Why fuel price volatility matters in energy production

Why fuel price volatility matters in energy production

Like any market, the rise and fall of commodity pricing influences not just the sector that commodity trades in but also the financial health of other sectors that it interacts with. Energy price volatility can significantly impact production costs and revenue for businesses. Energy price volatility can prevent corporate stability, as rising and falling energy pricing can affect businesses' budgeting and forecasting. There is also a direct link between fuel prices and electricity tariffs - if the cost of energy increases, this will increase energy tariffs, pushing up the price for both residential and corporate energy consumers. 

What causes fuel price volatility in the energy market?

Understanding the sources of fuel price risk

A number of factors affect fuel pricing, many of which aren’t always within the control of energy producers, such as global market conditions, political fractions, or seasonal demand patterns.

Global Market supply and demand shifts

In the past, fuel pricing has become volatile because of factors like global market supply and demand shifts, with fuel prices even contributing to inflationary periods.

Geopolitical tensions and disruptions

When an exporting country restricts energy export into certain countries, it can push the price of energy up, as seen during the Russia-Ukraine war.

Seasonal and weather-related demand changes

The reliance on weather-dependent renewables, such as wind and solar, makes energy supply more vulnerable to extreme weather, influencing pricing.

Hedging strategies to minimise fuel price exposure

Financial instruments for hedging fuel costs

A method called hedging can help protect businesses from the energy market's volatility, including tools like PPAs, options, and swaps.

Contract and procurement strategies

Long-term supply agreements such as PPAs can fix energy over much longer than traditional energy agreements. Some PPAs may fix energy pricing for as much as ten years, meaning that a business will pay the same price across those ten years, regardless of price fluctuations. This is beneficial because if the price of energy goes up due to geopolitical tension or shortness of supply, the energy procurer still pays the fixed price. When this can become a negative scenario is when the price of energy drops, and the procurer doesn’t benefit from those savings. 

To mitigate the inflexibility of PPAs, the option to draw up an indexed contract also exists. This type of contract is more flexible - energy changes is factored into the long-term agreement. Prices tend to be calculated a day ahead, which allows for more flexibility and transparency. 

Certain kinds of PPAs allow you to personalise different types of PPAs to create a bespoke agreement, such as combining different types of fuel sources. This could be a combination of renewable sources or green sources combined with fossil fuels. The idea of this method is to spread the risk over a couple of different fuel types, and it's called portfolio diversification, which spreads risk, potentially avoiding energy spikes. Bundled PPAs also allow you to combine fixed and flexible pricing, meaning you can benefit from the stability of fixed pricing and the cost savings of flexible contracts. 

Reducing fuel dependency through operational efficiency

Operational approaches to reduce fuel dependency

One crucial method of minimising the affect of energy pricing volatility is to improve energy efficiency. This increased efficiency leads to reduced energy consumption, making energy more affordable. This affordability results in the increased ability for businesses to deal with fluctuating energy prices because there is less energy consumed to mitigate, as energy bills are lower and so less impactful in the face of changing pricing. 

Integrating renewable sources to hedge fuel exposure can also help reduce fuel dependency. Spreading fuel needs across a number of different sources—fossil, green, and combination—can help reduce a business’ dependency on one source of fuel when that fuel experiences pricing volatility. 

Strengthening risk management in energy operations

Risk management and governance frameworks

Risk management from a structural perspective within a business can also help organisations mitigate the impact of price volatility. This can be done by introducing risk management from a transformation perspective, for example, considering risk using technology implementation such as data analytics. Security and compliance risk modelling could detect unusual activity in regards to compliance, or security might highlight factors like energy theft or issues with the grid itself, such as damage or unscheduled down-periods. Risk management teams and committees can examine patterns in data and identify these risks when they occur, or potentially even before they occur, by monitoring the behaviour of the energy market. 

Looking ahead: planning for a dynamic fuel market

Businesses are adapting strategies for a low-carbon future thanks to technology and data analytics, including AI in price forecasting, with AI seen as the future of predictive analytics in energy pricing. AI can be used to analyse data points within the energy sector and then predict movement within these markets. For example, energy traders may use AI to identify patterns within market uncertainty, supply trends, demand changes and energy generation, producing detailed advice bespoke to particular energy market sectors with enough data. The accuracy and speed of the technology make AI a particularly good candidate for the energy finance sector. 

Fuel price volatility is unavoidable, but with smart hedging, operational shifts, and risk frameworks, energy producers can stay resilient and competitive.