In-depth German power analysis: behavioural drivers behind the shape of the forward curve

The forward curve of the German power market has over the last two years adopted an odd shape. If prices trend down towards delivery, as German power prices did for a number of years up until 2013, longer-dated contracts are often priced higher than their shorter-dated equivalents. Since 2013, however, longer-dated contracts for German power have often been priced below shorter-dated products.

But now, with the shape of the curve attempting to shift again and longer-dated products again rising in price relative to the near end of the curve, Germany-based ICIS analyst Ann-Kathrin Kotte analyses the fundamental – as well as behavioural – factors that influence the shape of the German curve.

The fall of German power prices closer to delivery over previous years was primarily driven by a general downturn in commodity prices, as well as a reduction in demand and higher-than-anticipated expansion of renewable power. Contracts with later delivery were generally priced above their shorter-dated equivalents until 2013. Such an upwards-sloping forward curve is often observed in markets in which prices fall over time.

In 2013, however, prices of shorter-dated contracts meandered above those of longer-dated contracts, as a wide premium of longer-dated to shorter-dated coal contracts started to narrow. Coal is an important driver of the German power market because coal-fired power stations are often the price-setting plants, and coal constitutes a considerable share of production. Clean dark spreads, a measure of profit margins for coal-fired power plants, are therefore often more stable than power prices.

What was a small premium in longer-dated coal prices could no longer offset the price effect of expected renewables expansion. Therefore prices for German power contracts with later delivery were pushed below the earlier-dated contracts. Due to renewables expansion assumptions, year-ahead clean dark spreads also narrowed.

Behavioural drivers

As well as fundamental drivers having an influence, price developments and shapes are also influenced by the behaviour of market participants.

Hedging strategies is one example of this.

While many producers aim to hedge production early, low profit margins have forced many producers to hedge with more granular contracts that only become liquid closer to delivery. Later hedging of supply likely exacerbated the downwards trend of power prices closer to delivery because the removal of volume from longer-dated contracts and consequent shift into shorter-dated products is bullish for longer-dated contracts and bearish for shorter-dated ones.

On the demand side, several industrial end-users and small utilities, known as Stadtwerke, reported procuring power for end-user demand at a later stage, too. Later hedging on the buyers’ side removes demand from longer-dated products and shifts it into shorter products. This has the opposite effect to the later hedging of production, and is bearish for longer-dated contracts but bullish for shorter-dated ones.

Given the large share of end-user demand that is supplied by Stadtwerke, such a behavioural change can have a real effect on the shape of the forward curve. The Big Four – RWE, E.ON, Vattenfall and EnBW – dominate the production side of the German wholesale market. In 2014, 73% of German production or 67% of combined German and Austrian production originated with these four companies, according to a report published by grid operator BNetzA in 2015.

But on the consumption side, local utilities play a more dominant role, with only 36% of end-user demand being met by the big four and the remaining 64% by smaller suppliers. As small utilities constitute 64% of national demand, the point in time at which they place their demand in the market matters.

Supply-side hedging strategies

Utilities have several options for procuring power to meet end-user demand.

They may buy an entire profile back to back. This reduces risk considerably, but at a high cost.

They may hedge the profile with base and peaks products back to back. The residual profile remains unhedged until spot trading.

They may hedge the profile with base and peaks options back to back and purchase base and peak contracts when the price is perceived as appropriate. The residual profile remains unhedged until spot trading.

They may hedge the profile with base and peaks products within a hedging corridor over time. The residual profile remains unhedged until spot trading.

They may hedge the production with an asset by purchasing underlying fuels and locking in the spread.

While relatively low risk, the last strategy is in many cases not appropriate, because utilities would lock in negative spreads with plants that are out of the money in terms of meeting the customers’ profiles. As many Stadtwerke operate combined-cycle gas turbine with high fuel costs, asset-backed end-user demand is often not an option.

The first strategy contains the lowest risk, but is also viewed as the most expensive. The second and third strategies eliminate base risks and only leave residual, hourly positions unhedged. The fourth – and very common – strategy leaves both base and shape temporarily unhedged. This strategy is perceived as low risk, as power is not purchased at a single price but at several different prices. It does, however, expose the utility to the full risk of adverse price moves during the period in which hedging is completed.

Why are hedging patterns on the supply side changing?

After years of low profits on the wholesale market, many Stadtwerke are looking for alternative sources of revenue in the power sphere. Many are looking at the retail market for pain relief and state their key objective as attracting more customers.

Retail markets are not only perceived as potentially more profitable, but also as lower risk than wholesale markets. On the retail market, however, new discount entrants have driven retail margins into grossly negative territory, and while less price-sensitive customers can be maintained on the basis of better customer service, local identity or a green image, these marketing spiels are costly and equally affect margins. Sales departments, finding themselves regularly undercut, naturally demand lower prices from the trading departments, which can be provided in exchange for higher risk, such as later procurement.

To enable higher retail margins, hedging corridors are shifted closer to delivery with the expectation that power can be purchased at lower prices this way. The premise of this strategy is that power prices will continue to fall towards delivery, as the particularly enduring bear cycle of the past eight years has created the impression that power prices naturally fall towards delivery. While this speculative decision is risky, it also implicitly assumes that the market does not set a ‘fair’ price and past trends can be extrapolated forward to create predictions for the future

Many analysts, however, agree that the market sets the fairest prices it can, given the state of information, and that the past is at best a poor indicator of the future. In fact, the recent pick-up in coal, gas and oil prices has provided bullish momentum for power prices.

Implications of later hedging

The trend to hedge retail positions later creates a torque movement on the wholesale market that is bullish for shorter-dated contracts and bearish for longer-dated ones. As buy volume is removed from longer-dated contracts and shifted towards shorter-dated products, there is less demand for longer-dated contracts and prices further out on the forward curve can consequently weaken. Increased demand for shorter-dated contracts supports the price of those contracts.

The key drivers influencing price shapes on the German power market are likely still fundamental, for example, the shape and development of underlying commodity prices and the renewables expansion. Further changes in hedging behaviour on the supply and demand side may, however, become increasingly important price drivers. ann-kathrin.kotte@icis.com