Energy markets change quickly, making energy management critical to protecting your bottom line. Here are the most important things to know about successful energy management programs.
Hedging versus Speculation. The CFO of one of our large international clients had a habit of telling his energy management staff that hedging was speculating– taking a price position was, in effect, betting that we knew we had the best market price available to us, when in reality markets could drop later, giving us a better price at that time. He opined that this was tantamount to speculation and was forbidden by corporate policy. He was partly right–market prices are going to do one of two things in the future: 1) Go up, or 2) go down. We never know, with certainty, which.
But here is where he was wrong: His firm (a large, energy-intensive, industrial company) was naturally short, meaning that they are always going to use energy in the future. Without any hedges in place, they will take whatever price the market offers at the time they use energy. That means they are exposed to all of the volatility in the market between the point in time when they could have hedged energy prices and when they ultimately use energy. It means without hedges, they have taken a short position. They are betting prices will go down. Simply put, they have already placed a big bet. The effect of the hedge is to counter or neutralize the bet they took.
By countering a short position with buying energy ahead of the time of its use (hedging), they are getting back to a neutral risk position. This is not speculation. It is the opposite.
Laudable Objectives Can Become Your Undoing. Here is a laudable but elusive objective we hear from one of our clients regularly: “I’m just looking to reduce my prices year-over-year.” I understand the sentiment. But it isn’t an objective.
If futures indicate pricing for next calendar year is 20% higher than this year, the client’s objective isn’t particularly useful, even if I share their desire.
We help our clients develop energy objectives such as defining risk tolerances for cash flow-at-risk, risk capital risk limits, absolute price points for futures and options, and so forth.
The point is that we need to first control risks through a well-defined set of risk objectives, and then we can work toward cost reduction or savings objectives.
The Bidding Conundrum. Many of our clients believe deeply that bidding schema will result in lower prices. The thinking, underlying most purchasing paradigms, is that bidding business to new competitors will naturally bring about innovation in the supply chain, and with it, price compression. Or that a large volume purchase will drive a lower price.
Energy markets don’t work that way. Because energy commodities are based upon very visible, liquid, futures contracts, sellers all have basically the same comprehensive market information available to them at the push of a button, and will not offer discounts to sell to Party A when Party B will buy at the undiscounted price. Granted, some suppliers are more competitive than others, but the best sellers will be within a hair’s breadth of one another.
Choose suppliers that have 1) the geographical coverage you need for the commodities you use, 2) sharp pencil pricing, and 3) most importantly, solid financials, because who wants to business with a supplier who melts down and takes your hedge into bankruptcy with them when an adverse market happens (think Enron).
Bidding, by itself, will not drive low prices. Market timing and a strong understanding of the phenomena of contango and backwardated market curves are much more valuable (more below).
Power Laws. Most of our clients manage energy purchases as a purchasing function: Commodities are like all other consumables, right? Well no, not exactly. Because commodities are subject to mathematical power laws (a common element of all financial markets), commodity prices fluctuate much more radically, and quickly, than do other feedstocks a company might buy.
Recognizing that energy prices have characteristics unlike other products a company might buy augurs for a fundamentally different approach.
Value-at-Risk Models Can Increase Risk. VaR is used to assess the risk of markets and specific transactions. VaR uses “certainty” levels to say things like, “There is a 95% probability that the price we will encounter will fall between X value and Y value.” Energy traders, and energy users who listen to them, often get a false sense of security that if we’re within the certainty range, all is well.
The problem with VaR is that it truncates historical data. What I mean is that the analysis ignores infrequently occurring high and low market prices in order to make the statistical model work. In fact, that is exactly what makes the model not work. What we are most interested in are the infrequently occurring high values that could wreck our profitability of they do come about.
When using VaR to assess risk, add stress testing to the analytics. Calculate VaR, but then stress test the model by forcing it to consider effects of very high prices. See what happens. If the model predicts a disastrous outcome, look into ways to control them. Don’t ignore high prices; use them as a tool to build a more robust solution.
Models are important, we can’t emphasize that enough. But to get the right answer, you’ve got to ask the right questions.
Savings Conundrum. Success of energy management is often measured with the metric of savings. But if we are starting with a short position, there is no guarantee of savings. And waiting for savings to arrive means leaving risk exposures open, hoping that markets move favorably.
What if they don’t? I’ve known many well-meaning plant managers, with their own performance incentives based on plant operating cost reductions, who left positions open because markets wouldn’t cooperate at budgeting time. Such actions are at cross-purposes with effective energy management objectives. There is a better way.
We can structure performance goals around risk reduction objectives, profits earned on energy risk capital, and incremental improvements on hedges after their initial placement, as well as other measurements. These are very real metrics, and more importantly, are supportive to a well thought out energy management program.
Market Timing. Market timing, leavened with a deep understanding of the behavior of futures curves, is crucial for capturing savings. While no one knows when a market will hit its absolute top or bottom, we can know when we have reached our objectives, or reached a risk tolerance limit.
Building an energy management program based on appropriate objectives allows us to tap into the power of market timing without opening ourselves up to unfair Monday morning quarterbacking from those who might later criticize a decision to lock in prices. Approval of energy management objectives at the outset gives us the ability to protect the company’s interests, with alignment throughout the decision-making chain of command.
BOTTOM LINE: A successful energy management program, with well-defined objectives, can create tremendous, measurable value for an organization, and allow energy users to harness insights into energy markets to its advantage.