The Foward Fuel Oil Price Used by EMA

5 October 2008

Introduction
The Energy Market Authority (EMA) recently announced that our electricity rate would increase by 21%, the highest one-time increase in seven to eight years. This is because EMA has pegged the electricity rate to the forward fuel oil pricing for the next 3 months.

EMA’s Explanation for the Price Hike
EMA, the electricity and gas industry regulator, explained that since 2004, electricity tariffs had been pegged to the "forward fuel oil prices" for the next three months. This price was $155.14 per barrel, up 38 per cent from $112.35 per barrel for the current quarter.

What is “Forward Fuel Oil Price” ?
There are about 4 types of oil market:
a) The Spot market
b) The forward market
c) The Futures market
d) The Swap and options market

More information about the various oil markets can be found here
There are also more about futures and forward contracts in here and here.

Forward contracts are traded in the forward market. Like the futures contracts, forward fuel oil contracts are traded for the delivery of fuel oil on a future date at a pre-agreed price; but unlike futures contracts, the forward contracts are traded informally between principals such as big oil companies who are not obliged to publish the details of any deal that is done. The forward market has therefore lesser price transparency than a futures market such as NYMEX Oil Futures traded in the US.
Deals in forward contracts are usually done over the telephone. Participants either trade directly between each other or through specialist brokers (like Goldman Sachs) who provide a useful service by quoting bid-ask levels for forward Contracts. The main difference between forward and futures trading is as shown in the following table:
Why EMA used Forward Pricing of Fuel Oil?
EMA explained that “forward fuel oil” prices are the prices of fuel delivered to the Power Generating Companies; also, they are less volatile than the 'spot oil' prices quoted for immediate deliveries. To illustrate, EMA used the following graph:-

While there is no way to verify the authenticity of the forward fuel oil prices quoted by EMA, the following 2 curves in this article about forward contracts of West Texas Intermediate (WTI) and Brent will illustrate that forward pricing can also be very volatile.

Correct for EMA to use Forward Pricing?
Forward pricing, like future pricing, is often used as a hedge against any future price variation . If it is used for other purpose, it can act as a double-edged sword, working for as well as against an investor. In this case, as a peg for electricity rate for the next 3 months, it will work for consumers if the oil price is rising and against the consumers if the oil price is falling. Furthermore, EMA uses forward fuel oil pricing quoted 3 months ago, it is forever lagging months behind the actual fuel oil prices.

Forward pricing is less transparent as spot pricing. To protect the interest of the consumers, it would be better to use the spot or futures pricings that are traded in public exchanges such as NYMEX.

Will SP & Power Generating Companies lose?
SP and Power Generating Companies will not lose out with any price set by EMA if the set price has been agreed upon. This is because SP and Power Generating Companies can always hedge against any future fuel oil price variations. SIA's hedging policy on jet fuel price is one of the good examples. On the other hand, if consumers were to be asked to pay higher fuel price today for the next 3 months and if SP and the Power Generating Companies could hedge the future price correctly, they stand to earn a good profit.

As no contract or hedge will be able to cover all future price variations, at some point, consumers inevitably will have to pay for any higher fuel cost incurred by SP and Power Generating Companies. This is when EMA can come in to mitigate. Asking the consumers to pay electricity rate upfront based on a forward contract price is not necessary the way to protect the consumers’ interest.

Conclusion
EMA has chosen the forward fuel oil pricing to be "peg" to evaluate electricity rate but this pricing has lesser transparency. They also used forward fuel oil pricing quoted 3 months ago. There will always remain a question as to whether this forward fuel oil pricing is a good peg to protect the consumers' interest.

Afternote: EMA was referring to SWAP fuel oil pricing as Forward Fuel Oil pricing

Related Articles

1. Confusion in the use of Forward and Swap Fuel Oil Pricing
2. Is it fair to use Forward Fuel Oil Pricing?