Despite the 2018 forward energy curves trading through a 20% range this year, we find ourselves looking at spot and 2018 gas forwards that could have for all intents and purposes been lifted from December 2016. It’s a similar story in power, although the spot hasn’t thus far seen the extreme peaks of 12 months ago, and the forward curve for 2018 sits some 5% higher than last December’s highs.
You can’t begin to understand UK gas and power pricing in isolation from the energy big hitters. Oil and coal have set the tone for the wider energy complex, with Brent Crude trading through a $20/bbl range this year. Coal wasn’t so much volatile as a one-way bet in 2017, with short-dated contracts and the calendar 2018 contract reaching three-year highs in linear fashion. In the context of power and gas futures pricing, both these base fuels still set the direction of travel despite the myriad of fuel-specific drivers.
Politics has played its part too. The US lifting its ban on energy exports has pressured stocks just at a time when OPEC/Russian production cuts have targeted the global overhang. Middle East politics are at the hub of the oil debate, with all of the region’s producers hurting from 2015’s race to the bottom. Oil may be $20/bbl above its summer low, but with the Trump bounce washing out of the US dollar, its denominated commodities find themselves needing to make up the 10% devaluation deficit just to stand still for non-US producers.
Structurally, the UK transmission network operator has said that the UK looks to be in better shape this winter than in the previous two. Certainly, the restructuring of the capacity market means that generation asset availability should add flexibility. Already this autumn we have seen coal picking up share where maintenance is hampering nuclear output. Gas, despite the closure of Long Range Storage (LRS), looks to offer the kind of flexibility needed to meet all the peak demand scenarios.
More Russian gas into Europe, 10% uplifts in Troll output and higher UKCS availability all bode well on the supply-side. However, capacity doesn’t equal flows, and the UK remains very vulnerable to supply-side disruption. One problem notable this summer was that price signals didn’t always determine the flow of power or gas, which makes predicting or justifying price behaviour extremely difficult. Simply put, a commodity shouldn’t follow any route other than the highest price available, and for significant periods this summer and into the autumn they didn’t.
Perhaps the clearest shift in pricing signals this year was the summer prompt. Day-ahead power and gas averaged above £40/MWh and 40p/th respectively during Summer 2017. Figures that thus far seem to completely validate the current 2018 summer forward pricing structure. In terms of the more recent developments in power availability and gas, coal, and oil pricing, there would seem to be room to suggest that current pricing has plenty of potential upside from here if we encounter supply difficulties or sustained pressure from demand growth. More grist to the upside mill comes in the form of historic analysis and markets like nothing more than a target to hit. Futures prices are hovering in the middle of five-year ranges, so there is little to suggest that they are overblown or lack the room for significant upside given a forecast for significant material change.
This winter season, gas spot prices raced up towards 60p/th. At this level, we typically start to see demand destruction and a quick flip back though history tells us that, 2013 aside, a few occasions saw sustained prices above these levels. Of course, history is not the definitive guide to the future, and certainly, the shape of the market continues to evolve, so we cannot afford to be complacent. Under adequate supply conditions, we expect the 60p/th rule to hold, although it is obvious that with ever-greater reliance on imports, the UK is much more vulnerable to supply shocks than ever before. LNG’s ramp-up in production has been slower than expected and the Asian appetite for it to supplement/replace coal even greater.
Were we to have a major pipeline outage, it seems unlikely that we would easily or cheaply be able to attract enough LNG to fill the void, at least not for the next year or two. The scenario traders have always been in play around peak demand seasons, but assuming that oil stays in its new $60-65/bbl range and sterling and supply hold up, then that upside could be limited. Significant downside looks unlikely ahead of March despite the favourable long-term weather forecasts. Summer, with lower injection demand and growing renewable power contributions, means average prices just above 40p/th, which might prove slightly short if a difficult Q1 skews premiums into Q2, but given a fair wind, prices shouldn’t find too much appetite higher up. Mindful of the supportive wider complex, winter gas under 50p looks to offer good value, with downside limited to maybe 10%.
For power, the outlook remains heavily gas-dependent despite growing renewable contributions. The political involvement in the French power markets to continue to support prices through 2018 with the interconnector flipping more regularly than we have been used to. Assuming adequate gas for generation, there could be similar patterns to gas-for-power price movement. There seems little scope for upside in summer above £40-45MW with current conditions, but we would rate winter power futures under £50MW as serious value.
By Jason Durden. A former equity derivatives trader with Citicorp and RBS, Jason has worked in energy for 14 years. As well as managing trading teams looking after gas and power energy funds and multinational European contracts, Jason has personally risk managed some of the UK’s largest flexible gas and power contracts.
Photo Credit: Andy via Flickr