Volatile times: how COVID-19 is affecting wholesale energy prices

In the world of global trading, last week made history: for the first time ever, US oil prices dropped below zero and went into negative figures. Oil producers were literally paying buyers to take the oil off their hands. We all know that the COVID-19 virus has had a devastating impact on the world economy, but how exactly did we get to this point? And how should UK businesses plan for their energy needs in the future? Andrew Anderson-Shepherd, senior risk manager at BiU, explains.

Unhappy new year 

China first reported cases of an unknown pneumonia to the World Health Organisation in late December, then January was all about racing to stop the spread of the virus. Because China is such a big economy, even the early stages of this had an effect on global markets. Eventually, the Chinese government imposed a lockdown in 14 provinces and cities, and those areas were responsible for over two-thirds of China’s economic output. Global commodities markets immediately responded to this drastic reduction in energy demand and output. So the price of oil started falling.

In the UK, our main energy source is natural gas, rather than oil. Gas prices hit a mini peak before Christmas and then were naturally coming off that peak just as news of the coronavirus started to come through from China. Although oil isn’t a big energy source for us, the fall in the price of oil had an impact on UK energy prices because it was a sign that activity was slowing down in one of the biggest economies in the world. The interconnected nature of the global economy means that when a huge economy like China has a problem, the rest of the world is affected.

Fightback against falling prices 

Oil producers obviously got concerned about the drop in prices. One of the most worried was the Saudi Arabian Oil Company (Saudi Aramco), which controls the second-largest reserves of crude oil in the world and is reportedly the world’s most profitable company. Last year, Saudi Aramco made the biggest stock market launch in history when a small proportion of the company was put on the Saudi stock exchange. But as the global oil price fell, Saudi Aramco’s stock fell with it.  

Saudi Aramco is part of OPEC, which is an international group of oil-producing countries that works together to influence prices, mostly by agreeing production targets for each member country. But as they were discussing how to handle the falling price of oil, reports of coronavirus cases started to come in from different parts of the world. We all watched in horror at how badly Italy was affected, then other countries started to follow suit, including the UK. The oil price, already down to around $40 a barrel, took an even bigger hit.

OPEC members started talking to Russia and other countries as part of a wider grouping called OPEC+. They agreed to cut production so that prices would recover, but they were overtaken by events. The planned drop in production of 10 million barrels a month, or about 10% of the global oil supply, would work well in normal circumstances. But these extraordinary times have caused global demand to drop by 25 million barrels a day, or 25%.

To make things worse, the agreement fell through anyway, so everybody involved carried on pumping out oil as normal and the price went into free-fall.

How did we end up with negative numbers? 

Because the oil produced wasn’t being used, storage facilities started filling up. To give just one example: the main storage hub for the USA is a place in Oklahoma that has the capacity to hold 80 million barrels of oil. As recently as February, it wasn’t even half full. Now it’s three-quarters full and they think it will reach capacity next month. We’re seeing a dramatic increase in the use of tankers being used as offshore storage.

But it’s still being traded, and the issue with trading in oil is that if you take on a contract to buy it, you are legally obliged to actually take possession of it. The contracts for May were expiring last week, just as the storage issue started to bite. Most traders who bought those oil contracts had no intention of receiving the oil itself – their plan was to sell the contract on at a profit. Most did not want to deal with the headache of transport and storage, so they were desperate to offload their oil contracts. That’s how we reached a point last week where people were actually paying to get rid of oil.

Will prices rally soon? 

The oil purchase contracts for June aren’t looking quite so stark because there’s been a very small rebound in prices. OPEC+ has finally agreed that the output reduction of 10% will really happen, and that takes effect from the start of May. Meanwhile Donald Trump is causing a distraction by threatening Iranian ships. But oil prices are still way down on long-term averages.

UK energy 

Here in the UK, we’re seeing a plentiful supply of our main energy source: gas. It’s coming in from Norway, the UK continental shelf, etc.

We’re also getting plenty of LNG (liquefied natural gas) coming in from all sorts of places: Qatar, Trinidad, the US, Norway, you name it. This is gas that’s been supercooled into liquid form and then when it reaches the port it is turned back into a gas. We have anything between 5 and 15 containers of LNG coming into the UK every month, so stocks are high, and we’ve actually been exporting some to the Continent.

The challenges for UK businesses 

UK businesses currently face two big issues: the immediate one of how to manage their energy costs during lockdown, and the longer-term question of energy supply for when we start to emerge from this difficult time.

As companies go into what many are calling “hibernation”, many are finding that energy use hasn’t reduced in line with business activity. You might expect energy use for a business that’s not trading at the moment to be close to zero. Actually, we’re hearing reports that some are at around 40% of their previous levels of energy use. Some of this is explained by the presence of systems that shouldn’t be switched off even in an empty building, like computer servers, security lights or alarms. But a big part of the problem is automation. While a human retail manager might switch the shop lights off until they’re needed again, an automated building management system will keep them on in line with the usual trading hours, and it’s not possible for an individual onsite to override that and turn them off.  This is something that many businesses need to look into.

It’s good for the businesses still running that energy prices are in the UK are at a five-year low, but this is yet another area of uncertainty. My role is to help businesses secure the best price for their future energy supply and manage risks. This normally involves forecasting and fixing prices in advance, but the market is currently in a very short-term and volatile mindset.

Our procurement team look at all the data on wholesale energy prices and come up with a strategy that is tailored to the specific needs of the business we’re advising. It’s never easy to predict the future, but now that the coronavirus crisis has been underway for a while, we do have a lot more data to base our analysis on.

This terrible crisis has affected the whole world, and the economics are just a small part of that – but many UK businesses are working hard to rise to the challenge. For those looking to cut costs in this uncertain time, an informed energy purchasing strategy may be an easy way to find savings and reduce risk.