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Vegas Meets the Energy Fuel Markets

image credit: Photo by Nick Fewings on Unsplash
Patrick McGarry's picture
Senior Director PCI

Patrick recently joined PCI as a Senior Director in May, 2019. He owns over 32 years of experience in commodity trading and owns an extensive record working closely with energy market...

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  • Jun 8, 2022
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Vegas Meets the Energy Fuel Markets

 

Photo by Nick Fewings on Unsplash

 

We live in a boom-and-bust economy in a world getting smaller every passing day.

It’s either the best of times or the worst of times.

We also live in a society increasingly embracing gambling.

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Both trends seem to be impacting the formerly staid energy industry.

When it comes to hedging risks, especially natural gas and oil prices, the gloves have come off.

As a result, a potential credit and collateral crisis storm is forming out at sea.

Vegas meets the energy fuel markets.

 

Why Do You Hedge?

 

 

Before I explain why we will witness a significant credit event in the energy markets, let’s take a second to review the basic purpose of hedging.

A hedge is an investment made to reduce the risk of an asset's price moving in the wrong direction. A hedge usually entails taking an opposite or offsetting position in a related security.

You generally look to reduce price and volume risk.

In our personal lives, we buy insurance in the hope we never need it.

Car crashes. Home fire or flood. Sickness or death.

But why do we really hedge these risks?

Capital preservation.

Our homes often represent our largest financial asset. We do not want a single, random event to destroy the equity we build over many years.

Same goes for our cars and our health.

We try to avoid financial disasters by recognizing the known risks. I like to call it “healthy fear.”

In a similar vein, energy producers and consumers hedge the known risk of an adverse price movement.

At least they used to.

The Hedging Gloves Come Off

A few weeks ago, Bloomberg published an article explaining how U.S. shale giants are unwinding hedges, whereby they sold into the future at much lower prices than today’s frothy spot market. Why would they do so? Quite simply, they hope or believe prices will remain at today’s levels or higher for a sustained period that will allow them to offset the realized losses of these hedges and earn additional revenue.

It’s a very risky bet. If prices go lower, they can lose twice.

On the consumer side, utilities and commercial entities, difficult hedging decisions confront portfolio managers. Do I acknowledge the new reality where natural gas prices are triple from a year ago? Anecdotal evidence suggests a growing portion of utility and commercial consumers of natural gas do not wish to hedge at the same percentage as last summer.

It’s also a very risky bet.

Utilities are generally allowed to pass along fuel costs to customers and are not supposed to profit from those costs. Each year, the commission sets the amounts that utilities can collect for fuel in the following year. However, the Covid pandemic introduced a new revenue risk to utilities throughout the country.

Unpaid bills.

According to the Census Bureau, one in five US adults lived in households that were unable to pay all their utility bills in 2021. Natural gas prices are three times higher in 2022.

Households currently owe power companies over $20 billion.

One may logically assume that unpaid balances will continue to present headaches for utilities going forward.

If you are in the camp believing prices will not go much higher, please point your attention to European Nat gas prices for the past 18 months or the blowout U.S. prices witnessed during Winter Storm Uri.

Volatility in natural gas prices may reasonably be expected to continue for a sustained period now that producers and consumers are both gravitating to the spot market.

Therein lies the problem.

Markets can often remain irrational longer than you can stay solvent.

 

Risk Management Advice

Photo by Scott Graham on Unsplash

“Who” gives your risk management advice is as important as what advice you receive.

If you get your advice from somebody speculating in the market, you will likely hear their view on spot prices. They tend to speak “their book.”

But I do not think that is what producers, or especially consumers, need to hear these days.

Risk Management Committees need to understand that fuel prices fundamentally changed when we entered the new era of reduced supply and increased demand. Neither variable seems destined to change anytime soon. So, in many ways, you need to toss the past lessons learned in the era of cheap and abundant fracking and consider the new realities and risks in 2022.

You need some healthy fear.

A decision not to decide is of course a decision.

A decision to not hedge is a gamble on the direction of future prices. A gamble on energy prices is the exact opposite reason you executed hedges originally.

So, when it comes from the people or entities providing you risk management advice, consider the source.

Some will provide you with their view on future prices and some will provide you advice based on preserving your capital.

I assert that you need to listen to the latter more than the former.

The latter will help you realize the risk and folly in embracing the “everybody is doing it” approach.

Who really wants to stand in front of a Board and explain why you decided to risk the company entirely in the spot market?

 

Why A Potential Credit Crisis Looms

Photo by Raychel Sanner on Unsplash

Credit rating agencies serve a valuable purpose in our financial world.

But are they missing the potential energy credit & collateral crisis in a way like the subprime mortgage crisis from 2007-2010?

When I read press releases about the credit grade of an energy company, I rarely see credit rating agency concerns about hedging exposure or unpaid customer bills.

Nobody likes to speak about credit until it’s a problem. What is emerging is not a solvency issue, it is a liquidity issue.

Talen Energy Supply recently filed for bankruptcy after rising natural gas prices squeezed its cash position.

As more entities eliminate or fail to renew hedges, more entities enter the world of the spot market.

The spot market takes on a casino environment where extreme volatility can cause these collateral calls much quicker and more severely than say five years ago.

Of course, higher natural gas prices translate into higher energy prices in the wholesale markets.

Higher prices naturally cause higher credit and collateral requirements to participate in these markets. The organized RTO/ISO wholesale energy markets socialize the costs of bankruptcies to all market participants.

Nobody escapes impact.

In 2021, we witnessed the financial ramifications of ballistic natural gas prices for just a few days. Some entities declared bankruptcy while others peanut buttered the financial impact out over thirty years.

And if prices collapse?

Already shy of making any long-term capital expenditure decisions, even a moderate decline in energy prices from today’s level could introduce a significant negative impact on fuel producers just starting to rebound from the heavy losses incurred in the pandemic.

If this crisis develops, many will point the finger at market manipulation and climate change as root causes.

But it will have been caused by our history of boom and bust in addition to our growing addiction to “rolling the dice.”

Expected bailouts often cause irrational behavior.

Uncertain Future

If anybody truly knew the future of natural gas prices, she or he would have locked in a long-term purchase when prices plummeted during the first six months of the pandemic.

Nobody knows the future for certain.

But we can reasonably expect continued and unprecedented volatility as Europe weans itself off its Russian supply and leans heavily on U.S. LNG. The transition will not come easily, and severe turbulence likely awaits.

The volatility itself argues against reducing or eliminating hedges.

When it comes to making this critical decision in these times of uncertainty, you need to ask yourself two simple questions:

What type of risk am I looking to reduce and what can happen to me if I do not?

I call it healthy fear sprinkled in with a teaspoon of humility.

Avoid the Vegas approach.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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