Energy procurement strategies for an industrial company
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Situation
A French energy-intensive industrial company has been paying high costs for its power and gas consumption. With a few suppliers, it has entered fixed price bilateral contracts which offer some volume flexibility.
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Complication The gas and power market prices dropped significantly over the past 3 years so this industrial incurred large opportunity costs due to its rigid energy procurement practice.
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Solution We presented our client with 3 alternative energy procurement strategies and collaborated to create a tailor-made strategy that reflected its risk appetite. This resulted in a measurable price flexibility while maintaining the same level of supply security.
More details
The challenge
- In energy intensive industries, feedstock prices can have a significant impact on the bottom line.
- If energy costs are not actively managed, they can lead a company to exceed budget forecasts, or worse, lower profit margins or inflate losses.
- Companies that want to prevent huge swings in operating expenses and bottom line profitability will choose to hedge energy prices.
- While the risk can be mitigating through hedging, there is no a perfect hedge available in either the over-the-counter or exchange traded derivatives markets.
Due to market illiquidity, proxy hedging leads to
- product basis risk: quality, consistency, weight, or underlying product mismatch
- time basis risk: hedge contract maturity does not match physical delivery date
- locational basis risk: a mismatch in the price of the product from one location to another or a mismatch in the delivery point for the derivatives contract, among others.
- Having the right energy procurement strategies and buying energy in a highly competitive environment present formidable challenges to energy intensive industries.
Purpose
- To mitigate exposure to volatile energy prices
- To provide protection against short-term energy price increases
- To enter into energy hedging transactions that will enable “locking-in” profit margins
Critical questions and factors
- Who is responsible for developing, implementing and managing the energy hedging strategy(s)? A hedge committee, chief financial officer, treasury department, etc.? What resources (manpower, risk management systems, commodity market data, etc.) will they need?
- What sort of protection could the company receive to address market, volumetric and currency risks?
- Is feedstock purchasing dealt with in isolation from currency management?
- Are the risk managers looking to reduce cash flow volatility, minimize costs, hit a certain budget, or some combination of these?
- What level of insurance premium is the company able and prepared to pay for protection against such risks?
- Who is responsible for selecting appropriate counter-parties and what criteria will be used to evaluate them? Who and by what means will counter-party credit exposure be measured and monitored?
- What is the maximum financial exposure (gross and net) that the company is willing and able to tolerate?
- How will the financial exposure be measured and by whom?
- When and how will existing positions be reviewed to ensure that they are still appropriate given the company’s risk tolerance, hedging policy and current market conditions?
Depending on the company’s risk appetite, it can adopt one of these strategic energy procurement approaches which then can be tailored to its specific situation:
Price Locking
When certainty is priority, this strategy is designed to fix procurement costs upfront so that any movement in energy market prices will not impact the price the company pays for commodities.
Price Capping
When budget protection is priority, this strategy is designed to allow for protection against rising markets enabling the company to work to a budget, while still capturing downside price movements.
Dynamic Price Optimization
When cost optimization is priority, or the company has a variable consumption profile, this strategy allows partial cost protection, in exchange for potential profit from volatile spot markets.
In a price locking strategy, the total energy requirement is bought in a single transaction, prior to the start of the processing period. However, it is important to have the right timing for purchase in order to achieve a competitive price.
In order to strike an optimum time for price locking, we:
- use statistical and fundamental approaches to track market activity within the energy wholesale markets.
- put the tender process with suppliers at the right signal to buy.
With a price capping strategy the company is able to optimize the price right up to the point of delivery. At the same time, it is protected against any price increases that are above the ceiling level.
Unlike a Lock-in Price strategy, the company does not have to buy all of the energy at once, which means that risk is spread over a longer period.
Benefiting from both the cap and risk management techniques, this strategy is effective in either a rising or a falling market.
Similarly to the price capping strategy, the company is able to optimize the purchase price for a proportion of the volume up to the point of delivery and leave the rest to be purchased on the spot market.
The spot market can outperform the forward market by 10% or more due to the absence of forward risk premia, thereby offering cheap buying opportunities. However, there are occasions when the spot price volatility can wipe out any cost saving.
Energy Procurement
We help you design and implement the right procurement strategy by conducting a thorough market analysis and proposing a lock-in table based on statistical models.
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