Electricity and natural gas commodities trade in both physical and financial markets. Physical markets represent cash transactions for physical commodities that are either used, stored, or resold. Financial markets, on the other hand, are standardized digital contracts that represent the future purchase or sale of a commodity. This future agreement to buy or sell a product is often referred to as a futures contract and trades in a futures market. To truly understand why a futures market exists, let’s look at coffee…
In the example above, the coffee farmer grows coffee beans and sells them to the coffee shop chain. Both parties, while partners in the transaction, have different incentives.
The Coffee Farmer: The farmer loves it when the market price of coffee is high. Since his costs to grow and harvest the beans are relatively constant, when the price of coffee is high he makes more profit. On the other hand, if the market price of coffee goes too low, he cannot pay his bills.
The Coffee Shop Chain: The coffee shop chain, on the other hand, has just the opposite incentive. They love it when the price of coffee is low, so they can purchase cheaply and make more profits. However, when the price of coffee is too high, it eats into their profit margin.
Enter the Futures Market: In an effort to find some sort of middle ground, the coffee farmer and the coffee chain come to an agreement that no matter what the market price of coffee does they will transact with each other at an agreed upon price for a certain period of time. In other words, the coffee farmer agrees to sell coffee beans to the coffee chain at a certain price in the “future”. The beans might not even be planted, yet a futures contract has transpired.
What Does This Mean For You?
Just like coffee, energy is a commodity that moves up and down with the market. Like the farmers, generators of electricity like when electricity prices are high, and consumers of electricity like when prices are low. On the energy futures market, these two parties can agree to enter into a futures contract in order to stabilize their costs and revenues for the years to come. When you sell a customer a 36 month electricity contract, the customer is entering into a futures contract with the energy supplier to purchase electricity in the future at a certain price.
How To Sell Energy Futures
Whenever you sell an electricity contract for a certain term (12 months, 24 months, 36 months), the total price of the contract is the average of all the prices for each month of the contract. For example, a 12 month contract starting in January 2022 is the average of January’s price, February’s price, March’s price, etc. Because each calendar month has a different price, different contract terms and start dates affect the total price of the electricity or natural gas contract. Since most of the recent market volatility is in the immediate short term calendar months (November – March), you could sell a contract to a customer that starts in April or May for a lower price.
Giving your customers the option to buy a future-dated contract to avoid expensive winter months is a great way to act as a true energy advisor and offer them lower rates. Using the example below, you might start a contract in the month of April to avoid the more expensive months (November – March).
Need help structuring a supply contract for one of your customers? Call us today and speak to one of our expert energy pricing advisors!