, commodity market contango means that prices will trade down as the delivery date approaches. For this reason, the optimal strategy for energy is to set reasonable targets based on historical prices to begin purchasing as far as a few years in advance, and then to look for increasing value (i.e., lower prices) for each incremental purchase. Even then, we suggest that some energy should be left open to spot market pricing possibly even a majority if lower price targets are not reached in advance. These advance targets should be re-examined regularly and modified as necessitated by changing market conditions. We suggest that some energy should be left open to spot market pricing possibly even a majority if lower price targets are not reached in advance. Block and Index Strategy 3.0 2.5 2.0 MW 1.5 1.0 0.5 0.0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Hour Ending 5x16 On-Peak 7x24 Baseload Hourly Usage 3
Below is an example of the block and index strategy and the savings it could have generated during a volatile period during 2012 in the Electric Reliability Council of Texas (ERCOT) versus a typical fixed price full requirements scenario. ERCOT operates the electric grid and manages the deregulated market for 75 percent of the state of Texas. The graphs shows the prices for an around-the-clock (unshaped, no supplier adder) block of power June- September 2012, as traded from July 1, 2010 through April 1, 2012, and then the corresponding spot prices (real time and day ahead) for unhedged portions for summer 2012. ERCOT Futures: June-Sept 2012 $50.00 $45.00 $40.00 $35.00 $30.00 $25.00 $20.00 $15.00 $10.00 $5.00 $0.00 Below is a comparison of two strategies intended to show some of the advantages of a block and index approach. Strategy 1: Fixed Price Full Requirements June September, 2012 Locked: 1/1/12 Price: $43.14 Strategy 2: Block and Index 33% Block (Locked 1/1/12) $43.14 33% Block (Locked 4/1/12) $33.20 33% Real-Time $26.99 Net Average Price Paid: $34.44 Savings Strategy 2 vs. 1 = ($43.14 - $34.44) x 80,000 MWH = $696,000 Note: Above prices are not load shaped, no supplier adder 4
Strategy 2 Load-following hedges Purchasing firmly-sized, multi-hour blocks of electricity in advance is the equivalent of trying to forecast and purchase the exact number of hot dog buns for a large party. Buns (and kilowatt hours, or kwh) are only sold in certain quantities, and inevitably you will need to buy a few extra if you want to make sure you are able to serve all of your guests. Additionally, it is difficult to forecast how many guests (or kilowatt hours) will actually show up for the party when buying in advance. For this reason, many suppliers offer a load-following hedge in order to simplify the purchase for consumers. Through this product, customers are able to hedge exactly X percent of energy for every hour, regardless of how many kilowatt hours are actually used. Using the previous load shape as an example, the usage in orange in Figure 1 would represent a 50 percent hedge against the blue load shape. The usage above the orange shaded area, but below the blue line, would be unhedged. The load-following hedge strategy greatly simplifies the purchasing decision for large energy users and works particularly well for organizations with smaller utility accounts or a large number of accounts, where it becomes quite complicated to match and allocate bulky blocks across the individual accounts. However, organizations will pay a shaping premium when asking a supplier, who is buying in blocks, to hedge an exact percentage of usage. Additionally, suppliers will charge a risk premium because of the possibility that more or fewer kilowatt hours may be consumed than were forecasted, yet they will still need to honor the exact percentage hedge. While there is some exposure with load following, there are also ways to limit that exposure by developing consumption forecasts, taking production schedules and seasonal variations into consideration, and creating a minimum or maximum range. The result can look like Figure 2. Organizations that are also able to take demand into consideration, linking strategically with seasonal variations and production forecasts, can better help forecast energy requirements and plan accordingly to maximize their energy budgets and understand their risk profile. Figure 1: Load Following Hedge Strategy MW 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Hour Ending 50% Hedge Hourly Usage Figure 2: Load Following Hedge Strategy with Min/Max Ranges MW 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Hour Ending 50% Hedge Proj Hourly Usage Min Max 5
