Trading power to spark profits

The spark spread represents the theoretical margin of electric power producers. Its understanding can reveal several speculative opportunities that traders can use to expand their market activity.

There are several fundamental methods of transforming various energy forms into electrical energy. These include static electricity, electromagnetic induction, electrochemical effect, photoelectric effect, thermoelectric effect, piezoelectric effect and nuclear transformation. The electromagnetic induction method has the widest commercial application today.

In electromagnetic induction, an electromagnetic generator transforms kinetic electric energy (energy of motion) into electricity. This process involves conversion of energy generated by rotating turbine blades that usually are driven by heat engines. Heat engines, by burning different fuels, heat water and transform it into a vaporized state, thereby producing steam that puts turbine blades into motion. Fuels used in heat engines include coal, natural gas, oil and biomass. Even nuclear power plants make use of nuclear decay energy to transform water into steam, which drives turbine blades.

Apart from heat engines, turbines also are powered by the energy of falling water (hydroelectric power plant) and wind (wind turbines). Recently, an electricity generation method using photovoltaics, in which solar energy is directly converted into electric power by special silicon cells, has become increasingly common.

Electric market makeup

The electric power market is quite diversified, featuring a host of independent companies, both privately and state owned. This market has two components: Wholesale and retail.

In the wholesale market, companies generating electric power sell it to retail resellers. End consumers, as a rule, do not participate in this market, although recently, on the back of an ongoing liberalization of the market, some major users, such as aluminum smelters, have started buying electricity directly from power generating companies. Retail market players resell electric power directly to end consumers, such as businesses and private individuals.

Alongside generating companies and retailers are independent operators of transmission systems, which control electric power distribution across the entire system. Recently, several countries have set up electricity exchanges that serve as trading floors where electric power suppliers and consumers can sell and buy power and hedge their risks. Apart from electricity exchanges, there are also futures contracts traded on CME Group’s New York Mercantile Exchange (Nymex), the IntercontinentalExchange and others. Furthermore, there is a highly developed over-the-counter (OTC) market that allows its participants to efficiently handle these tasks.

All these options stir up competition, eventually reducing electricity prices for end consumers. However, because population represents the primary electric energy consumer, the government monitors pricing in this market and interferes in it, where necessary, by putting caps on prices or, vice versa, taking measures to support producers.

Spark spread

The key behind the spark spread is to make use of derivatives to trace electricity generation economics. Just as a generator buys natural gas to produce and sell electric power at a certain gross margin, this process will be replicated similarly at the “paper” level through purchase of natural gas futures and sale of electricity futures.

This spread is primarily of interest to hedgers — that is, power generating companies that wish to fix their margin by selling electricity futures and buying natural gas futures. Speculators, too, may find the spark spread opportunistic because of high volatility of electric power and gas prices. However, because electricity futures were introduced relatively recently (Nymex has been trading them since 1996), they lack liquidity. This prevents many speculators from becoming active players in this market.

As far as OTC electricity exchanges are concerned, they are not sufficiently accessible to a large number of investors. However, considering the trading profits that can be uncovered in such a volatile commodity, electricity futures remain promising in view of the rapidly developing spot market.

An electricity futures contract gives one of the parties an opportunity to receive a certain amount of megawatt-hours at a specified price and place during a certain month. Under a five-by-eight contract, its owner receives electricity in off-peak hours (from 11 p.m. to 7 a.m.) during a certain month, five days a week (from Monday to Friday). Under a five-by-16 contract, the contract owner receives electricity in the peak hours (from 7 a.m. to 11 p.m.) during a certain month, five days a week (from Monday to Friday). Under a seven-by-24 contract, the owner receives electricity during a certain month, daily and ‘round-the-clock.

There are several varieties of spark spreads. The so-called “dark” spark spread reflects the economics of a coal-fired power plant. There is also the “clean” spark spread that takes into account the need for the generators to obtain carbon dioxide emission allowances. An investor wishing to trace the electric power generation economics considering the cost of emission allowances will have to buy (sell) futures that have such allowances as their underlying asset, in addition to natural gas futures.

The “clean dark” spread means the same as the “clean” spark spread, but in relation to coal-fired (as opposed to gas-fired) power plants. The “clean dark” spread is an important indicator reflecting the profitability of a coal-fired generating facility. Given that the coal burning process results in emission of more than two times the carbon dioxide, the cost of obtaining emission allowances for such facilities is fairly high.

