Energy risk management and energy trading have become pivotal in navigating volatile energy markets. With the increasing complexity of energy supply products, the uncertainty of supply and demand dynamics, and the impact of geopolitical events on the global energy economy, managing risk effectively is critical for energy consumers. This article delves into the intricate world of energy risk management, exploring the strategies, tools, and technologies that companies, energy traders, and energy brokers employ to hedge against price fluctuations, ensure financial stability, and capitalize on market opportunities. From the fundamentals of risk assessment to the sophisticated energy contracts available in the market today, we will uncover the ins and outs of mitigating energy price risk.
Who Is Affected By Energy Price Volatility?
Both consumers, producers, and energy middlemen are greatly affected by market swings and price volatility. While energy producers tend to be long the market and benefit when prices are high, consumers are short the market and look for lower costs. Let’s explore the various energy market participants in more detail and how they can be affected by price volatility.
Energy Consumers
Energy consumers always have a short view of the market. Energy is an expense for all types of consumers. Industrial manufacturers use natural gas to make goods, while grocery stores need electricity to keep food frozen. These types of customers benefit when prices are lower as they can pay less for energy bills. When energy prices begin to rise due to external factors, energy consumers are at risk.
Energy Producers
Energy producers, on the other hand, such as electricity power plants and natural gas fracking companies benefit when energy prices are high. Since these companies have a fixed cost for producing energy, their profits increase when prices rise. These companies are at risk if and when energy prices tumble. In fact, at certain times, energy prices can be so low that they lose money by simply operating.
Energy Brokers And Suppliers
Retail energy suppliers and energy brokerage companies act as middlemen between producers and consumers. They facilitate transactions, arrange for the consistent supply of energy, and can often help offset risk. While suppliers and brokers have an easier time selling energy when prices are low, they also can benefit by selling excess energy back to the market when prices are high. We will explore the role of energy brokers and suppliers in more detail below as it relates to counterbalancing market price risk.
Energy Market Risk Factors
There are many factors that can move energy markets and create price risk for its participants. Let’s explore some of the more common energy market risks in more detail.
- Supply & Demand: Supply and demand have an immediate impact on physical energy prices. When supply outweighs demand, prices fall, and vice versa.
- Production: Energy production also plays an important role in affecting total supplies. When production is high, supply is supported and can lead to lower prices.
- Gas Storage: Natural gas storage is another key factor that can influence prices and potentially create risk. When storage numbers are low, prices trend to trend upward and can be quite volatile.
- Global Incidents: Geopolitical situations and events can have an impact on supply and demand figures. Conflicts such as the Ukraine-Russia War impact natural gas supplies to Europe and create an imbalance of energy. In fact, to counteract this price risk, the European Union instituted a gas price cap.
- Regulation: Energy regulation can also influence energy prices. When permission to operate natural gas pipelines are terminated, this can create an imbalance of supply in the market and promote price volatility. Other environmental regulations, while beneficial for the planet, can cause price risk in the fossil fuels commodities markets.
Managing Energy Risk
There are several strategies, tools, and market products used to offset price risk for energy industry participants. Let’s explore how some of these players implement energy risk management and hedging strategies.
Energy Customers
Energy consumers can purchase fixed rate energy contracts from suppliers to offset index market price risk. In deregulated energy states, consumers can elect to purchase variable products that float up and down with the market, or fixed rates that are set for a defined period of time. Furthermore, consumers can bundle multiple cost components of their energy supply, such as energy capacity and transmission, into their fixed price. While premiums are charged by energy suppliers to do this, it is a great way for consumers to obtain budget certainty.
Producers
Energy producers can utilize financial tools to offset their market risk. Remember, producers benefit from high prices, so they can sell futures contracts to lock in revenue figures. While selling futures is one way to hedge with financial instruments, energy producers can also enter into over the counter forward contracts with counterparties to achieve the same goal. This is a common practice for energy production companies as they are unable to obtain financing for their operations without a guarantee of future profits.
Retail Suppliers And Brokers
Energy suppliers and brokers utilize hedging strategies to offset energy risk. In order to offer fixed rates to customers, energy suppliers must purchase sets of futures contracts or enter into forward contracts with wholesale counterparties. Energy brokers help their customers manage risk by structuring customized energy supply contracts that meet their needs. While many energy brokers sell fixed-rate products to their customers, more sophisticated energy brokerage firms can advise on hybrid energy products, such as block + index contract structures.
Need Help Developing An Energy Risk Strategy?
At Diversegy, we are more than just an energy brokerage firm. Our team of energy advisors has the experience and expertise to craft custom energy risk mitigation strategies that can help you achieve your price targets while eliminating price volatility. If you want to discuss your energy risk tolerance and budget goals, contact our team today.
