By Zack Hallock, Senior Energy Services Advisor
The volatility of energy markets has businesses thinking about the best time to sign a new energy contract or when to renew an existing one. Simply put, people are wondering whether to sign their contract renewal soon – amid heightened instability -- or take on added risk by signing closer to a contract’s upcoming rollover date? Good questions, all.
Analysis paralysis is real and often goes hand-in-hand as decision-makers navigate and lead during turbulent economic times – and, specifically, as companies try to make strategic energy-related decisions that impact budgets (sometimes for years to come).
The CES Energy Services team provides counsel daily on this topic. In so doing, our advice is tailored to each unique client situation. While seeking expert guidance, there are steps that you can take, too. A good place to start is understanding global and national dynamics at play that are impacting the energy market. Solutions for your business are also rooted in identifying your organization’s unique energy needs and goals.
Before we dive deeper into the timing of your contract, let’s consider how the world energy market is changing.
The Great Reshuffle
It’s no secret that consumers across the globe are facing historically high gas prices at the pump (this isn’t a uniquely American problem).
The “price at the pump” is not always the best litmus test of energy markets but it is a fair representation of supply/ demand imbalances across the energy sector right now. Fundamentally we have leveraged a globalized economy for more than a decade to interconnect our flows of energy between the United States and Europe. Some may say we have reached the point of no return – a place where we cannot separate ourselves from the EU on a commodities risk/ security perspective.
The invasion of Ukraine by Russia showed the world what happens when we need to reconfigure this interconnected flow of energy at the drop of a hat. Keep in mind that in early 2022, Russia only accounted for about 3 percent of total crude oil imports in the U.S., while simultaneously accounting for approximately 20 percent of European oil supply. In countries such as Lithuania and Slovakia, Russia accounted for more than 70 percent of their oil supply! With the EU firmly banning any Russian crude via sea (about 2/3 of supply from Russia to Europe) by December 2022, who is left to supply this product? You guessed it. The United States is first in line to meet that demand for our allies across the Atlantic.
What does this mean for U.S. markets headed into winter 2022-23? The U.S. Energy Information Administration (EIA) is forecasting “heightened levels of uncertainty” in the latest Short-Term Energy Outlook (STEO) which is a detailed monthly update on U.S. energy markets. Looking ahead to 2023, the EIA claims the major factors in our supply/ demand balance will continue to be uncertain with regard to the impact of Russian sanctions, the production decisions of OPEC+, and finally the rate at which U.S. drillers increase oil and natural gas production. For a deeper dive into how this impacts your energy budget on site, take a look at CES President & COO Andy Price’s piece from April 2022 titled “Russia’s Invasion of Ukraine: Impacts to World Energy Markets and to Your Energy Budget.”
In a nutshell, the global flow of energy in the form of crude oil and natural gas is currently centered around Europe. The flow of fossil fuels throughout the world – with Europe as the epicenter – has quickly entered a transition, away from Russia acting as a major player in Europe’s fuel supply to a new, and yet unknown world energy order. Russia is still producing and exporting significant quantities of oil and natural gas, but this energy is increasingly heading east to China and India. This transitory period must have a time horizon before the markets balance, as all markets do. With that in mind, history tells us that the markets will settle. It is not just a matter of when, but about recognizing the signs indicating when that moment of “normal” is coming into view. Understanding the nuances of the world energy market provides insights on timing of market stabilization and opportunity that leads to informed decision making.
New England in the Shadow of the Great Reshuffle
To distill these mammoth global forces down to impacts on your local or regional business, look no further than the constraints around New England. It is important to consider the issue of when New England’s energy demands are the highest during the course of a year’s time relative to infrastructure capacity. As you might guess, New England winters challenge the region’s energy infrastructure capacity as heating demand spikes. What provides that heating demand? The burning of fossil fuels, mainly natural gas, and oil. We know that New England is starved for adequate natural gas pipeline capacity into the region during the winter which causes an undue reliance and exposure to the global liquid natural gas (LNG) market to meet the combined heating and power generation loads of the region.
Last October, CES captured the essence of the global LNG conundrum and regional fuel security concerns in New England in a short video by Eben Perkins, Vice President, Consulting titled “What You Should Know about Fuel Security.” It’s a conversation that we continue to have today and one that will continue for the foreseeable future. Fuel security concerns pose a fundamental risk for all New Englanders and winter heating demand is our structural bottleneck. Aaron Rubin, Senior Energy Analyst did a terrific job explaining this dynamic again in a March 2022 article titled Energy Management Strategies for a Volatile Energy Market.
Over three of the four past years, winter spot gas stayed below $18 in New England as shown in Figure 1. The availability of low-cost LNG and crude oil helped keep winter prices in check, despite the region’s natural gas pipeline constraints. The winter of 2021-22 was a different story as higher LNG and oil prices caused spot gas in New England to go up nearly 75 percent from prior years.
Figure 1 – Trends in historical spot natural gas price settlements in New England at Algonquin Citygate & Tennessee Zone 6.
In addition to paying attention to spot natural gas pricing in New England, it is wise to look at energy pricing trends in Europe and the foreign market that U.S. LNG producers are attempting to supply. Dutch Title Transfer facility (TFF) – is a virtual trading point for natural gas in the Netherlands. Dutch TFF is the common benchmark used to compare Europe to other markets, like New England. As seen in Figure 2, it is clear that the TTF pricing continued to become more elevated and volatile throughout the winter of 2021-22. This trend started back in November 2021, and it speaks to the already tight European market as a fundamental baseline. In effect, there was an issue centered around low storage inventories and high demand in Europe, which provided fertile ground for the Russian invasion to have maximum short-term implications.
