Streetwise Professor

November 26, 2021

Boris’ Big Short

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 8:09 pm

Due to the immovable object of price caps and the irresistible force of spiking natural gas and power costs, about 20 retail energy suppliers in the UK have gone toes up. Most of these have been addressed using what is called the Supplier of Last Resort (SoLR) mechanism, whereby customers of the failed firm are transferred to another supplier. (SoL sounds about right!) This mechanism effectively socializes losses:

Energy suppliers that rescue customers via the supplier of last resort can recoup their costs through an industry levy that is funded by bills.

Although the foregoing suggests that all UK energy consumers share in the costs, energy market regulator Ofgem suggests that the customers of failed firms may bear some of the costs:

Could bills go up?

When we appoint a new supplier using the Supplier of Last Resort process, we try to get the best possible deal for customers.

Suppliers we appoint will likely put you on a special ‘deemed’ contract when they take on your supply. This means a contract you haven’t chosen. A deemed contract could cost more than your old tariff, so your bills could go up. However, they are covered by the energy price cap Ofgem sets, which ensures you get a fair price if you are put on one. 

When contacted by the new supplier, it’s best to ask to be put on their cheapest tariff or shop around if you want to. You won’t be charged exit fees. This is a challenging time in the market and we know that there may not be many tariffs available when shopping around right now.

Deemed contracts can cost more because the supplier takes on more risk. For example, they might have to buy extra wholesale energy at short notice for new customers. So they charge more to cover these costs.

Up to last week, all the failures had been dealt with using this mechanism. But the failure of Bulb (Dim Bulb?) was evidently too big for Ofgem to deal with using the SoL mechanism. Instead, it resorted to a “Special Administration Regime” which basically nationalizes Bulb. This regime permits the government to “make grants and loans to the company in administration and may also give guarantees for any sum borrowed while it is in administration.”

That is, SAR is essentially a bailout/nationalization of losses and risk.

Ofgem notes:

The energy price cap, which sets a maximum price for customers on standard default tariffs, will remain in place to protect millions of people from the sudden increases in global gas prices. 

(Aside: It is impossible to protect millions of people from the sudden increase in global gas prices. It is only possible to determine–based on political mechanisms–which millions pay and how much. So this statement is typical government bullshit.)

Thus, given the price cap and the fact that Bulb is now owned by the UK government, Boris now has a big short position in natural gas. So how is he going to manage it?

I have heard that the government approached Vitol, which told them to fuck off. So . . . what next?

The company still has to procure energy at market prices and sell them at fixed prices. Since the government is now the residual claimant, it has a short exposure and can take this exposure on the balance sheet, as it were, and essentially run a naked short.

Or it can try to hedge by buying gas forward. But this is not a trivial problem. This is not a position of fixed size that faces only price risk that could be hedged using fixed quantities of swaps/forwards/futures. There is volumetric risk as well: cold weather increases both the price of gas and the amount of gas that must be supplied. A sophisticated hedge would involve both forward fixed price purchases and weather derivatives. Or through the purchase of a sophisticated structured product that has payoffs that depend on both volumetric and price variables.

I’m guessing that the government is not into sophistication, or frankly, capable of it. As a result, it is likely to be at a severe disadvantage in negotiating a price on a structured product or weather derivatives or long dated forwards.

It is also likely sweating out the hedger’s hindsight dilemma. If it doesn’t hedge and prices spike it will catch hell because of the large losses passed on to taxpayers. But if it hedges and prices don’t spike or in fact decline, it will catch hell too: you idiots overpaid!!!! Both of these judgments are based on hindsight, but even though hedging decisions should be evaluated ex ante on the basis of how they effect risk, inevitably they are evaluated ex post based on how they pan out.

Consider California in the aftermath of its 2000-2001 electricity crisis. It entered into long term contracts at what retrospectively was the height of the crisis, and thus paid higher prices than it would have had it procured on a short term basis. Of course, California attempted to recover by suing the contract sellers, claiming it was a nefarious manipulative scheme. Alas, it succeeded to some degree.

The best solution would be to do what clearinghouses do when a big member collapses–auction off the positions. This is what NYMEX did when the hedge fund Amaranth collapsed due to natural gas futures and swap losses in 2006: JP Morgan and Citadel assumed the positions in exchange for consideration. Similarly, when Lehman collapsed in 2008, the CME auctioned off its futures portfolio.

Even in these situations, however, there is always controversy about whether the price is right. Assertions that the buyers of Lehman’s futures positions received a windfall (i.e., bought on the cheap) led to litigation (filed by the Lehman bankruptcy trustee) and considerable controversy. (Here’s my take on the issue.)

