By Paul J. Purcell and Joseph Toomey
Pandemic-related energy demand volatility, supply chain disruptions, inflationary pressures stemming from fiscal and monetary excess, and now war in Ukraine have all combined to threaten access to energy supply sources and have sent prices soaring around the world. With over a combined 68 years of experience working with a wide variety of clients on both the “buy” and “sell” side of energy markets, we have come to recognize there are two types of crises, Implied and Actual. During that time, we have had the good fortune to help numerous clients weather several implied and actual crises affecting the U.S. domestic energy complex, particularly within natural gas and electricity markets.
Many small to medium-sized companies have been reluctant to adopt long-term “living” energy risk management programs. More often than not, crucial energy risk management decisions are made by Procurement or Facilities Management personnel. These people usually don’t possess energy risk management expertise and rarely bother to retain qualified 3rd party professional energy risk management services. This is especially true following extended periods of relative price stability. This laissez-faire approach to risk management often leads firms to adopt irrational responses to implied or actual crisis events. A typical example of irrational response behavior would see firms engage in a buying frenzy during the initial stages of an energy crisis as fear leads buyers to assume that the wild price volatility of the present moment will become the “new normal” and persist well into the future.
Following the February 24th Russian invasion, Western nations announced a series of sanctions on Russian banks, commodity suppliers and oligarchs. UK firms that had been acquiring significant portions of their natural gas purchase quantities in spot markets began to take substantial long positions in futures markets to lock in prices and assure adequate supplies. Within a matter of a few weeks, natural gas prices shot up to $8.00 per MMBTU. The buying frenzy predictably had a spillover effect in contract markets, applying upward pressure on short and near-term natural gas contract prices. Near-term and longer-dated futures contract pricing curves are now exhibiting this short-term market reaction, creating a risk management dilemma for firms. From a risk management strategy standpoint, does it make more sense to:
- Absorb all of the implied risks now and take long positions well into the future to protect against supply disruption and possibly even higher prices in the future?
- Wait out the current volatility with some interim strategy in hopes markets stabilize at lower, more advantageous levels in the near future? or
- Adopt some other risk management approach?
What factors might lead us to conclude the first approach, locking in guaranteed supplies with a series of long positions at today’s elevated prices, is irrational? First, despite the upheaval that the war has engendered, natural gas supply and demand relationships are fundamentally unchanged. Domestically, the U.S. has at least a 50-year in-ground reserve of natural gas, and there has been no significant demand destruction throughout the lower 48 states.
Second, the rig count for natural gas production in the U.S. has remained relatively flat over the past several years, implying that supply is sufficient to meet the short and near-term demand. Indeed, having adequately satisfied domestic demand, the U.S. has witnessed a substantial uptick in natural gas export cargoes in recent months, many of which were initially dispatched to Asian markets but were actually re-routed in transit to more opportunistically-priced European destination markets.
Third, there is every reason to expect that Liquified Natural Gas cargoes (LNG) will continue to chase very high-priced UK natural gas market opportunities. The reality at present is that all U.S. LNG export terminals have been at or near capacity for some time. Given the very long lead times involved, there will be no new LNG terminals that can be brought on line anytime soon. This implies that every molecule of natural gas that could possibly be sold to UK customers is likely subscribed and already planned for delivery across the Atlantic.
In all sectors, demand for natural gas remains high. This was made painfully apparent in European electricity markets in the first quarter of 2022 as the supply of wind energy dropped to excessively low levels sparking a panic natural gas buying frenzy to keep the lights on. Day Ahead electricity prices soared in some EU countries to over €450 per megawatt-hour (MWh) in early March. That compares to an average Day Ahead wholesale electricity contract price in the U.S. in 2021 of just €53.80 per MWh ($58.40 per MWh) at the Euro exchange rate in mid-April 2022.
The chart below shows an analogous relationship between current natural gas prices and the pattern of natural gas price behavior in 2008, which was an actual credit crisis. One would and by all rights should be loathe to forecast the future direction of any market based solely upon some pattern of historical behavior. Yet it is instructive to recognize that future market behavior will be heavily impacted by the same patterns of human behavior that were exhibited in previous, substantially similar sets of conditions. In addition, some patterns of more rational behavior will likely manifest themselves as market price inflection points occur, creating a different post inflection point behavior.
So, what can be done in the face of deep market uncertainty and high price volatility? Our preferred approach is to adopt a “living” energy risk management plan. What do we mean by a “living” energy risk management plan? It would be one that follows a general outline as follows:
- Formulate a plan based upon the reality-driven needs of the firm.
- Breathe life into your risk management plan by setting up by a diverse group of knowledgeable individuals from a variety of functional areas within the firm.
- Agree upon key determinants of success and key metrics to be used in the assessment.
- Include a succession plan as a key aspect of the holistic strategy.
- Adjust the risk management plan on a regular basis as circumstances change.
- Agree upon and include a set of built-in criteria for extemporaneous plan reevaluation and planned business/operational adjustments.
- Be flexible rather than rigid in your schedule of on-going assessments.
Current market volatilities are taking a significant toll on corporate earnings and margins. Our team of energy industry professionals can assist clients in navigating the volatility of these uncertain market conditions.
About the Authors
Jay Purcell is a seasoned executive with more than thirty years of experience in the energy and technology sectors. He has held senior positions at a Fortune 200 company, The Gas Company, and Constellation Energy Inc. In addition, he was a member of Governor Schwarzenegger’s trade delegation to Mexico in 2006. Over his career, he has been involved in more than $3 billion of transactions, including annual P&L responsibility for more than $300 million. Mr. Purcell is a former United States Marine where he received two meritorious promotions in his four-year enlistment. He received his Bachelor of Science degree in Industrial Engineering from California Polytechnic State University in Pomona, California having graduated with honors.
Joseph Toomey has 38 years of experience as a trusted consulting advisor to a wide variety of marquee clients in the areas of financial modeling and analysis, logistics, supply chain, transportation, economics, and procurement. He has worked at several consulting firms including A.T. Kearney, PwC Consulting, IBM Business Consulting Services and Infosys Consulting. Mr. Toomey’s consulting work has been mostly focused on the Energy industry, but has also included automotive, chemicals, consumer packaged goods, and food manufacturing, heavy equipment, integrated oil & gas, mining, precision manufactured products, and transportation. His work has been delivered in more than two dozen countries all over the world. His client experience includes Chevron, Kraft Foods, Ford Motor Company, BP, Kimberly Clark, Bristol-Myers Squibb, Cummins, Mars, Coca Cola, The Walt Disney Company, Conagra, Royal Dutch Shell and numerous other global leaders. Mr. Toomey holds an MBA in Finance from the University of Maryland and a Bachelor’s degree in Finance from Xavier University.