Managing Energy Price Risk

Benjamin Hall

Our previous blog post, Preparing for Volatile Energy Prices, explored the key drivers of energy price volatility this past winter. As we have moved into the cooling season, moderate temperatures and significant natural gas storage injections have provided welcome price relief.

With prices easing up, it’s easy to become apathetic. Energy pricing may become an afterthought and last winter merely a memory. However, this is the right time to prepare your business for future price volatility by evaluating and refining your energy strategy.

MANAGE RISK THROUGH STRATEGY

How your company manages volatility will be dependent on your risk appetite, which will vary by business. In considering risk appetite, be sure to account for operational, market, budgetary and regulatory risk. The best way to manage these risks is to have a strategy in placebeforemarkets become extremely volatile – now is a good time.

Your strategy should couple your company’s risk tolerance with current fundamentals, technicals and historical market patterns. The objective is to create and refine an energy supply strategy that prepares you to react to and communicate during volatile events.

LINE UP THE TOOLS TO COMMUNICATE VOLATILITY

To manage risk, you must identify and communicate volatility as it happens. Although direct volatility measurements may aid in purchasing decisions, the data is speculative and does not forecast the direction of the long-term market. As an example, Ecova uses Bollinger Bands, a technical indicator, to monitor volatility and assist in calculating probability. Bollinger Bands are volatility bands placed above and below a moving average, based on historical price changes. When the bands narrow (converge on the moving average), that is an indication of decreased volatility. When they widen (diverge from the moving average), that’s an indication of increased volatility.

Below is a chart showing Bollinger Bands on the prompt month NYMEX Natural Gas contract. Notice the extreme widening during the winter months and how much the contract price moved around (very volatile). After the winter season, the bands narrowed and the market maintained a less volatile trading pattern, albeit more volatile than at the end of 2013.

nymex-natural-gas-bollinger-bands

In addition, the market is experiencing what the industry has termed “walking the band,” as the prompt month’s contract trades on the lower band. This is an indication of a strong downtrend. Pricing has leveled off and is returning to the moving average. This is an indication that the downtrend is losing steam.

PLAN BEYOND ENERGY PRICES

Pricing is the key component of any energy supply strategy. But to perform well in volatile markets, your energy strategy should take other factors into account, including:

  • Bandwidth: Do your energy supply contracts allow for a specified quantity each month? If so, anticipate scenarios in which your usage is outside of the contracted volumes. Consider whether paying a little more for extra bandwidth is appropriate for your business. Bandwidth issues become more pronounced in extremely volatile markets.
  • National Footprint: What percentage of your entire utility budget is exposed if another market-moving event comes to fruition? Be able to quantify what is deregulated vs. regulated and where you have positions that may be exposed to volatile market conditions.
  • Speed of Execution: In the event that a price target (or price ceiling) is met, how quickly can your business react and execute on that opportunity? Remember that volatility is the variation of price over time. In a volatile market, prices can have large movements in short periods of time. A delay of a week may mean that you have missed your target.
  • Term Length: We often see market backwardation in periods of price volatility. An example of backwardation is when a 12-month energy price is more expensive than a 24- or 36-month price. Will your business be able to commit to these longer terms?
  • Regional Market Risks: Not all regions are created equal. Have you identified the regions that have pipeline and capacity restraints? While prices have declined over the last few weeks, the declines have been more pronounced in some regions than others.

With many businesses in the midst of budget season, this is a great time to take steps to mitigate energy price risk. For a more detailed discussion of budgeting and risk mitigation for price volatility, view our streaming webcast Energy Budgeting in Volatile Markets.

Take advantage of Ecova’s energy insight resources:

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