Note that the factors mentioned above mean that the pricing in any putative auction of Bulb obligations is likely to be more discounted, and thus subject to more controversy, than the Lehman positions. As in the Lehman case, the positions will be auctioned in a stressed market. Moreover, as noted above, the exposures are far more complex and difficult to manage than Lehman’s rather vanilla (though large) futures positions. That complexity will bring a discount. Furthermore, apropos California circa 2001, the bidders realize that they are subject to government attempts to clawback any gains that result ex post due to favorable fundamentals (e.g., an unexpectedly warm winter). That is, the bidders may fear that the government will actually acquire a long option position, and hence they will be short an option: if prices spike, the auction “winner” will bear the brunt, but if they don’t the government will claim that it was exploited and over payed.

That is, unless the government can credibly commit to adhering scrupulously to the results of the auction, the auction may well fail to attract any bidders.

NB: credible commitment is not one of most modern governments’ strong suits. (This is likely one of the reasons Vitol told the government to bugger off. It realized that it was assuming a totally skewed position–heads they lose, tails they don’t win.).

According to the FT article linked above (amazingly factual and informative for a current day FT article, BTW) the government rejected two offers to assume the Bulb portfolio. I surmise that the bids were discounted heavily to reflect the factors mentioned above and Ofgem accordingly rejected them.

So I’m guessing the government will wear the risk. Perhaps it will try to manage it–and do it badly. Or more likely it will just let it ride. Maybe it will bet on Covid, thinking that the new variant or the new variant after that or the new variant after that will cause governments (stupidly) to lockdown again and crater economic activity and hence gas demand.

I note that Bulb might not be the end of the story. As noted above, the price caps remain in force, meaning that other suppliers may fail in the future–including those that have already gone through the SoL process. The government would be the ones SoL then. That is, the government not only has the Bulb liability–it has a big contingent liability that could dwarf Bulb.

Ofgem has already hinted at this:

In a letter to Kwarteng justifying the decision to pursue a special administration for Bulb, published on Wednesday, Ofgem’s chief executive Jonathan Brearley said the supplier of last resort mechanism was already “under considerable” strain from managing the failure of 20-plus other energy companies in recent months.

So Boris’s already big short could get bigger.

And perversely, it could influence government policy on COVID. Doing something (like lockdowns) that would crush energy demand would benefit its short energy position (existing and contingent). Talk about moral hazard.

Good luck with that Boris! Or should I say, good luck with that, Limeys?

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  1. And when government is the SoLR of everything, the socialist utopia has arrived.

    So let’s see: make war on fossil fuels so they become rare and expensive. Then cap prices so that energy suppliers can’t adjust prices to cost. Nationalize energy delivery after suppliers go bankrupt. Solve energy demand by crashing the economy. People shiver in their homes. Excess deaths from Winter fuel poverty remove the demand.

    Is that about it?

    Comment by Pat Frank — November 27, 2021 @ 9:51 am

  2. What sort of dimwit introduced a regime whereby the retail price at which a provider sells energy is capped while the wholesale price he has to pay for it will vary freely? It sounds like a recipe for ruin.

    I suppose the answer lies in “the energy price cap Ofgem sets, which ensures you get a fair price …”. Anyone who thinks in terms of a “fair price” is an economic moron.

    This is the sort of economics you should learn at your father’s knee. There’s no need for formal instruction in economics to see how stupid this is.

    Comment by dearieme — November 27, 2021 @ 10:49 am

  3. What sort of dimwit…
    I thought that was California energy policy not too long ago – but I suppose that answers the question.

    Comment by dcardno — November 27, 2021 @ 2:20 pm

  4. Part of me can’t believe this sort of thing still happens in the 21st century.

    It’s the part of me that doesn’t accept the idea of ‘Idiocracy’.

    Not long now until the USDA mandates that farmers irrigate their fields with Gatorade, I suppose. Because electrolytes.

    Comment by Ex-Global Super-Regulator on Lunch Break — November 27, 2021 @ 6:31 pm

  5. Ofgem already raised the price cap back before the latest price spike. They will do it again, but will it be enough to save the Big 6 suppliers? Their forward hedging has to be rolled over at increasing cost and they aren’t charities: one or two might just decide to exit the industry, or at least the domestic supply sector.
    Crashing the economy is one way to lower wholesale prices. The EU looks like doing us a favour in that regard.
    If demand holds up and supply remains tight (or Putin puts the squeeze on – can he afford it?) then we are in a new price era. Boris could do something about long term prices by issuing drilling permits. The Bowland shale is 400 metres thick and could supply the UK for a century. Treat the isssue with the same urgency as developing an emergency vaccine and most of the problem goes away.
    He could. But he’s so invested in woke green that he won’t.