Whether a spread is purchased or sold depends on what we do with the end product (that is, electricity futures). Accordingly, if the investor wishes to buy a spread, he buys electricity futures and sells natural gas futures. He will do the opposite on a sale.

For a spread to be calculated correctly, a few concepts should be introduced first. Electricity prices are measured in kilowatts per hour (kWh) or megawatts per hour (MWh), while gas prices are measured in British thermal units (mmBtu). Apart from these two concepts, there is another concept important for calculating the spread value.

The so-called “heat rate” shows how many mmBtu are required to generate 1 MWh of electric energy that is specific to each particular generating facility. The essence of this concept has to be explained in greater detail. Indeed, no generating facilities today have 100% thermal efficiency. Convention is to use thermal efficiency of 49.13% for gas-fired plants and 38% for coal-fired plants. Thus, plants with 100% heat efficiency would consume 3.41 mmBtu to generate 1 MWh of electric power. Plants with 49.13% efficiency, accordingly, will use about 6.94 mmBtu.This value measured in mmBtu/MWh will be the “heat rate.”

“Static electricity” (below) shows the profit/loss profile of an investor who has bought this spread.

Fundamental factors

Several fundamental factors affect this spread. These include: Electricity price, natural gas price, market sentiment and seasonality.

Electricity price — The demand for electricity is inelastic. Today, it is almost impossible to limit electricity consumption; moreover, electricity demand for the daily peak hours is hard to estimate. On the other hand, electricity supply also is inelastic as it is next to impossible to create reserves of electricity that could be supplied to consumers if the requirements increase. The balance between supply and demand is partly maintained through redistribution of electricity within the national network. Yet, inelastic supply and demand tend to cause price surges in the wholesale electricity market that inevitably affect the spark spread value.

Natural gas price — Even though the spark spread value primarily depends on electricity prices, fluctuations in natural gas prices also can play a critical role in influencing the value of this spread. A rise in natural gas prices causes the spread to narrow, whereas their reduction makes it widen.

Gas prices are highly volatile. Neither oil nor heating oil can compete with natural gas in terms of volatility. To some extent, this is caused by neither the supply nor demand of natural gas being flexible enough. This means that gas consumers are unlikely to be able to reduce their needs if required over a short-term period.

At the same time, gas supplies also cannot be increased quickly during a short period of time. Such inelasticity in supply and demand may lead to extreme price fluctuations. Therefore, sometimes we see that electric energy producers are forced to incur losses during a certain period of time because of gas prices increasing while electric energy rates have not. This generally can be explained by the government determining pricing policies for power-producing companies, while gas prices are not controlled.

On the other hand, over short- and medium-term periods, supply and demand factors will be in balance as global gas reserves are sufficient, and storage inventories can be restored quickly if any disruptions occur. Nevertheless, if this balance is disturbed for even a short time, it may lead to extreme price and spread fluctuations. In particular, if the market suffers gas shortages, this would narrow spreads; vice versa, long-term oversupplies would lead to a decrease in gas prices and significant widening of spreads.

Market sentiment — An additional, although fairly subjective, factor that still exists that may temporarily affect spread values is the mood of market players. When the majority of market players are optimistic about the outlook for the global economy or for the U.S. economy, the prices of electricity futures contracts are likely to surge, widening the spread. Conversely, if a pessimistic approach prevails in the market, spread values tend to narrow. It should be noted that such trends often are ruled by emotion rather than by any substantial justification.

Seasonality — The spark spread exhibits a strong seasonal pattern, tending to widen in the winter, which is explained by an increase in electricity consumption for lighting and heating purposes, and narrow in autumn and spring, widening again in summer. Widening of the spread in summer, if it does occur, is attributable to increase in consumption of electricity because of high air conditioner usage.

When traders think of energy futures, their thoughts naturally turn to crude oil, gasoline and natural gas. While all of these markets are key elements of any energy trader’s portfolio, none of them affects our lives as consistently and significantly as electricity. Trading power itself, in the form of the spark spread, can open a new path to speculative profits. But first, you must understand not just the logistical make-up of the contracts themselves, but the fundamental drivers that can carry the lifeblood of modern society to new heights, or send it crashing to historical lows.

Kirill Perchanok’s research focuses on exploring the possibilities of combining different types of market analysis to maximize the profitability of trading. He can be reached at: service@futuresspreads.eu.com.