US energy traders expect rebound in hedging activity
An increase in US energy prices and greater fragmentation among regional markets could lead to an upturn in hedging activity, according to traders, reversing a trend of decline due to falling power prices.
Over the past few years, the need to hedge has become less pressing for both producers and consumers of electricity due to the recent lull in prices. That has hit the bottom line of trading firms, but has been particularly tough for banks, with some firms deciding to exit the market amid stricter regulation and higher capital requirements in the form of Basel III.
“Loads, which would normally like to purchase in a low price environment, do not see any reason to buy now, when every month they experience low prices in the spot market,” says Cody Moore, Houston-based head of North American power at EDF Trading, the trading arm of Paris-based utility EDF. “Generators don’t want to hedge at these levels either, because they tend to be bullish and they suspect prices will go higher.”
While many firms have become less eager to hedge, participants note this activity hasn’t come to a complete halt. Many utilities have little choice but to hedge, since they are required to risk-manage a portion of their exposures in line with targets set with the approval of company boards or regulators. But despite that, many utilities and power producers have been adopting a wait-and-see approach.
“Utilities and producers often have a hedging programme outlining certain hedging targets throughout the year,” says Kyle Dickard, Houston-based head of trading for GDF Suez Energy North America, part of Paris-based utility GDF Suez. “But they are now exercising more flexibility in those programmes – they are not quite as stringent on exactly when they have to put those hedges on and are being a bit more thoughtful about the process.”
Price declines in the US power market are closely tied to developments in natural gas. Advances in hydraulic fracturing and horizontal drilling technology have unlocked massive reserves of cheap shale gas, bringing down the cost of fuelling gas-fired plants. Having reached $9.23 per million British thermal units (/MMBtu) in 2008, the average annual spot price for natural gas at the Henry Hub delivery point in Louisiana has steadily declined each year since. By 2011, average annual spot prices for Henry Hub natural gas had dipped to $3.98/MMBtu, before hitting $2.77/MMBtu in 2012, according to the US Energy Information Administration (EIA).
During 2012, average on-peak wholesale prices at PJM Interconnection’s Western Hub fell by 22% compared with 2011, hitting $40.18 per megawatt hour (MWh), according to EIA data. Other trading hubs also saw significant declines. Average on-peak wholesale prices for the Electric Reliability Council of Texas’s Houston Zone dropped by 43% to $35.91/MWh, for example, while the Palo Verde hub of the California Independent System Operator saw prices sink by 18% to $30.03/MWh, according to EIA figures.
Nonetheless, banks and trading firms are optimistic power prices and volatility will pick up over the coming years, as an increased tightness takes hold in the market for natural gas. A growing reliance on gas from power producers and industrial consumers should help prices recover, they argue, along with exports of liquefied natural gas from the contiguous US, which are expected by as early as late 2015.
“There are a lot of things that are beginning to make the picture for natural gas quite a bit more bullish structurally [and] this year, you’ve begun to see some pretty significant volatility… So things are changing,” said Blythe Masters, New York-based head of global commodities at JP Morgan, speaking to Energy Risk during May.
Spot prices for Henry Hub natural gas stood at $3.30/MMBtu on January 2 this year, but hit a high of $4.28/MMBtu on April 19. By June 17, they had slipped back slightly, reaching $3.78/MMBtu, according to the EIA.
Going forward, the EIA expects the average annual Henry Hub spot price to increase to $3.80/MMBtu in 2013 and $4.00/MMBtu in 2014. That recovery in natural gas should feed through to power prices, say analysts. At the same time, regional factors will begin to play a larger role in power price formation – something that has already occurred in some areas. “We would expect to see a more usual divergence in power prices across the country,” says Tyson Brown, a Washington, DC-based analyst at the EIA.
Amid a cold winter in the US northeast, spot natural gas prices at Boston’s Algonquin Citygate hub hit $34.25/MMBtu on January 25, while prices in New York’s Transco Zone 6 ballooned to $36.00/MMBtu. The moves caused a similar increase in wholesale electricity prices, with day-ahead on-peak prices for the New England and New York independent system operators reaching $260.51/MWh and $253.36/MWh, respectively.
Such moves should lead to an increase in hedging, says EDF Trading’s Moore. “I do think the market will start to recover from these uncertainties and we’ll start to see volumes and liquidity start to pick up,” he says.
This article was first published on Risk