The only way is up

7 mins read

Today's oil prices are no guide to tomorrow's energy prices, warns John Dwyer.

Manufacturers need to adopt energy strategies that keep them above the turmoil. Whoever you ask, the tale is the same. In consultancy BDO Stoy Hayward's end of October summary, during the third quarter of 2008 UK manufacturers were paying 23% more for electricity than in the previous quarter. BDO's quarterly manufacturing energy tracker says this means that "electricity prices have now increased by an overwhelming 243% since the same time last year". Or take Deloitte, which points to a 121% rise in average industrial gas prices and 76% in industrial electricity prices between 2001 and 2006. Even after recent falls, says BDO, oil and gas prices were still half as high again as a year earlier. Intensive Energy Users' Group director Jeremy Nicholson says the three-to-six-month lag before oil price falls reach the price of either gas or gas-reliant electricity means no-one in the UK will benefit from lower oil prices "until the other side of the winter". Even then, the fall in the pound means UK industry won't see as much benefit from the fall in dollar-priced oil as those in dollar or euro economies. N icholson's constant theme is the competitive shackle energy puts on UK manufacturers. According to Deloitte, in July 2008 UK gas prices were about 16% above those in continental Europe and, in September, year-ahead UK electricity prices were about 38% above those in Germany. France's mix of nuclear and renewable generation makes it immune to fossil fuel prices, so French short-term electricity tariffs are a third to half of the UK price this winter, says Nicholson. The UK's elderly power stations haven't been replaced and are often down for maintenance. Two-fifths are gas-fired, so electricity prices also reflect gas prices. The UK has too little gas storage capacity. "We don't have the ability to import gas when the prices are relatively low and are constrained for storage in the short term. Even in the medium term it's doubtful whether we're going to get enough storage relative to our growing import dependency," says Nicholson. Liquified natural gas (LNG) doesn't even reach our one LNG terminal, at the Isle of Grain, unless the UK outbids the Atlantic and Pacific markets for cargoes. The UK's wholesale gas market has failed because only a fifth of the gas on the wholesale market is traded publicly. The rest is sold in secret bilateral deals for future consumption, says Dominic Whittome, a former head of gas trading for one energy supplier. He told the BBC's File on 4 in October that this 'under the counter' trade "creates a perception of traded gas scarcity, which pushes the prices up". That, he said, is "one of the major reasons prices have risen 400% over the last 10 years". A recent Datastream figure is that the UK's one-month natural gas forward price increased 141% from the start of 2007 to September 2008. But the nub is that today's energy price is useless as a predictor because there are so many conflicting influences on what tomorrow's is likely to be. Industry's strategy has to be directed around two certainties - long-term rises and short-term volatility. A new Deloitte report, The Balance of Power, deals directly with the strategies manufacturers have available to deal with both. One of its authors, Julian Denee, a director in Deloitte's energy trading and risk management practice, says forward energy prices are now in 'contango', a commodity-market term to describe a situation in which the long-term cost of a commodity is higher than its current spot price. It's these prices for forward deliveries, not falling spot or prompt prices, that matter to oil companies and it is these forward prices that remain high, says Denee. He notes the latest International Energy Agency prediction that oil will go back to $100 a barrel as soon as the world economy recovers, and reach $200 by 2030 - if you can trust any prediction that far ahead. Denee says oil prices aren't just driven by high demand from the emerging economies. There's also a shortage of refining capacity because of shortages of skilled labour and geo-political unrest in Iran, Nigeria and other producing countries. One terminal explosion, as at BP Texas in 2005, can send the market into turmoil. Big Oil - the term used to describe the world's top half dozen oil companies and the power they wield - has made itself so unwelcome in many of the places where oil is to be found (Venezuela, Bolivia, Chad, Ecuador, even Australia) that there has been severe under-investment in production capacity. There's nowhere to invest in conventional fossil fuels, says Denee. This year's lesson for Big Oil was that, even if prices rise astronomically, they could fall to earth just as quickly by the time a new investment comes on stream. So don't invest. Already non-conventional sources like tar sands have become too expensive and energy intensive. In October alone, Canadian tar-sands projects worth more than C$40 billion (£20 billion) were postponed. The oil firms "don't have the appetite for it," says Denee. Renewables are no answer. Nicholson says the feed-in tariffs that some say have encouraged greater use of renewables in continental Europe may put a cap on prices, a cap unavailable from the current renewables obligation system. But alternative energy is intermittent and doesn't provide base load power. More important is that oil is what oil companies know, and they won't put their