Timing Your Energy Contract Decisions – Best Practices to avoid Bad Markets

Smart and savvy energy buyers know that a well thought out energy procurement strategy is critical to realizing long-term cost savings. However, many procurement managers do not dedicate as much rigor to it as necessary. This often leads to them being caught up in challenging energy markets or making uninformed decisions on their purchase, that results in them spending more than they should. This is compounded when there is a portfolio of sites in multiple energy markets, each with their own nuances and structures. However, these situations can be avoided by asking themselves just two questions and then following a systematic process. Those questions are:

1. What to buy – selecting the right energy supply product from the available options, and
2. When to buy – determining the right time to execute energy supply purchases.

This article will help guide buyers towards answering these questions and thus setting themselves, and their businesses for continuing success.

Question 1: What to buy?

Not all energy buyers know that there may be several product options available to them and with a little bit of knowledge, they too can structure their purchases for maximum savings and benefits. It starts with identifying the various cost components that constitute their energy bill, and then knowing which ones to fix and which ones to actively manage. For example, with power the main cost components are:

• Energy – Measured in kWh, it constitutes the actual consumption of electricity over a period.
• Losses – Costs associated with energy losses in getting power from the grid to your business.
• Capacity and Transmission – Measure in kW, these are based on your hourly demand, and are used to pay for demand on Generation and Transmission.
• Ancillaries – These are a variety of charges assessed by the local Independent System Operator (ISO)/Regional Transmission Operator (RTO) to ensure grid reliability.
• RPS – These are charges associated with your State’s Renewable Portfolio Standard

Additionally, power suppliers also assess buyers’ premiums for their energy load’s shaping and variability, which allows them to manage risk.

Buyers are now faced with an option – which of these components to fix, and which ones to pass through (pay as you use). While fixing components allows for simplicity, passing through components allows buys to actively manage their consumption, and thus their costs. Table 1 below outlines some of these cost components and general guidance for buyers to consider.

Table 1: Power Cost Components

If the answer to the question of, which components to fix vs passing through is not immediately apparent, energy buyers should invest some time in product modeling and risk analysis. By analyzing available data related to their energy consumption profile, as well as the market’s they are in, buyers can compare different commodity product configurations. This includes scenario modeling of various market conditions and their impact on the said product structures, followed by stress testing different options through considering historical market conditions and fundamentals, that put potential extreme market outcomes in context. Only this rigor can facilitate informed buying, which is almost guaranteed to yield savings and long-term cost control.

Question 2: When to buy?

This is a logical follow-up to the earlier question, which helped answer which product energy buyers should choose for their business. There are typically two approaches that buyers utilize when deciding when to purchase energy:

1. Calendar-Based: Decisions to purchase/renew is based on existing contract’s expiration dates. This approach lacks any sort of strategy and can subject energy buyers to unfavorable market conditions.
2. Market Opinions: The purchase decisions are based on opinions or view on the prevailing market. These opinions are often subjective in nature and may lead to sub-optimal results, which leads to a lot of second guessing.

Neither of these approaches are ideal when it comes to timing. What sophisticated buyers should be doing, is following option 3 which is:

3. Market Analytics: This approach utilizes a purchasing framework, which is based on fundamental and technical market analysis encompassing large historical data sets, with deep market understanding, and is tuned for buyer’s risk preferences.

The market analytics-based framework for energy purchasing should be built upon analytics that generate a set of buying parameters, each of which is tuned for buyer’s location and preferences. This includes study of fundamental factors such has historical pricing for that region as well as any forthcoming information about electric and gas markets, all of which that drive pricing and buying decisions. This allows buyers to establish a range of potential expected market outcomes and utilize those to set their risk preferences. This coupled with statistical analysis of forward market curves can guide timing decisions on making a purchase. While there is no guarantee that buyers will always hit the bottom of the market during a period, this approach will yield superior results in buying at lower 25^th percentile of market pricing.

The discussion above goes a long way towards effectively answering the 2 questions we stated – “What to buy” and “When to buy”. However, depending on the execution approach that buyers employ, there may be a bonus third question that they may need to consider.

Question 3: How much to buy?

Energy buyers can execute on their purchases utilizing 2 approaches:

1. Single Purchase: These are made at a single point in time for a given quantity and term. While the benefits of this approach are simplicity of product and lower transaction costs, it does mean there is reduced flexibility in product structuring and inferior risk management.
2. Layered Purchase: These are made at various points in time with flexibility in quantity and term for each purchase. The benefits are increased flexibility and superior risk management, but also means that buyers must ensure a proper contract structure with their supplier, and know how much energy to purchase at each transaction.

The buyers who enter layered purchases, need to do an analysis of the amount of their load they want to fix as a block each month, and how much to buy in spot energy markets. This includes running extensive simulations on various market conditions – forward and spot – and then making decisions on the quantity to purchase based on financial outcomes and their risk tolerance. Tracking their portfolio’s exposure to spot markets each month is critical to ensuring that risk is managed and there are no unpleasant surprises.

Implementing a Procurement Process

Theory alone regarding design and timing of energy purchases is not enough to ensure an optimized approach towards energy procurement. This also needs to be coupled with a fault-free process, that ensures contracts are executed in a timely fashion and that nothing is missed. Smart buyers start off by maintain a robust database of their energy contracts, so that simple queries can yield information about all their transactions – prevailing suppliers, products, terms, pricing etc.

This includes being familiar with supplier contractual terms, so that all key stakeholders can sign off on a transaction quickly, without lengthy delays which run the risk of missing out on timing the purchase. Treating a procurement cycle like a will rehearsed drill, guarantees efficiency and optimization, and thus superior long-term results.

We hope this article helps your business procure power and gas more effectively and with confidence. If you have any questions or would like to learn more about the process AEP Energy utilizes to help customers, please contact your AEP Energy representative.

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