Figure 2 - Trends in European Natural Gas Winter 2022-23 Pricing vs. New England Full-Value Winter 2022-23 Pricing.
As we consider these implications it’s important to recognize this rebalancing of how commodities flow around the world does not impact the entirety of the United States equally. What I mean by that is you must consider how certain parts of the United States are exposed from an infrastructure perspective to foreign energy commodity markets, for instance, the European natural gas market.
ISO New England has far more exposure to the European market than other Independent System Operators (ISOs) like New York ISO (NYISO) right next door. This is driven by the percentage of natural gas fired generation in the regional electricity grid mix. Among several factors, the electricity grid mix and ability to transport U.S. domestic natural gas into the region via pipeline in adequate quantities to meet peak winter heating and power generation demands are the most important to consider. In the case of ISO New England, there is a fundamental tension between policy (a regional commitment to transition away from fossil fuels towards renewables) and existing infrastructure (a near term inability to meet existing power generation and heating loads during peak winter days) that are in a constant tug of war.
It is also important to consider state policies around renewable energy mandates for the electric grid mix that may be influencing certain ISOs and Regional Transmission Organizations (RTOs) across the country. In conjunction with understanding the global energy market, having your finger on the pulse of regional constraints helps to mitigate analysis paralysis and encourages informed decision making.
Energy Options for Your Business
It is important to consider available options if you need to make a supply contracting decision over the next 6-12 months. First, it is safe to assume that a contract-over-contract decrease is not likely if you have a near term renewal, given current market conditions, which means that you are standing squarely in risk mitigation territory.
We often speak to managing cost exposure by using the blanket term risk, effectively driving at the financial impact of our decisions and the opportunity cost of those decisions. The opportunity cost speaking to the notion of the “what if’s” out there, likely in the form of “standard offer” supply with your local utility, longer or shorter-term commitments, or other 3rd party supply products.
The decision ultimately boils down to the notion of being able to financially manage fixed or variable energy rates as they relate to operating costs and budgets. Assuming that you need a high level of budget certainty, there are a limited number of contract structures to seriously entertain.
“Fixed, Full Requirements” or “Fixed, All Inclusive” contract structures offer a secure fixed rate for the term of the supply contract. If a contract states that you can use as much or as little energy as you need [1] with a fixed rate, this is the safest and most common contract structure out there. Naturally with fixed rate contracts, there is a premium added to protect suppliers from exposure to rising costs and higher than expected energy usage in the future. Market and usage risk can be transferred from the end-user to the supplier in exchange for a rate premium.
If your business is able to take on some budget risk, variable rate products can be considered. There will, of course, be a tradeoff of accepting greater risk in exchange for potential savings against the fixed contract structure alternatives. When deciding between term lengths and types of supply contracts it’s important to consider the regional energy and infrastructure constraints influencing energy rates locally.
The Reality of Contracting
Once global and regional factors are considered, it is essential to look within your very own organization to get the whole picture around your exposure to these larger forces. Is your organization risk averse and budget sensitive, where known costs and fixed rates stand above all else? Or are you in a business that can manage potentially lucrative, yet risky, options in the energy space? At what times throughout the year do you use the most energy? Is that energy in the form of electricity or another fuel like natural gas for heating in the winter? Does your organization require vast amounts of process load during a cyclical busy season?
Like any business decision, there is no stock answer, but most decision-makers lean into budget certainty over riskier products that have highly variable, and possibly lower, charges. Despite the possibility that these variables result in lower costs, most businesses prefer as few unknowns as possible when looking to the future of their energy budgets. Being able to understand your business’ tolerance for risk and the options available within that framework of understanding is invaluable information that inform your future energy decisions.
Where Do You Start?
As stated earlier, it is vital to first understand the baseline of global influences. Second, look to regional market signals before you evaluate your needs. If any of these three pieces poses a challenge where you don’t even know who to ask, simply seek objective advice from an industry expert.
Any CES Energy Services Advisor will be happy to talk you through your concerns no matter how large or small. Regardless of where your energy priorities lie, CES is poised to offer our independent expertise. We already do this for hundreds of clients who trust our advice after years – some even decades – of dedicated service and perspective. Our company’s history and culture is rooted in our independence, expertise, and in the trust our clients have in us. In a January 2022 blog article, Andy Price, President & COO of CES discuss the Three Pillars of CES, a great expression to how CES carries itself down to our DNA.
For you the decision maker to attain meaningful results, it’s also important to manage the expectations of those around you. More likely than not, in risk mitigation conversations there is a potential for cost increase. Having a plan rooted in facts and numbers with specific short- and long-term goals is paramount. Measuring against that plan over time is the best way to manage expectations as you look to execute a decision.
This approach to making strategic budget decisions amid a volatile world energy market has a proven track record for many CES clients stretching back 20+ years. Part of this success has stemmed from the fact that our customers are not making these decisions in a vacuum. Proactive communication and tailoring risk exposure to each specific customer is how CES has done this so well for so long.
In addition to our track record, we have been sharing our expertise on topics of interest for our clients in our ongoing Insights Blog Series. I encourage you to visit our website and read more about energy perspectives that will help inform your daily and longer-term decision making. And as always, please feel free to reach out to one of CES’ Energy Services Advisors with your questions. We are continually available to provide independent and trustworthy expertise!
[1] Most contracts include some form of language around sensitivity to monthly deviations from contract volumes by way of Material Adverse Change or “M.A.C” clauses. M.A.C language provides protection for suppliers against customer energy consumption deviations outside a specific percentage bandwidth or range for 2-3 consecutive months relative to the contract volumes. Again, supplier and contract specific but this type of language in contracts must be reviewed, discussed, and understood before requesting an executable 3rd party supply contract.