Throughout the year, energy companies buy and sell based on perceived loads for their customers, or the normal.
Power forecasting systems “normalize” loads in setting projections and building curves. Each year over the past five years, we have seen weather that is far from normal. These instances have broken a lot of good portfolios and cause much angst for suppliers as they try to plan for “normal”.
Just this past month we saw some of the coldest temperatures recorded in the continental United States. Low temperatures spread over a significant portion of the United States with some estimates of up to 200 million people having significantly below-normal temperatures. The question now that all suppliers face is, “What is normal?”
The emergence of the polar vortex in 2014 and again this year–or as we knew it as children, “winter”–has created those annual extremes that energy companies have come to dread.
In the winter of 2014 we saw pricing spike in some markets 10 times their previous cleared prices and again this year prices across the midwest were five to seven times higher than anticipated.
While the polar vortex points to a specific weather pattern pulling arctic air masses into the U.S., over the years energy companies have always had to deal with crazy weather. The real issue is what do you plan for now?
A good risk manager will look to build in a premium from a volumetric perspective. When building a future price, consider additional volumes at specific times that will add cushion for those volume and price spikes.
From an overall perspective, power and natural gas retailers can “flex” their volumes and create additional cost in the times where we expect significant weather fluctuations. In doing this, you will see that increased cost added into your overall pricing and create some cushion.
In the most competitive bidding situations, energy service companies will look to shave those precious pennies to win the bid and hope that, on an overall basis, you will make back any of the extreme price fluctuations over time. This rarely, if ever, works out.
Those price spikes and accompanying volumetric increases become the death of many retail transactions, especially in the natural gas market where the vast majority of volumes come in a very short time-frame. Thinking you will make that up is a fool’s errand.
So, how do you plan?
Which sorts of deals do you want in your portfolio?
How much of a price move can or should you expect to survive?
Planning comes in two areas: first is volume and second is pricing. It is not just the adjustments you make to your volume in pricing that matter; it goes double for the changes in your scheduling and hedging. If you are hedging physical volumes it is about buying blocks as opposed to long term flat products.
Thus creating, volumetric protections by layering your way into a hedge around what you have for baseline values. Picking these spots becomes imperative in profit protection. For your retail natural gas portfolio, you are stuck on the physical volumes that you need to provide as they are dictated by the utility programs.
You will then need to make sure you are accounting for those extra volumes in your price. It is easy to get aggressive on a deal that you really want. However, just make sure that you are not leaving yourself overexposed for a severe weather event.
We have seen over the years that when ESCO’s get overly aggressive on their price and take on reduced margin business, the outcome is more than likely unpleasant. These smaller margin transactions bleed through all aspects of your business and into your financing arrangements.
Borrowing base transactions becomes untenable when ESCO’s reduced margins cannot recover cash flow quickly enough. The inability to keep the borrowing base at a low number will begin to impede operations and growth in the future in the form of lower monthly borrowing ability and higher financing fees.
The premiums that you build into your price for load shape, risk and location become more important when facing weather extremes. You cannot capture all the risk in the short term on your portfolio, so understanding and managing the cash flow that arises from the fluctuations is essential.
Your cash will take short-term hits regardless of the extremes in times of higher pricing so managing cash throughout the year in areas where you will face these short-term moves becomes a task that extends throughout your organization.
A strong relationship with your financing entity and creating an understanding with them regarding your cash needs for both increased supply costs and operations during these extremes will allow you to survive these times.
Another way you can protect yourself is to balance your portfolio. Having deals that have both summer and winter peaking load will allow you the ability to buy a flatter hedge product at a cheaper price. Building these deals into the load you will create your own winter and summer extremes.
This is harder than it seems because you are captive to the deals that you can bring in. However, seeking load that you know will be a winter peaker, like schools, and a summer peaker, like shopping malls, can help lead you to a more balanced book.
Here is the most important piece: Don’t get blinded by a deal. Make sure that you are looking at how the deal fits into your portfolio and that it doesn’t weigh your book one way of the other. This is why having an experienced risk manager in your corner is essential. A good one should be able to see these variables and assist you in creating a strategy to deal with them and protect those all-important profits.
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