The key drivers that need to be considered when preparing a macro energy market outlook for the next couple of years include the potential impact of weather, renewable energy production, infrastructure development, supply fundamentals, energy storage, UK’s economic performance and political influences.
I will briefly look at each of these in turn and then consider the combined impact to provide a summary.
Winter Weather: Forecasts generally predict a slightly colder winter on average than normal this year though probably not significantly colder. However, there is an expectation of several very cold spells that come and go over a few days interspersed with periods of mild weather. Forecasts also imply a slightly dryer than normal winter though with wet and stormy spells coinciding with the mild periods between the cold spells. Also, it is worth noting that the start of the current winter was quite mundane, which tends to lead to lower winter prices on average and possibly weaker summer prices too if combined with a generally mild winter. In summary, this indicates relatively stable prices with the possibility of volatility spikes.
Renewable energy production: Considering the likely variability in weather conditions and mix of cold with mild and wet spells during the winter, renewable energy production may be unreliable, which will support higher prices as gas will be relied upon as the main electricity generation.
Infrastructure development: In the near term, new high cost infrastructure will not be required as evidenced by the recent security of supply tenders being run by National Grid. This allows short term market fundamentals to drive the market. Recently we have seen this has led to backwardation*, with prompt prices higher than forward prices, implying a move up in prices in the near term but with forward prices keeping relatively depressed. However, as time goes by and the need for infrastructure development will increases, we could see forward prices increasing, pushing the market in to a more contango** structure; indicating a possible change in direction in a year or so.
Energy market structure and supply fundamentals: With oil markets, relatively balanced, perhaps averaging at approximately $55/bbl during 2017, most analysts do not see a significant market shock either up or down. The LNG market has become much more global over recent years with the result that the global LNG market is getting more balanced as market prices encourage arbitrage, thereby ensuring LNG goes to the markets most prepared to pay (i.e. in most need of supply). Unless we see any new political crisis that results in a boycott of Russian gas or Russian imposed restriction of supply, piped gas supply to EU also looks good. However, such circumstances shouldn’t be rules out, particularly in the annual renegotiation period around year end, which will support prices at current or slightly higher levels. Furthermore, major concerns over the supply of electricity from the large French nuclear sites can have significant impact on peak prices as we have already seen this year; any concerns in this area will cause prices to increase and may be the biggest risk to prices in 2017.
Energy storage: We have been very fortunate this year that the winter has been relatively mild. Gas storage, and the development of power storage, is very influential in dampening energy price moves and without sufficient storage, large market shocks usually occur. The sooner Rough storage gets back to full operations the better the market will operate, though in the meantime, short term market disruptions will continue.
UK’s economic performance and other political influences: Unsurprisingly, UK’s economic performance is intrinsically linked to Brexit negotiations. Accordingly, over the next 2 years it is likely we will experience a risk premium in prices, primarily FX driven, resulting in a maintenance of a backwardated market and underlying bullishness in market prices. However, within about 2 years, when Brexit terms become known, it is reasonable to assume a reduction in the risk premium and potentially a shift back to a contango market.
2017 Beyond Renewables Outlook
As the years progress and more renewable energy comes on the tendency to contango will return. Part of the reason for this is that the marginal cost of energy production from renewable sources is low/zero and forward prices will assume an average electricity production with the balance made up by higher marginal cost gas generation. It is also likely the forward prices will embed some long run development costs, encouraging investment whereas nearby prices are unlikely to include this. So in the future it is likely we will see contango return putting downward pressure on prompt prices.
Arrows – In renewable box should be up then down in longer term.
Renewable energy production
⇑ then ⇓
⇑ then ⇓
Energy market structure and supply fundamentals
⇒ with potential for large spikes
UK’s economic performance and other political influences
⇑ then ⇓
Drivers are mixed for the next two years though can be summarised as the market as being held up on risk premiums perhaps artificially. During quiet spells in the market the risk premium may dissipate helping prices to weaken though the general market nervousness with keep an underlying support to the market, even though it may feel artificial.
Some of these risk premiums are intermittent, meaning prices may be volatile with a tendency to spike, potentially even high spikes. However, assuming there are no new significant political events or unexpected large supply disruption, as we move forward the risk premiums may abate, signalling a return to a weaker contango market.
In terms of hedging strategy, in such an uncertain market it may be prudent to hedge small portions on a regular basis, buying-in longer term hedges in the early years but leaving some later year volume to cover nearer to delivery time as the market turns from backwardation to contango.
*Backwardation: Occurs when prices are higher for nearer delivery dates than for forward delivery dates. The opposite of contango.
**Contango : Occurs when prices are higher for forward delivery dates than for nearer deliver dates. The opposite of backwardation.