weight behind anything else. If, as some predict, 'peak oil' is reached between 2011 and 2015, oil reserves won't decline as gently as they rose. They'll fall off a cliff as whatever's left is hoovered up by all the demand that's built up in the good years, made worse by steeply rising developing-economy car ownership. "That's going to have a massive problem," says Denee, "and I don't think we've got our heads around that yet." Add in what Denee calls a geological fact of life: "Once a field goes down, it goes down very quickly, because you can't maintain the pressure." For now, lower or more volatile oil prices, ironically, could also lead to higher prices. Opec's first reaction to a prices tumble is to drive them back up by turning off the tap. The volatility issue is critical, says Nicholson: "Even if on average our prices were the same as those in Europe, British business has higher risk simply because of the unpredictability. And if you run an energy-intensive business, you would like to know for at least the next season, if not a year ahead, what your input costs are likely to be." You can only obtain certainty by fixing ahead on a forward price which locks you into an uncompetitive margin. Instead, industrial gas purchasers increasingly buy much, though not all, of their gas on flexible 'prompt' (for delivery a month or a day ahead) contracts: "You don't know what the price is going to be from one day to the next," says Nicholson, "but you do know that on average you'll probably get a slightly lower price than you would do by fixing." It's risky. In a mild winter the prompt-price gamble may pay off. Otherwise, or if there's a plant failure, it could, says Nicholson, be "ruinously expensive". Be prepared either to absorb some hefty price increases or, as happened when the interconnector failed two winters ago, to suspend production, as Terra Nitrogen, the UK's biggest producer of nitrogen fertilisers, and its competitors did. Today, says Nicholson, "we're not in that territory quite, but it's come uncomfortably close". Denee says: "If you're a relatively small business then I'd encourage people to go fixed, so you can do your budgeting. If you're a bigger company, it makes sense to have a mixture of fixed and floating." Short term, says Nicholson, "we are where we are. We are warning members that, because of the retirement of a large amount of our generating plant by 2015, partly because of environmental legislation, prices in the power market are likely to remain volatile and relatively uncompetitive." The good news is that manufacturers who dedicate resources to dealing with the energy issue will have a sharp competitive advantage over those who don't. Denee says the winners will be those who wean themselves off the idea that energy is an overhead with an annual bill you pay at the end of the year. Energy is now both a scarce resource and a critical business cost, he says. This can't be left to the purchasing function. Energy strategy needs to be a boardroom-driven combination of demand management, flexible purchasing contracts (for companies of appropriate size), risk-management tools, local generation and innovative solutions to reduce fleet costs. It's vital to understand the impacts of direct, supply chain and compliance energy costs on a business. And manufacturers need to understand that, whatever the recent falls in the oil price, the medium and long-term energy price trend is upwards. Allied to that is the need to apply continuous improvement techniques to energy purchasing and consumption. And companies need to develop energy reduction, process efficiency, purchasing innovation and other strategies as part of a route map to energy independence. Nicholson says car manufacturers and other large users are now talking about long-term deals with EDF and other energy suppliers - already available elsewhere in Europe - which will free them from the vagaries of the wholesale market. Deloitte's report notes that car makers and other large energy users are adopting microgeneration. Eight wind turbines at Nissan's Sunderland plant generate 6% of the factory's energy requirement. Ford's diesel plant at Dagenham also uses wind and its engine plant's energy-from-waste systems have earned green awards. Investment is key, whether in smart metering, or, as a next step, in retrofitting existing plants and facilities with more efficient equivalents. There is mounting evidence of huge investments in such replacements. Denee says: "People realised they weren't going to make their budget [because] their energy costs were doubling." David Friend says business at his Lincolnshire Industrial Energy Surveys consultancy was flat until March this year. Now his clients in power stations, steelworks, breweries, chemical and process plants are desperate for energy efficiency. Step improvements in the design and efficiency of air compressors, boilers and, particularly, refrigeration plant have encouraged new investment in lower-running cost equipment: "The sheer breadth of work that's coming in is quite astonishing and firms are spending." In none of his recent projects - a 15-factory soft drinks company, power stations, a penicillin manufacturer, even a big steelworks - has money been an issue: "They're all big capital spends. It mystifies me where the money's coming from if things are supposed to be so tight." According to the manufacturers' organisation EEF, there's no mystery - the investments are being funded from profits. Let's hope they keep coming.