Information on the Market #7 - Price forecasting via the hedge market
Hedge markets provide a mechanism for parties with opposite exposure to price risk in an underlying spot market to achieve a beneficial level of price certainty. Where standardised hedge products are traded at a transparent price, that hedge price will reflect the market view of future spot prices. If this were not so, and there was a bias in the hedge price away from the expected future spot price, more hedge volume would be traded at that biased price, pushing it back to an expected price.
The NZ electricity futures market, operated by ASX, comprises market-makers posting buy and sell prices at Otahuhu and Benmore for quarterly contracts for three years ahead. The market-makers have agreements with ASX to post buy/sell prices with no more than a 5% spread, for the period 3.30pm - 4pm each trading day.
As these market-makers have substantial value riding on the ASX price, the forward price curve in the ASX market conveys very good information about their current view of future spot market prices. This information emerges from the analysis of the various participants in the hedge and spot markets, their confidential or public information about future conditions, and their commitment of real money on the basis of that analysis. Even the activity of a single player with superior information will improve the quality of the futures market as a price forecaster.
The electricity futures market therefore has value as a means of socialising the benefit of confidential information, whilst maintaining confidentiality.
The forward price curve for futures contracts at Benmore is illustrated above. The market expectation of spot prices at Benmore has changed significantly between 30 November 2011 and 10 February 2012. In the intervening period inflows into South Island hydro storage lakes have been very low, and a La Nina climatic situation has evolved with implications for future low inflows for winter 2012. The sharp upward shift in futures prices for the March, June and September 2012 quarterly contracts shows how the hydro situation has changed participants' view of the risk of higher spot prices in winter 2012.
In a dry winter, spot prices climb to very high levels to induce infrequently-used thermal plant to come into the market as backup to hydro plant. As the probability of a dry winter occurring starts to increase during autumn, hedge contract prices for winter periods therefore ought to increase as well. It would be possible to get some indication of this future risk from current spot prices. This is because the value of stored water, itself a form of hedge to the owner of that water, will increase in value to its owner as storage levels and the likelihood of high future inflows deteriorate. However, the relationship between current increasing spot prices and future spot prices is not clear as it is affected by many other factors, including the strategic behaviour of those generators holding storage.
If the actual spot price in a dry sequence were $400/MWh above a normal winter price, and given that hedge contract prices have increased by about $40/MWh for this winter, we can estimate that the market sees about a 10% chance of sustained high prices this winter. However, the current increase in hedge contract prices includes many other possibilities of severity and probability.
The current somewhat low storage situation is not relevant to price expectation in future years, as storage levels in one year are not observed to influence storage levels in future winters. This is reflected in the ASX prices for 2013 and 2014 where we see no change in hedge contract prices, and consequently there ought not to be any impact on retail prices as a result of the current storage situation. A net retailer still has access to the same priced hedge contracts for 2013, as it did in November 2011. If it did not have hedge cover already in place for 2012, then it will be undercut by other retailers that did, if it attempted to pass on exposure to the spot market in its retail tariffs. Of course this assumes that there are minimal barriers to prompt switching of retailers.
Strong seasonality is evident in the hedge contract prices. Quarterly contracts over winter are risk-weighted by the long run expectation of the use of dry year reserve plant being required in a winter, and that plant recovering its long run marginal cost at the time (which would be higher than the actual hedge contract price). In summer months more plant is idle, so there is an expectation of lower prices.