Director of Contracts and Pricing
A commodity buying strategy should always have a focus on the long-term and help mitigate risk and provide savings under varying market conditions. The strategy will change as the markets and contract timing do, but a long-term approach should always win out over time. Even if a short-term contract is sought, it should be part of a larger, long-term buying strategy and, more importantly, mindset. Commodity market conditions can change quickly, and you always want to be in a position to capitalize on market opportunities when they present themselves.
As a buyer, it’s important to familiarize yourself with the different options available to you and the benefits of each so you come up with a strategy; you also understand the tools at your disposal for entering into commodity agreements.
There are two significant components to a retail commodity price; 1) the energy (power or natural gas) and 2) the non-energy components (everything else that gets you to a fully bundled retail price). Each non-energy component is passed through or included as part of the price you fix. On electric contracts, the non-energy components are traditionally called retail adders; on natural gas contracts, those non-energy components are typically referred to as the basis. The basis is typically included or not, but on electricity the larger buckets of the retail adder can each either be fixed or passed through.
There are three basic types of commodity contract price structures, each determined by what is being done with the energy. Those three price structures are fixed, index, and hybrid. A fixed price will lock in the price of the commodity for the duration of the term, whereas an index price will tie the energy price to some index (for example, the DA-LMP for electricity or NYMEX for natural gas). Finally, a hybrid price will entail some combination of a fixed and index energy price structure.
The best place to be in a rising market is a fixed product where you are fully insulated from upward market movement. The best place to be in a falling market is an index product where you can “ride” the market down as the price decreases. In scenarios where complex conditions exist, and there is no clear market direction, a hybrid buying strategy allows for some portion of the energy to be fixed while other portions are tied to an index. There are many variations of hybrid strategies, and they allow for flexibility and can be tailored to market conditions and business needs.
Current market conditions are challenging. Buyers who have not made decisions yet for their next contracts are facing the highest price contracts they have ever seen. A hybrid strategy can be effective long term, even if you only intend to be on a fixed price once the contract begins to flow. For example, some customers use a hybrid contract structure to get to 100% fixed before the contract flows. They start by securing some portion of their load and are always looking for buying opportunities in the unhedged or underhedged months to layer in more load to achieve this goal. Not only is this beneficial to time your purchases, but it also helps to dollar cost average the purchase, so everything isn’t secured all at once.
When market conditions were low in 2020, some astute buyers managed to secure pricing for an extra winter than they had initially planned for to have their contract come out in the spring, mitigating a future winter while prices were low and putting them in a more favorable buying cycle for the next contract. Then they can again use the strategy of pulling in additional non-winter months the next time prices escalate to lower the overall contract price. For many buyers, contracts end in November or December because of a decision to take the lowest price many contracts ago. When you add additional winter months to a price, it increases it, but the next contract starts with those expensive months and provides the buyer with no room to maneuver.
If you only focus on your energy contracts when your current contract is coming due, you are missing out on the opportunity to truly control your energy spend. Working with a energy advisor can help to keep you informed of market conditions and buying options and put you in a position where you can act on market information when the time is right.
Explore other energy industry articles in our September Newsletter to help you make informed decisions for your business.
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