Stuck in the middle with you!
October 1st 2007

After a period of relative stability, the energy markets have gone crazy again and while it's not quite a bloodbath, there sure are a lot of gangsters in sharp suits about; leaving many of you asking what on earth is going on?

Well, far be it from me to be the voice of supposition, but with all of the necessary caveats implied and with a liberal sprinkling of the word allegedly assumed; you could perhaps think of it a little like the cult movie Reservoir Dogs:

Cast: Mr Blonde – The Energy Trader Police Office No. 4 – The Fixed Price Consumer Mr Orange – The Flexible Consumer Mr White – The Energy Risk Management Specialist Nice Guy Eddie – The Energy Supplier Joe Cabot – Norwegian Gas Producer The movie is set an abandoned warehouse somewhere in LA…..

Mr Blonde has just gagged and tied up Police Officer No. 4, who is staring down the barrel of a fixed price deal on the October round.

Relaxed, Mr Blonde turns on the radio and that song begins….

'Well, I don't know why I came here tonight I got the feeling that somethin' ain't right……' and the music's going and Mr Blonde is starting his dance; 'Clowns to the left of me Jokers to the right Here I am stuck in the middle with you……'

For most energy consumers, this would be a good enough analogy for how the energy markets are currently functioning. The upshot is that the terrified energy consumer gets his ear cut off before being doused in petrol; it's one thing knowing you're going to be a victim, but an internet auction or a shared savings consultant is of little comfort if you only have one ear and find yourself highly flammable! Still, as with Mr Pink's theory on tipping, there's something else going on.

Across the room, the already wounded Mr Orange, the flexible energy consumer, is being tended to by Mr White, the energy risk management specialist. Seeing the impact that Mr Blonde is having on market prices, let alone innocent consumers, Mr Orange does the decent thing and shoots Mr Blonde dead, chalking up one for the relatively good guys and bringing some relief to Police Officer No.4.

However, it's not over yet. Just as Police Officer No. 4 thinks there's backup on the way, in walks energy supplier Nice Guy Eddie, Joe the Norwegian gas producer, and Mr Pink, (another energy trader, but with a better line in customer service).

Walking into the dysfunctional UK market, everyone starts shouting at each other and in true gangster style asking what in the sweet name of procreation is going on? Hearing that Mr Blonde was killed by Mr Orange because Mr Blonde was going to kill Police Offer No. 4, Nice Guy Eddie pops three bullets into the hapless fixed price energy consumer which places their position in the energy food chain into grim context.

Joe purports to know what is going on, which, since he controls the majority of marginal gas flows into the UK,one would hope is true.He pulls a gun to finish off Mr Orange, the flexible energy consumer, only for Mr White to leap to his defense. Nice Guy Eddie is now clearly confused; he's not used to anyone siding with consumers.He pulls a gun on Mr White, which at least makes him think that he's doing something.

So now everyone is pointing a gun at everyone (save for Mr Pink who is hiding before running off with the diamonds, his ill-gotten gains from his raids on the energy market) and after much more shouting and confusion, all the major players shoot each other, leaving the flexible energy consumer to a slow and painful death.

Now it doesn't have to be this way.

If someone had just asked Mr White what was going on instead of pulling guns and jumping to conclusions,he could have pointed out: The short term gas price is being held up by lower than expected gas inputs from Joe, who is making the most of his position at the top of the pecking order Because this is keeping the prompt price gas price up, Mr Blonde and Mr Pink are building a risk premium into the forward curve.

The electricity prompt price is suffering from a push from gas prices, a pull from coal prices, transport constraints and high Far Eastern demand, all of which have driven an increase in prompt prices of 30% Mr Blonde and Mr Pink are also therefore building a premium into the forward curve for electricity Mr Orange suspects that Mr Blonde and Mr Pink are building premium into the forward curve and is gambling that Joe and Nice Guy Eddie will sort things out, returning market prices to normality, reflecting the reality that the UK market has a healthy supply and demand relationship.

However, Mr Orange is forgetting that just because we have the capacity for a better energy supply than we have ever had before, that energy will only flow if Joe and Nice Guy Eddie say it will.

Joe, Nice Guy Eddie and many others will tell you that in November 2005, the UK had a shortage of energy and that's why prices spiked to over £1per therm and over £80 per MWh.

Mr White would point out that at that time there was no physical shortage of energy – it's just that Joe and Nice Guy Eddie wouldn't sell it.

There was a financial constraint not a physical constraint.The UK has 100 days of gas in storage, but there were over 150 days of winter left in November, a record number of consumers (poor Mr Orange) were on flexible contracts, and they had not bought any gas for the winter.

Nice Guy Eddie, Joe, Mr Blonde and Mr Pink got together and decided that if Mr Orange wanted his share of the energy industry's diamonds, he was going to pay a high price for them. So, Mr Orange paid the price for a record cold winter in 2005, even though we did not have a record cold winter.

We have to say that in 2005, the supply and demand balance was so close that it was difficult to tell whether we had a real physical constraint or not. However, here in Winter 2007, no-one can suggest that we do not have enough supply capacity - Joe and Nice Guy Eddie just have to want to sell you the energy.

At this stage, Nice Guy Eddie, still wearing an expression of exasperated confusion,would triumphantly declare that if Mr White was so clever, prices should not have collapsed in Winter 2006, so his analysis did not hold true.

To which Mr White would retort: There was a second factor that allowed Joe, Nice Guy Eddie,Mr Blonde and Mr Pink to enjoy excess returns in Winter 2005; the fact that a record number of energy consumers decided to buy like Mr Orange but did not manage the risk of their position.

Having been burnt badly in the winter of 2005, all of the consumers who had behaved like Mr Orange and got themselves shot did not have the help of a Mr White, and decided in true lemming fashion to buy fixed price energy like Police Office No.

4 for Winter 2006, only to find themselves doused in petrol when prices collapsed.

Because Joe and Nice Guy Eddie did not have any distressed buyers to sell to, Mr Pink and Mr Blonde suffered but that's the life of hired guns.

Having seen how prices collapsed in Winter 2006, the really interesting question is what did the majority of energy consumers do going into Winter 2007 - did they decide to be Mr Orange or Police Officer No. 4? Do you think they have been managing the risk of Winter 2007 since it started rising back in February 2007 or do you think they have been speculating that prices will fall to 20p/therm again? In 2005 we wrote in this magazine that it doesn't have to be like this, you don't have to be stuck in the middle, you don't have to be Police Officer No.4, with only one ear and a fuel habit, you don't need to be a Mr Orange that slowly bleeds to death.

By following the advice of Mr White, you can get through these events and any of the permutations they throw at you; there's no need for your energy portfolio to go to the dogs!

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