A Reuters Story that originally was published on November 10, 2022 (Exclusive: Energy firms’ multi-trillion derivative bets under ECB scrutiny | Reuters ) referenced the potential liquidity and credit issues that utilities with energy trading arms might be facing giving the heightened volatility in the market and the potential for derivative trading to exacerbate the financial impacts. Thus raising the question of who is ultimately “wearing the trade” or the ultimate financially responsible party. In the case of the European market that may well be the German government as referenced in the Reuters article. In North America, while we have not faced the extreme price volatility across the entire energy landscape that has been experienced in Europe we are seeing relatively high volatilities that are expressing themselves through rapid price changes. What was historically an escalator up, elevator down price change environment has transformed into an elevator up, elevator down environment (not to be confused with turtles all the way down for you Sturgill Simpson fans). There are a number of factors contributing to this change, and leading the charge on the fundamental front is the rapidly increasing relevance of intercontinental commodity trade. However equally important is the role of liquidity in exacerbating price moves. The second order impact of rapid price changes is the impact on credit- the ability to pay or as is currently the case – the ability to transact. This is not a new concept for anyone having lived through periods of heightened volatility, however, the ramifications of the present market environment are bleeding over into non-traditional realms. Below we will explore a few examples of how this is impacting three broad groups of energy market participants, and how they are ultimately all intertwined.
As we mentioned we have transitioned from the typical escalator up – elevator down dynamic, which historical price charts would tell you is the norm, to an elevator both up and down type of environment. For evidence of this paradigm shift take your pick of NYMEX natural gas, European natural gas, both domestic and European power, and of course the hottest topic of the moment diesel pricing. Risk mitigation in such a volatile price environment is both crucial and costly for the producer and consumer of commodities, with the credit side still in the backseat yet arguably just the second row rather than the rear facing bench seat of the station wagon from a bygone era.
As credit capacity and the cost of credit support increase who bears the cost? The answer to this question is not the swap dealer, or the regulatory powers that be, but rather the entities and individuals whose livelihoods are more directly dependent on the commodities. This is not to say that swap dealer employees and members of regulatory bodies are not impacted, but rather their organizational cost structures are not as directly impacted as say an oil and gas producer, an independent power producer (IPP), or a low-to-middle class household, pretending for a moment that a household is akin to an organization with varied priorities.
The first two directly impacted market participants, the E&P companies and IPPs, would ideally seek to mitigate additional volumetric risk in a rising price environment, but simultaneously become limited by their ability to do so when existing hedges reduce the credit counterparties are able or willing to extend. The final link in the energy market daisy chain, the ultimate end user or household, has limited ability to manage exposure in most instances, with the most practical tool in their tool belt being cost sensitive reduction in consumption (the infamous “sweater hedge”). In summary, if producers (oil, gas, power, diesel, etc.) were not limited by credit capacity they theoretically might be more active risk mitigators in elevator up pricing environments, and households/individuals would benefit from more short interest in forward markets.
However, there is that pesky credit issue in the way. An issue magnified by the presumably unintended consequence of a loss of liquidity that have resulted from legislation such as the Dodd/Frank Act. Now for a moment let’s consider who the counterparties are taking on the short interest of a producer of energy. There are of course the typical commodity desks at banks, but then there is also the universe of energy merchants providing liquidity to the E&Ps, IPPs, and large industrial energy consumers. What happens when one of these energy merchants has a parent or subsidiary company who is a direct provider of consumable energy (power, gasoline, diesel, natural gas, propane, etc.) to the ultimate end user, and the need for additional credit capacity arises? This is one of the questions the Reuters article raises, who is ultimately the responsible credit counterparty or “who writes the check” at the end of the day?
In North America we have seen a number of credit counterparties leave the energy trading space including banks and high credit worthy institutions such as Shell most recently. This has adversely impacted liquidity and that ultimately gets reflected in more volatile price swings. However, there remain a few merchant players, some of whom have utility parents. Take Florida Power and Light, who in collaboration with the Florida PUC, sets power prices for Floridians. Their parent organization Next Era Energy, is a liquidity provider, or hedge counterparty to E&Ps in the Permian Basin of West Texas. What if a rate payer in Florida had to, through their regulated power price, help cover the credit cost to support a Permian Basin oil or natural gas trade. I doubt the Floridian would be too pleased with such a possibility, if it occurred, and of course if they knew about it. Ire would mostly certainly spike, in today’s world where gasoline, diesel, and power are all more than double what they were not too long ago.
The answer to the credit conundrum is multi-faceted involving changes in market settlement methodologies, regulatory improvements and technological changes (some of which we at Mobius are working on like smart contracting). What is most immediate is increasing awareness. As one of our astute client’s says “credit- it doesn’t matter, until it does”. The availability to transact and mitigate market risks is incredibly important, but so is understanding what entity is the financially responsible party. Or from a different perspective, “am I the financially responsible party?” as the government and the people of Germany are currently exploring.
Zane Curry
Zane has been with Mobius Risk Group since February of 2016. His primary responsibility is a fundamental analysis of the North American natural gas market. Additionally, he assists in the valuation of gathering, processing, transportation, and physical sales agreements. His experience in energy has been focused on natural gas, however, as the North American hydrocarbon value chain has become a more integrated system his knowledge has expanded to crude oil, petroleum products, and seaborne LNG. Prior to joining Mobius, Zane spent 6.5 years with a Houston based hedge fund (Goldfinch Capital) with AUM of approximately $750M. In his time with Goldfinch Capital, Zane was tasked with developing detailed models of the North American natural gas market, including 1st derivative components such as power generation by fuel source, supply side impacts of liquids focused drilling, etc. Zane is a graduate of Rice University, and a former member of his alma mater’s baseball program as both a player and coach.