Commodity Management Blog

Innovative Ideas and Thought Leadership for Volatile Commodity Marketplace

 

Chinese Curse“May you live in interesting times,” is a traditional Chinese curse that could be applied to today’s energy markets.  There is a conflation of events consisting of rising demand, uncertain supply, infrastructure constraints, shifting global environmental policies, and changes in technology. Taken together, they create the conditions for a “perfect storm” in energy trading. So what are these events, and why should they concern us as a CM system vendor?

Firstly, let us consider the supply-demand balance of the main energy feedstock – oil.  In a number of market reports, including those produced by the oil majors, there is talk of a permanent return to “$100+ oil” as an increasing shortfall in global supply is brought about by the emerging economies’ increasing appetite for energy. Putting to one side the debate on “peak oil”, it is clear that recession or not, absolute levels of demand are rising and the only short-term response the market can make is to increase price. Adjusting for inflation and currency fluctuation, there is no reason why we shouldn’t see $150, $200, and $500 oil in the near future.

These oil price increases will ripple through the other commodities of the energy complex, with significant real price rises in coal and gas – especially those commodities whose price is directly indexed to the price of oil. We shall also expect to see more bouts of extreme price volatility as various economic sectors suffer dislocations as a result of rising energy prices.

Secondly, the environment is back on the political agenda again after it was announced at the end of May 2011 that Carbon dioxide emissions are at their highest ever, creeping inexorably closer to crisis “tipping point” levels entailing “dangerous climate change.” Even without this extra stimulus, and no firm lead from a “Son of Kyoto”, the European Union is setting more stringent emissions reductions targets. Phase III of the flagship EU ETS starts to bite in 2013, imposing very real and costly emissions reduction obligations. Power generators will suffer a double whammy, as they suffer disproportionately higher reductions targets and have to bid for scarcer Allowances in an auction process.

The European power sector is also being hit with additional Directives aimed at the de-carbonisation of generation. EU policy on increasing generation capacity from renewable fuels is seeing a big rise in power generated from “intermittent” sources, leading to wild swings in the power grid’s supply-demand balance, and causing extra price volatility. Grid operators are expecting to be compelled “constrain off” fossil fuel plant on windy days, and some argue that this will increase maintenance costs of coal and gas stations as they are forced to operate outside their optimal mechanical and thermodynamic performance envelope.

All this points to substantial rises in the prices of Carbon and electricity, and a knock-on effect on the prices of all goods where energy is a significant proportion of their cost-base. To make matters worse, some countries, e.g. the UK, are proposing to give the current price of Carbon “a little helping hand” by setting a floor price. For some economic sectors, this amounts to a double taxation and higher costs again.

On the flip-side of green generation is the hunt for “Negawatts”, or the ability to reduce load at short notice. It has always been a truism to say that it’s much easier to reduce electricity demand rather than increase supply, especially as most systems have significant amounts of latent flexibility that can be tapped in to. The hunt for “Negawatts” is gathering pace, and we shall see some hard bargaining occurring between the demand side, system operators, and traders as the former discovers its market power.

Thirdly, in parallel with energy supply/demand fundamentals, major investment is needed in new energy infrastructure, ranging from refinery capacity, pipes, wires, storage, and power generation. The sums are staggering – the London Financial Times forecasts that this will be the “trillion Euro decade” for European infrastructural spending. In the current age of austerity, one wonders where this money will come as neither the public nor private sectors are in a very fit state. In the UK, DECC estimates a necessary spend of £233.5bn.  Germany has announced it needs to spend over €50bn just on a single project to reinforce the transmission grid to move power from its northern wind farms to southern population centres.  The UK has already seen substantial “constrained off” payments made to wind farms because the grid cannot accept delivery of their power. The most recent event, costing nearly £1m, was made to a Scottish wind farm in early April. It attracted widespread criticism in the press, mainly because of the observation that not only were UK electricity consumers paying a subsidy to build wind farms; they were now paying a second one to switch them off.

Lastly, US and EU regulators are introducing new rules to reduce systemic risk and increase transparency in OTC derivatives trading, including commodities, forcing commodity traders to clear their “standard” OTC trades, and post higher levels of collateral for un-cleared “non-standard” OTC trades. This is not cost-free as traders have to post initial and variation margin, and deposit collateral. It is thought the cost of these new measures could run to $1 trillion.  Very large vertically integrated groups in Europe may have working capital/cash facilities of over £1bn, but most firms will be lucky to have facilities of only a few hundred million. This problem will escalate as commodity prices rise – just because the oil price doubles, bank lending lines do not. Credit and liquidity risks are becoming the most important issues for the commodity market place. The cost of trading OTC instruments will rise steeply as traders have to meet stringent new margining and collateralisation obligations. Again, where these funds come from is problematic, especially if they have to be transferred from budgets belonging to “real business” activities.

Taking all these elements of the “perfect storm” in to account, it appears that future energy trading market dynamics will change dramatically as energy prices rise in real terms, and are increasingly volatile against a background of increased regulation, environmental politics, changes in technology, and shortages of trading capital. Some commentators have remarked that there will only be two kinds of energy trader, the “quick” and the “dead”. We are heading into uncharted territory – “here be dragons” as they said on old maps, or a “dislocation event” in modern speak. Whatever the metaphor CM systems will be under increasing pressure to capture and analyse a complex matrix of variables, many changing dramatically in real-time, and support optimal execution of an increasing range of complex asset-related trading strategies.  Tight integration of all system components is demanded like never before, entailing the need for broad, flexible trading platforms as opposed to diverse point solutions.

In Energy, our generation lives in “interesting times”. Only history will tell us if we were “cursed”.