As we discuss hedging risk, let’s remove the discussion of gas from the equation for a moment and just focus on the Heat Rate – or put another way, isolate the POWER component of the math formula (Heat Rate x Natural Gas = Fixed Price Power). Also let’s establish that Heat Rates are directly correlated to where Realtime LMP prices clear every 15 minutes. In August 2011, Realtime LMP prices blew out, and when they did, caused Summer Heat Rates all the way out the curve to jump up. Heat Rates settled down once folks decided it was just an anomaly, until around Feb 2012, when ERCOT and the PUCT started discussing the need for more power plants, that no one was building any, and suggesting that Aug 2011 might not have been an anomaly, but maybe just the beginning of more volatility to come. The PUCT pushed through higher LMP caps for the immediate Summer of 2012, and as we headed towards June, with heat looking strong in weather forecasts, Heat Rates hit all time new highs in ERCOT all the way out through summer 2017 (see chart).
Some trading shops and even most REPs got long power, looking to make monster $’s when LMP went to the cap. In hindsight though, the summer was quite mild after June of 2012, and after no real high LMP’s in June, and rain much of July, and no price volatility in August, two things happened: 1) people psychologically gave up on the idea that summer would blow out, and 2) traders with long positions that were losing money, were forced to scale back long positions which meant selling Heat Rates – so since August 2012, and despite the PUCT raising the caps incrementally for the next 3 Summers, Heat Rates have tumbled on these 2 factors – again a psychological component as well as a real physical one and that is pressure into forced selling of a position.
So where are we today?
The forces that created August 2011 are not only still present, but they are magnified. Load in ERCOT has continued to grow and the price caps are higher. The ERCOT market, and by that I mean traders, REPs, Generators, all are standing around waiting to see what happens, and the ERCOT market is notorious for “reacting” when things happen. So if a plant trips off line unexpectedly once things start to warm up this Spring, and prices pop to the cap real quick (which they always and historically have done) then it’s our belief that the market and especially those that are long power, are going to rally around that and, folks that are short – such as REPs who don’t hedge effectively or who float the realtime index to make $, or large loads, react and buy the curve up and up to cover positions off. Summer 2012’s low prices may turn out to be the anomaly and not 2011’s highs, and the “damage” done to those caught short will be much more severe. Analyzing where the market currently has the Summer 2013 5×16 Heat Rate priced, around a 23.75, it implies LMP prices going to the new $5000 price cap for about 4 hours. For comparison, August 2011 produced over 13 hours at the cap, and 2011 as a whole year produced 18 hours at the cap. 2012 produced only a single 15 minute interval at the cap. What we are saying is that ERCOT is potentially 1 “event” away from a real and potentially long-term “step-change” into a higher heat rate market to reflect the risk and reality of volatility and growing load. The market is already moving Heat Rates up over the last few weeks and we believe that there is still quite a ways to go (and definitely has a way to go before it reaches the highs of 2012).
– Summer 5×16 Heat Rates have doubled in the last 2 years.
Now, there are plenty of people on the other side of this argument who say we will have plenty of capacity, BUT, what even they would have to agree with is that the PUCT WANTS AND IS DESIGNING THE MARKET TO PRODUCE HIGHER PRICES. So aside from the LMP price caps bumped up, they have also made several other very important, though less widely discussed changes to the market. For instance, now whenever certain ancillary services are deployed, prices have a floor of $140/MWh, meaning that in the past those intervals may have cleared $30, now they have to clear $140. The PUCT and ERCOT are now debating a white paper by a Harvard economist named Hogan (calling it the Hogan Paper), that seeks to implement changes where it may reduce the number of times that prices go to the absolute cap, but it would mathematically create higher prices many more times a year in more of your standard hours. If adopted, that means the overall clearing price of energy moves up – a more gradual “step change” as opposed to a drastic and overnight one from a big LMP event.
We believe that the PUCT will continue to work on new regulatory policies until they get the desired result which is: higher prices which will give someone enough incentive to build more power plants. And for that to happen we have quite a long way to go. At the very least, that’s a slow and steady move up in heat rates. Another scenario sees a repeat of Aug 11 but with 2x the dollar impact. Looking at the forward curve for power today, estimates provided by consultants to the PUCT in the Brattle Report suggest that the curve has to move up at least another 30-40% in order to reach levels where someone would build new generation.
If I was a retail customer, I would buy to cover at least the next 2 Summers of exposure and probably also cover the 3rd Summer as well. If prices fall off, then I would blend it down – having made the smart decision and essentially bought insurance, if and when Heat Rates come down then do a Blend and Extend or other retail strategies. If the market explodes on the other hand, then you are a Hero. The risk is to the upside, things can change quickly, and once they do, I do not know what it would take or how long it would take for Heat Rates to revert back to the mean. If sentiment and psychology change, and people believe in the new high prices, then I would challenge you to find a seller at that point to aggressively sell the curve down out in the market. It might take years of low prices again to ease people’s minds.
So, from a heat rate perspective, I would hedge it. If a Customer hasn’t locked in and bought power yet for the future, but plans on consuming power in the future, then they are technically Short Summer power in ERCOT which is the most volatile power market in the world (which is the most volatile commodity in the world). I would recommend hedging that position. MP2 certainly is.
All of the above is around energy only, but other cost components such as ancillaries are correlated and driven by same things I describe above for energy, so if power blows out then so will Ancillaries and Line Losses. Which means other cost components go up in the above scenario which impacts Fixed Prices as well as Heat Rate Adders and LMP Adders so that’s the incentive to lock an Adder now for a longer term.
There has been some discussion that the PUCT might try and implement a capacity market similar to PJM. I personally don’t think it’s going happen despite ALL of the generators wanting it (because basically it hands them a check for doing nothing), but if that were to happen, then Heat Rates would likely react to the downside, BUT, there would be another line item to deal with and would certainly be a change in law with REPs. That said, it would take at least 2 years to implement if not longer (and maybe much longer), so I believe that the above strategy is not compromised by the PUCT going that direction. You still have to deal with the immediate Energy-Only market in front of us.
Finally, to layer in the Natural Gas component of question, it seems that everyone is a gas trader and has some opinion on where things are. If you have a “view” on gas then I would just go with it. If gas is going up or staying flat then do a fixed price. If they think the shale revolution is just getting started and gas is going to $2 then do a heat rate. We think it’s going to trade between $3 and $4 for the next few years I suppose so I would probably do year 1 fixed, and then heat rate for years 2 and 3 and look for just a bit of a pullback out there and if and when it does call it a day and move on to getting back to whatever business I’m in. Some Load Customers are more sophisticated in their approach to gas which can create more value (or risk it), but for the vast majority of Customers, buying energy is just not the top skill or priority that they are faced with.
Increasing prices and potential capacity shortages, the rapid emergence of powerful curtailment software and portal driven applications, coupled with PUCT momentum continues to create more and more opportunity for Demand Response at all customer size levels in ERCOT, and specifically for combining the REP and Demand Response provider in one Energy Provider. The single Energy Provider model creates more revenue and creates DR opportunities not possible with separate REP and QSE. MP2 combines both sides to optimize around Backup Power Generators, Price Avoidance, Peak Shaving, 4CP, ERS, TDSP DR programs, LaaR, Flexible Customer Operations, and custom designed products around unique production schedules or curtailment limitations. We believe that DR is a big part of the future solution and urge our Customers and Partners to have those conversations with us now.
As always, we are happy to sit down with anyone and talk about this, about strategies and approaches to mitigate risk, and how to fully take advantage of our deregulated market structure.