Strategy 3 Heat rate product Heat rate is a term that describes a power plant s (or group of plants ) efficiency in converting fuel to electricity, with lower heat rates being more efficient. In areas like Texas and New England where electricity is primarily natural gas fired, it is relatively clean and easy to convert electricity pricing to be based upon wholesale natural gas rates through executing a heat rate product. Example: $45 per MWH electricity / $4.50 per MMBTU natural gas = 10 heat rate If one were to lock in a heat rate of 10 for an entire year, their monthly electricity price in lieu of a fixed position would be: Jan 2013 Nymex natural gas settles at $3.354 / MMBTU x 10 = $33.54 per MWH power. If an organization desired to lock in fixed prices for any month, they could look at gas futures and know that, for instance, on May 22, 2013, natural gas for January 2014 settled at $4.569; and therefore they could lock in an electricity price of: $4.569 / MMBTU x 10 = $45.69 per MWH power. A heat rate product offers similar benefits to the block and index strategy, with the additional benefit of competitively securing and limiting supplier margin for all future hedges. Quite often price triggers are set with the supplier to automatically secure power based on target natural gas prices in future months. Additionally, a heat rate allows you to swap regionally volatile spot market electricity prices (Texas summer electricity) for a less volatile index (NYMEX Henry Hub natural gas). However, this introduces a new element of risk through this new index that must be considered as well. Finally, it should be noted that it works especially well to lock in a heat rate if there is a strong feeling that the natural gas market will drop in the short term or before the delivery date. A heat rate also works well if a company already financially hedges natural gas and would like to convert electricity volumes to a gas equivalent in order to financially hedge electricity using additional gas contracts. For instance: 5,000 MWH per month x 10 Heat Rate = 50,000 MMBTU per month could be hedged financially through NYMEX Henry Hub contracts. 6
Monitoring the markets The above purchasing strategies require that organizations are able to monitor markets constantly to look for hedging opportunities. Timely execution based on identified trigger prices and/or events are mission critical for getting the most out of your identified strategy in order to seize opportunities. This suggests a dedicated resource(s) to track, follow, execute and analyze market conditions for both natural gas and electricity will be needed, depending on the geography and number of locations being managed. Whether the resource is internal or external, third-party firms who are active in the market every day can provide organizations with additional expertise, specialized technology, tracking and reporting to monitor markets and support internal teams. What s a major energy user to do? Take control. This is easier said than done in many cases if your organization does not have dedicated energy resources that understand what to look for and how to take advantage of the dynamic energy environment. Here are some ideas to get you started: Identify the way your organization wants to manage energy spend. For instance, are energy purchases centralized? If not, there needs to be discussion about how best to leverage decision making to benefit the entire enterprise. This is a critical question whose importance cannot be overstated. Organizationally and culturally, governance can pose the largest challenge to optimizing energy spend. Research the energy market conditions in which your plants and locations operate, i.e., regulated or deregulated, pricing products available, mandatory versus voluntary options. Identify your energy consuming assets to know where you may be able to implement energy reduction programs and where your operations are most efficient today. Understand your organization s risk profile. Create or work with a partner to develop a strategic energy plan that connects your strategic business goals and infrastructure needs with your current and future energy requirements. Understand and predict energy consumption based on forecasted production volumes and seasonal variations. Understand where your operations can and cannot be flexible to capitalize on demand response programs that allow organizations to curtail power for financial reward during times when the grid is either stressed and/or energy prices are at their highest. Finally, you may need to engage energy management experts to actively monitor markets for opportunities to layer in fixed rates at advantageous prices with more sophisticated hedging strategies to both manage risk and take advantage of opportunities that price volatility provides. Look for experts who are constantly working on your behalf, long after supply contracts have been signed. Make sure these experts will keep you in the know so that you can help your organization take control and make better decisions about its energy spend. 7
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