    Comment by philip — November 27, 2021 @ 10:48 pm

  6. And another thing. We used to have masses of storage capacity in the North Sea, the Rough field. But to save a bit if money we closed it down.
    From months or even years of potential strategic reserve we now have the smallest capacity in Europe, about 4 days IIRC.
    So now we can’t buy extra when prices are low due to summer or lockdowns because suppliers insist on supplying.
    Keeping the lights on, running a health service, not tying industry in red tape – these are pretty basic functions of government. And our government fails in practically every way possible. We go sabre rattling in the Black Sea when we can’t even police the English Channel. C’est magnifique mais ce n’est pas la guerre. Come to think of it, it’s not magnificent it’s farcical.

    Comment by philip — November 27, 2021 @ 11:10 pm

  7. @philip: Boris has a backbone of jelly. The measure of how awful things are is that notwithstanding that the electorate was wise to prefer Boris to Corbyn at the last election.
    And then contemplate President Micron or Poltroon Brandon. Western Civilisation is in the mire.

    Comment by dearieme — November 29, 2021 @ 9:20 am

  8. Things are bad when the UK is less capitalist than France: What they’re doing here is introducing price caps from January (having allowed the price to rise until then – price signals and all that…) which obviously implies potential losses for the energy providers, however there will also be a price floor until 2023, to give those energy providers time to recoup their earlier losses. Seems like a fair solution to me: Vulnerable households aren’t getting shafted going into winter, prices at least partially reflect scarcity and encourage efficiency, and society as a whole is not being asked to subsidise certain groups. And none of the hedging issues that the Prof rightly identifies.

    Comment by HibernoFrog — November 30, 2021 @ 4:20 am

  9. Speaking as a Bulb customer, it certainly has been a strange couple of months. Up until September I had been in a fixed price contract but, after that ended, it was still cheaper for me to stick with them, despite all the turmoil in energy markets. Weird or what? Quite why they continued to supply below the price cap was bizarre, possibly the sign of a business in its terminal throes.

    As for its effective nationalisation, well we still own a chunk of NatWest after the ‘08 debacle, plus a few rail operators and the rail network (I think), and possibly a stake in a small ammonia plant. Quite a diversified portfolio of stressed assets.

    @Deari – “what sort of dimwit”? It was yet another example of demographically-driven (Tory) policies which have driven the country down the path it’s been over the last decade, along with the pension triple-lock, Brexit, this NHS/social care madness etc.

    @Philip – From what I’ve read that storage would have only have covered us for a few weeks at best, nowhere near enough to shield us from the vagaries of the market.

    @Pat – eh? You do know the price lock was partly intended to protect pensioners from fuel poverty? How exactly do you prevent fuel poverty without reverting to such “socialist” measures? Also, how have fossil fuels become ‘rare’?

    PS Annnd another DOS outage. Jeez, is this blog really such a thing? Here’s me thinking it was a weird little backwater.

    Comment by David Mercer — December 1, 2021 @ 4:14 am

  10. What ho, prof – any views on this blog post?

    Comment by dearieme — December 1, 2021 @ 7:30 am

  11. @9 David, Fracking ban in the UK:

    Coal use in the UK:

    Oil imports, UK:

    Unreliables, UK:

    All trending down. Except unreliables. And the fracking ban.

    Looks like you’d better buy that warm jacket and fiberfill jumpsuit, David.

    Comment by Pat Frank — December 1, 2021 @ 2:49 pm

  12. @ dearieme

    AIUI all these small suppliers were operating on the Northern Rock model of sell long-term buy spot. NR was doing it with rates, these guys are doing it with energy. I suppose the business case us that you sell fixed price to a lot of suckers who fix too high, and then you cover your short cheap and clean up.

    Of course the risk is you sell to them at what turns out to be too cheap, but if so, you just fold and hand the bill to someone else. So as a supplier, you can either win or not-win but you can’t really lose.

    I’ve failed to find anywhere how the intellectuals at OfGem set this price cap. If I were OfGem I’d set it it the higher of forward Dutch or UK gas plus 10%. Then I’d make the little guys show me how they have hedged their flat price risk and if I’m not happy I shut them down.

    It’s crude and facile but (a) what regulator isn’t and (b) it makes a nonsense of any price cap which is a feature not a bug.

    Comment by Green As Grass — December 3, 2021 @ 5:11 am

  13. @GaG: thank you. As I said to my wife yesterday “I may be old but I still reckon I could do virtually any government job better than its current holder”. Of course, being old I’d have the vast advantage that I could ignore the perverse incentives that the current chap is exposed to. Just another reason to hang ’em all and replace them with a battalion of codgers.

    I suppose I should conclude that the trouble with the US isn’t rule by codgers but by the Wrong Sort of Codgers.

    Comment by dearieme — December 3, 2021 @ 8:00 am

  14. @dearieme. I agree with every point made in that, but would add one more (mentioned in my post). Hedging a retail supply obligation subject to a cap is even more difficult because of the volumetric risk. So the number of call options is random, and correlated with the moneyness of the option.

    Comment by cpirrong — December 4, 2021 @ 3:07 pm

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