Utility Q1 hedging indicates pre-emptive bearish profit-margin forecasts

Utility hedging increased in the first quarter of 2016, but there is no consensus on the likely development of hedging strategies given uncertainty over the future direction of prices.

The hedging data indicates that utilities had little confidence in the sustainability of profit margins for coal-fired power plants.

But the movements of the energy complex since then suggest generators may have pre-empted the market’s movements in error, and would in fact have been better off waiting for the second quarter to hedge forward, as average profit margins widened during the spring season compared with the second half of winter.

Thermal plant

In the first quarter, some of the main European utilities increased their year+2 hedging ratios for thermal plant production in comparison to the same period in 2015, according to ICIS analyst data.

The greatest increases were seen for German utilities RWE and E.ON, both of which have a lot of coal-fired power generation in their production portfolios, and both of which increased their hedging ratios by 20 percentage points year on year.

The increased hedging would suggest that utilities were more bearish about the future direction of profit margins for coal-fired generators, known as clean dark spreads, in the first quarter of 2016 than they were 12 months previously. This is because, as the data suggests, utilities made a more pronounced effort to lock in profit margins in 2016 before any anticipated fall than was the case 12 months previously.

In the first quarter of 2015 German clean dark spreads – which also take into account the price of carbon emissions – averaged €4.69/MWh for 2017 delivery, according to ICIS calculations. However, the profitability of coal-fired plants actually improved in the second and third quarters of 2015, with average clean darks of €5.44/MWh and €4.83/MWh respectively in these two quarters. This suggests that utilities may have been better off hedging year+2 at a later point in 2015.

And in spite of the increased hedging in the first quarter of this year, a similar pattern has emerged so far, with average clean dark spreads of €3.76/MWh for the Cal ’18 contract recorded in the first quarter of 2016 but a slightly improved spread of €3.96/MWh seen so far in the second quarter.

Clean spark spreads, which measure profit margins at combined-cycle gas turbines (CCGTs), remain deeply negative, which means that generators have no incentive to hedge forward production from gas-fired plants. Therefore, anticipated coal-fired production spreads are the greatest driver of hedging strategies for utilities heavily involved in the German thermal power generation market.

Strategies

Ongoing uncertainty over the future direction of prices makes it difficult to predict the development of hedging strategies, analysts told ICIS.

“Hedging has become a tricky issue for utilities. They are struggling to get the right strategy to maximise profits,” Matteo Mazzoni, market analyst at research company Nomisma Energia said. “When it comes to prices nobody knows where the bottom is at this stage,” he added.

Each European utility will come to its own conclusion on potential profit margins going forward, which could mean that divergent hedging strategies are seen over the coming quarters.

This was already evident in the Year+1 hedging strategies of the leading utilities during the first quarter of 2016, with some utilities increasing their hedging ratios compared to the first quarter of 2015, while others reduced their ratios.

Financial performance

Among the leading European utilities, Dong reported the greatest increases in the first quarter of 2016 in terms of year on year growth in both electricity sales and pre-tax earnings.

Dong’s success was driven predominantly by its involvement in wind power projects, with a 53% year on year increase in earnings from wind generation reported in the first quarter.

With wind and solar power subsidised across Europe, many other utilities are attempting to increase their involvement in renewable generation to counteract low power and gas prices.

“After the first wave of renewables investment, utilities realised they should not fight the enemy but be part of the game,” Mazzoni said.

Some utilities are also attempting to restructure their business to spin off the more profitable elements. On Wednesday E.ON’s shareholders approved a plan to create Uniper, the new operator of what was its conventional generation and energy trading business, enabling E.ON to focus on the more profitable areas of renewables, energy networks, and retail market issues.

RWE announced in December that it also plans to spin off its renewables, grid and retail activities into a new subsidiary, while the parent company focusses on energy trading and conventional power generation (see EDEM 1 December 2015).

Portuguese utility EDP, which was behind only Dong in terms of year-on-year electricity sales and earnings growth in the first quarter, span off its renewables business in 2007.

In addition to the increasing focus on renewables and attempts to streamline operations, utilities are also looking to emerging European markets and countries outside of Europe for growth opportunities. matthew.jones@icis.com