Hedging strategies using forward curves in power markets

Market fundamentals

We use the forward curve to fix future prices to avoid the volatility of the spot market. This is driven by coal and gas increases, supply and demand and the integration of carbon allowances. Renewables can also impact, as their unpredictability can make it difficult to predict seasonal output. Seasonality is also a key market fundamental, resulting in premiums during high-demand periods such as winter.

Liquidity and positioning

We can use liquidity on a monthly, quarterly and yearly basis to hedge risk over shorter and longer periods. When liquidity is low, this can penalise smaller market participants meaning they have less ability to hedge. Traders can hedge in different ways: full hedging fixes prices for all energy demand levels, while partial hedging leaves some allocation for price deviations. Optimal hedging is another option: it aims to remove some volatility from the spot market through hedging.

Market behaviour

Market behaviours has a strong influence on forward curves and how they present to traders and energy producers. Liquidity, for example, can be lower in the case of long-term contracts, which makes it trickier to hedge against risk. We take a look at some of the curve movements and the patterns that can be identified.

How the phenomenon appears in curves

There are two main phenomena that appear in forward curves: the first is contango, where the spot price sits below the future price, which is a benefit for longer-term sellers looking to fix higher prices. The other is backwardation, in which future prices are lower than current prices. This is usually due to energy supply issues, pushing up the current price of energy. Traders would hedge the lower future prices in order to lock in lower prices to sell on, hopefully at a higher price in the future.

Typical patterns observed

One of the key purposes of hedging in power markets is to manage the volatility of current prices. Drivers of this volatility could include a lack of storage capacity or a spike in demand. Typical patterns tend to be predictable forward curves during seasonality, with contango and backwardation (the switch between forward prices and current prices being higher than the other).

Trading implications

Traders must look for opportunities between the current and future market prices of energy to buy at a lower price and sell at a higher one. This isn’t as straightforward as it may seem due to the volatility of the energy market, so traders will have to monitor market signals to ensure trades are executed profitably.

How traders act on signals

Analysing the forward curve is a key part of how traders identify off-peak or peak pricing and the difference between the two. They might hedge winter demand against summer during price dips, or combine baseload and peak contracts for balance.

Examples of strategies

Traders must identify pockets of opportunity between spreads, future predictions and changes in demand to capitalise on volatility or deviations from industry norms. 

1. Heat rate hedging

Hedging the spark spread, or profit margin of natural gas, allows traders to both buy natural gas as part of a forward contract and sell power forwards.

2. Retailer hedging  

Categorising customer load profiles by time, for example peak, and then hedging against these with forward contracts can help retailers fix large amounts of energy while leaving room for some flexibility in the future.

3. Static forward hedging

Preparing for winter by buying forward monthly contracts before the price hikes come in is what’s known as static forward hedging. Buying just enough forward contracts to cover expected load can reduce market volatility.

4. Location-centred hedging

Regional data can be used to hedge differences in energy pricing across regions with differing liquidity levels. This can protect against regional price spikes compared to other locations.

 5. Delta hedging forwards

For more sophisticated traders, some hedging can manage volume and price risks through combining with forward contracts. It involves hedging only a portion of capacity due to uncertainties, such as power outages or maintenance.

Risk considerations

When assessing execution risk, it's always worth traders bearing in mind liquidity, both at that time and in the future. It’s crucial to excuse a trade based not only on high levels of liquidity in the front-months, but also the thinner levels of liquidity in end-months. The basis risk should also be taken into account: the assumption that the spot price of delivery will not always perfectly align with the specific forward contract. Volume risk refers to the difference between energy demand and the actual amount of energy generated compared to the amount that is actually hedged. Mispricing can be an opportunity, but it’s worth bearing in mind the risk that comes with relying on modelling: trading is often based on models which utilise historical and real-time data points. When these data points don’t correspond to the usual models due to mispricing, we can no longer rely on these models to make trading decisions.