How to protect your company from energy price fluctuations
April 12, 2023
Energy price fluctuations refer to the volatility in the prices of various forms of energy such as oil, gas, and electricity, which can rise or fall due to various factors over time. For businesses, energy price fluctuations can have significant impacts on their operations and bottom line, as energy is often a major expense. When prices rise unexpectedly, businesses may struggle to manage their energy costs, which can lead to reduced profits, higher prices for consumers, or even bankruptcy. Conversely, when prices fall, businesses may miss out on potential savings if they have already locked into long-term contracts at higher prices. Therefore, managing energy price risk is a critical concern for businesses of all sizes and industries.
Understanding energy markets and price fluctuations
Energy prices are determined by a complex interplay of supply and demand factors, as well as geopolitical, economic, and environmental factors. Here are some of the key factors that can influence energy prices:
- Supply and demand: Like any commodity, energy prices are affected by the balance between supply and demand. When demand is high and supply is low, prices tend to rise, and vice versa. For example, a cold winter can increase demand for heating oil and natural gas, while a hot summer can increase demand for electricity to power air conditioning units.
- Geopolitical events: Political instability or conflicts in major oil-producing countries can disrupt the supply of oil and gas to global markets, which can drive up prices. For example, the Arab oil embargo of 1973 caused a global oil crisis that sent prices skyrocketing.
- Economic conditions: The state of the global economy can also impact energy prices. When economic growth is strong, demand for energy tends to increase, which can drive prices up. Conversely, during economic downturns, demand may fall, causing prices to drop.
- Environmental factors: Increasing concerns over climate change and air pollution have led many governments to enact policies that promote the use of renewable energy sources such as wind and solar power. These policies can reduce demand for traditional fossil fuels and put downward pressure on their prices.
- Speculation: Finally, speculation by traders and investors can also affect energy prices. These market participants may buy or sell energy futures contracts based on their expectations for future supply and demand, which can cause prices to fluctuate.
Overall, energy prices are subject to a wide range of complex and interconnected factors that can make them difficult to predict or control. However, understanding these factors can help businesses make informed decisions about how to manage their energy costs and minimize their exposure to price fluctuations.
There have been numerous examples of energy price fluctuations in recent years that have had significant impacts on businesses. Here are a few examples:
COVID-19 pandemic: The COVID-19 pandemic caused a sharp drop in global oil demand as businesses and consumers cut back on travel and transportation. As a result, oil prices plummeted to historic lows in 2020, with West Texas Intermediate (WTI) crude oil prices briefly dipping into negative territory for the first time ever. The drop in oil prices had significant impacts on energy companies and related industries, with many experiencing major losses and bankruptcies.
War in Ukraine: The ongoing conflict in Ukraine has had a significant impact on energy prices, particularly in Europe. Ukraine is a key transit country for natural gas supplies from Russia to Europe, and disruptions to gas transit through Ukraine have led to supply shortages and price spikes in the past. In 2014, following Russia's annexation of Crimea, Ukraine and Russia became embroiled in a gas dispute that led to a disruption in gas supplies to Europe. This disruption caused gas prices to surge, with some European countries experiencing price increases of over 300%. Since then, tensions between Ukraine and Russia have remained high, and there have been several incidents of gas supply disruptions.
Overall, the war in Ukraine has increased the risk of energy price fluctuations in Europe, particularly in relation to natural gas supplies. As a result, many businesses have sought to diversify their energy sources and reduce their reliance on Russian gas.
Texas winter storm: In February 2021, a severe winter storm hit Texas, causing widespread power outages and a surge in demand for natural gas to heat homes and businesses. The surge in demand caused natural gas prices to spike, with spot prices in some areas reaching as high as $600 per million British thermal units (MMBtu), compared to an average price of around $2.50 per MMBtu in 2020. The high gas prices had significant impacts on Texas businesses, particularly those in the manufacturing and agriculture sectors that rely heavily on natural gas for production and heating.
These examples demonstrate the volatility and unpredictability of energy prices and the significant impacts they can have on businesses, particularly those that rely heavily on energy for their operations. To mitigate these risks, businesses need to have a solid understanding of the energy markets and develop strategies to manage their exposure to price fluctuations.
Strategies for managing energy price risk
There are several strategies that businesses can use to mitigate the risk of energy price fluctuations. One of the best options is investing in energy efficiency and renewable energy to reduce consumption. For example, businesses might upgrade their facilities with more energy-efficient lighting, HVAC systems, and equipment, or install solar panels or wind turbines to generate their own electricity. These investments can help reduce energy costs and provide long-term savings, as well as reduce a business's exposure to price fluctuations.
Walmart has a goal of sourcing 50% of its electricity from renewable sources by 2025 and has invested heavily in solar and wind power projects across the United States. These investments have helped Walmart reduce its energy costs and carbon footprint, while also providing long-term savings and reducing its exposure to price fluctuations with on-site solar power generation. Its renewable energy investments have helped the company avoid over 6.3 million metric tons of CO2e emissions since 2005, according to the company's 2020 ESG report. According to its 2020 ESG report, Walmart has saved over $1 billion in energy costs since 2005 through its energy efficiency initiatives.
Another option is hedging with futures or options contracts: Hedging involves taking positions in futures or options contracts to lock in a price for future purchases or sales of energy. For example, a business might purchase a futures contract to buy a certain amount of natural gas at a fixed price in six months, which would protect them from any price increases during that time. While hedging can be effective in managing price risk, it requires a strong understanding of the energy markets and can involve additional costs and risks. For example, Southwest Airlines has a well-established fuel hedging program that uses futures and options contracts to manage its exposure to fuel price fluctuations. In 2020, Southwest's fuel hedging program helped the company save over $800 million in fuel costs, despite the significant drop in oil prices.
Lastly, monitoring and managing energy usage is another appropriate alternative. Businesses can manage their energy costs by monitoring and managing their energy usage more closely. This might involve implementing energy management systems to track energy consumption, identifying areas where energy waste can be reduced, and implementing best practices for energy use. By taking a proactive approach to energy management, businesses can reduce their overall energy costs and minimize their exposure to price fluctuations. This program has helped companies such as Salesforce reduce their energy costs and carbon footprint, while also providing valuable insights into energy usage patterns and opportunities for improvement.
These examples demonstrate the diverse range of strategies companies can use to manage their energy costs and mitigate the risks of price fluctuations. By taking a proactive and strategic approach to energy management, businesses can improve their bottom line, reduce their carbon footprint, and enhance their overall sustainability.
Energy price fluctuations can have a significant impact on businesses, particularly those with high energy consumption. The price of energy is influenced by numerous factors, including supply and demand, geopolitical events, and weather patterns. As a result, businesses need to develop a comprehensive strategy for managing energy price risk to avoid unexpected increases in energy costs.
There are several strategies that businesses can use to manage energy price risk, including hedging with futures or options contracts, negotiating long-term supply contracts with fixed prices, investing in energy efficiency and renewable energy, and monitoring and managing energy usage. By taking a proactive approach to energy management and risk mitigation, businesses can improve their bottom line, reduce their carbon footprint, and enhance their overall sustainability.
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For readers who want to learn more about energy risk management, there are many resources available. Industry associations like the National Renewable Energy Laboratory (NREL) and the Energy Risk Management Association (ERMA) provide valuable information and resources for businesses looking to improve their energy management and risk mitigation strategies.