Energy hedging is a must in Brazil… as elsewhere in the region

On last Tuesday, Petrobras announced that it would reduce its supply of natural gas to distributors in Rio de Janeiro and São Paulo, apparently limiting volumes to those levels agreed in the prevailing contracts with the latter. That decision came against a backdrop of gas consumption by residential and industrial users in recent months well above those contractually established between Petrobras and distributors.

The announcement by Petrobras is said to have followed a request of gas supply to the thermoelectric plants by energy regulator ANEEL, a request derived from the current seasonal low rainfall levels. There is no current water shortage in the reservoirs, as reservoirs in the Southeast and Midwest regions were at 52% of their maximum capacity in October, whereas the averages in the same month of the last seven and five years were respectively 37% and 42% (Credit Suisse, Brazil Highlights, 11/01/2007).  However, the price in the spot energy market in the Southeast region surpassed the cost of energy generation declared by the gas thermoelectric companies and this sparked the ANEEL’s request. Following the agreement signed by Petrobras with the energy regulator last May, the former is required to make gas available to thermoelectric plants whenever requested.

Despite the lack of gas for some companies and for vehicles in Rio de Janeiro, the event has been seen as having localized and temporary impacts, including likely gas price hikes. There is no high risk of electric energy rationing. And as Brazil enters its season of higher rainfalls, thermo plants will tend to return to their normal stance, liberating gas supply to other users. But the event has been meaningful in at least four aspects.

First of all, it confirmed how hard may the scarcity of gas supply currently become in face of wide fluctuations in both gas demand and supply of other energy sources. In fact, if all the installed thermoelectric plants were to be suddenly activated in Brazil, there would not be sufficient gas to supply them. The picture is expected to improve substantially in 2009, when importing of LNG and higher gas extraction in the Southeast basins will be available as mitigating factors. However, before new hydro plants start to operate – see here – the possibility of simultaneously binding energy supply constraints will remain as a threat, if not with high likelihood at the overall macroeconomic level, but at least at some spots of the whole productive fabric.

Secondly, it highlighted the premium to be accrued from costly energy hedging at the macroeconomic level. Energy hedging – i.e., preserving cross-reserves of unused energy-producing capacity at diversified sources, so as to reduce the overall vulnerability to both climatic and geopolitical factors affecting specific sources – is costly for two reasons. On top of inevitable margins of idle capacity that are technically required in the operation of each type of chain of production of energy, an additional layer of capacity must be available to substitute for occasional scarcity or disruption in other sources. Furthermore, permanent diversity usually means that more costly energy alternatives must be preserved, even if at some minimum level. However, in times of high global energy demand and prices, higher climatic uncertainty, and increasing politicization of natural resource markets, gains in terms of securing energy availability – and thus private investment decisions – certainly outweigh those hedging costs from any national standpoint. Of course, hedging itself reflects partially an unnecessary inefficiency component derived from unstable geopolitical relations, at both global and regional levels.

Thirdly, those costs of hedging may be lowered if the substitutability among energy supply sources is accompanied with higher flexibility at the user side. Flex-fuel means of transportation (e.g. combining gasoline/diesel and biofuels) and flex-energy plants imply higher responsiveness to specific supply conditions at the microeconomic level, facilitating the adaptation to shocks.

Finally, the role of prices in providing incentives to adjust is of the essence. Many analysts have remarked that the too robust growth of gas demand in Brazil’s Southeast has reflected tax factors affecting the price of gas relative to other energy sources, leading the former to not dully reflect its underlying true scarcity.

I believe the points raised here about energy hedging also apply to other economies in the region.