European energy markets are in for a very chaotic winter, as the soaring cost of energy threatens to trigger a financial crisis on a scale not seen since at least 2008. đ§”
European utilities have forward contracts to supply their customers with electricity at some future date and price. These contracts lock in future prices (and profits) by setting aside a portion of the value of the contract as collateral.
Many of these forward contracts become âfuturesâ, a type of derivative that is bought and sold on an exchange. The majority of the futures held by utilities are short positions (ie. previously sold contracts) that are settled prior to maturity by purchasing a futures contract.
The primary purpose of these derivative âside betsâ is to manage commodity price risk, particularly as a result of seasonal price fluctuations. However their use introduces new risks, in particular, swings in commodity prices can require substantial liquidity to âride outâ.
Now, as European spot prices for energy skyrocket due to gas supply shortfall, the value of these short contracts is plummeting. This in turn is causing the contract owners to margin call the utilities, forcing utilities to provide immediate collateral to cover their position.
The additional cash required to cover margin calls resulting from the 10x increase in energy prices isnât something any energy utility has on hand. In total, at least $1.5 trillion dollars in margin calls have been made in recent days. A crisis in the making, but whatâs the fix?
There are 2 likely market-based fixes: Governments or European Central Bank steps in with emergency liquidity or Futures contract owners begin accepting cash alternatives (eg. bank guarantees, carbon credits) as collateral.
If the former occurs, this liquidity will come at the cost of European govts now wearing the financial risk of further calls. If the latter, the collateral will require a value basis that is insulated from the wild fluctuations of European energy markets to be deemed acceptable.
Governments have also indicated that they intend to institute price caps on energy suppliers, primarily on gas supplied by Russia, to curb price escalation. However, Russia has plainly stated that supply will be cut off completely if caps are imposed.
If these measures fail to stabilize markets, itâs likely that governments will need to take further measures such as suspending trading of energy derivatives entirely. However this still doesnât address the underlying material problem at the root of this crisis: not enough gas!
If this crisis were limited to a single country, liquidity could be provided relatively easily. But with broad systemic risk like this, an inability to cover margin by a single utility could very easily precipitate a cascade of defaults that spreads like Lehman Brothers in 2008.
Unlike 2008, however, this crisis is fundamentally different. Far from being the result of a financial house of cards built on overleveraged and overvalued homes, this crisis is instead the result of a critical material shortfall. Quite simply: bailouts cannot fuel power plants.
