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#17: The Texas Freeze and Europe.
It was Sunday evening, Valentines Day, February 14, 2021.
A once in a generation storm had rolled down from Canada, cascaded across the US plains and settled in a thick blanket over the Lone Star state. It brought snow, ice, and bone-chilling cold. In just a few hours, millions of Texas homes would go black. The blackouts came suddenly, but the true collapse of the power market was a week-long car crash.
The first signs of trouble came the prior Monday. ERCOT - the state’s grid operator - issued an operating condition notice (“OCN”) warning of winter weather through the weekend1. An early warning shot, but nothing too unusual.
Besides, it was February. The Texas grid had been stretched to the limit a couple times recently, but only in the peak of August heat, when every electricity generator in the state needs to run to keep the air conditioners on2.
On Tuesday, updated forecasts showed sub-zero temperatures were expected as far south as Houston. Forward power prices had started to run.
By Thursday, the market began to crumble. While real-time market prices remained subdued, forward prices for the coming week began to signal disaster. Panic spread through power markets as participants scrambled to cover off their exposures. Anyone short physical commodity was in serious trouble.
Windfarms with fixed offtake agreements, gas generators without firm gas supply, and electricity retailers with purchase obligations were staring down the barrel of an existential short squeeze. Market intermediaries calculated the potential losses of their clients based on forward pricing and began demanding collateral. Margin calls.
Thursday night brought a deadly combination of freezing cold and moisture to the north of the state, freezing wind turbines and natural gas infrastructure. Gas supply in America’s energy heartland dried up overnight, taking with it the firm generation the state relies on for power.
By Friday, there was no longer a functioning forward market for power for the coming week. Natural gas at Oklahoma hubs had surged over 100x from $3/mmbtu to $300/mmbtu by Friday3.
By Saturday, with physical constraints worsening, contract wars had already begun - margin calls were demanding capital, and force majeure notices stated that supply would not be coming.
On Sunday, demand grew and spare capacity dwindled.
Finally, at 1:20 AM on Monday February 15th, the power grid began to lose frequency. In order to avoid a catastrophic full collapse of the grid, ERCOT began turning off the lights (and heat) of millions of Texans in order to keep the system in balance.
The human toll was immense. At least 246 people died from the storm, exacerbated by the grid’s failure.
Power was not fully restored until Friday morning. In the interim, ERCOT’s market protocols kept power prices at $9,000/MWh, compared to typical prices of around $30/MWh. In just days, customers ran up years worth of electric bills. Within the power market, if you came in long you made a fortune, and if you were short power you were bankrupt.
An entire industry of privately owned windfarms was thrown into lawsuits, restructuring or bankruptcy as their offtake agreements turned upside down. Gas and power traders made or lost enormous sums depending on their positioning. Everyday Texans with floating rate electricity contracts received bills for tens of thousands of dollars.
Not even the deepest pockets could pay such astronomical bills4. Brazos Electric Power Cooperative, Inc. (“Brazos”), Texas’s largest and oldest electric cooperative with an investment grade rating, received a bill from ERCOT for $2.1 billion for a seven-day period - nearly 3x its entire power procurement cost for the prior calendar year. The cooperative filed for bankruptcy on March 1, 2021.
The market failed both physically and financially.
Gas supply failed, coal stacks froze, nuclear plants went offline, and wind turbines iced over. The state simply did not have the energy supply that it needed to meet the record setting energy demand.
Meanwhile, the market’s financial construct, which is intended to incentivize new generation to come online, was useless. There was no new generation left to incentivize. Instead, running a supply constrained market at $9,000 price for four days resulted in chaos - an omelet that was impossible to unscramble post-hoc.
In fact, the blowup in the financial markets arguably occurred before the physical market. The ramp in forward prices forced entities with short exposure to cover their obligations either voluntarily for risk-mitigation or forcibly by margin calls, in a self-reinforcing cycle.
Markets that use price as a mechanism to balance supply and demand don’t work when supply is physically constrained, and demand is essential to human life. How much could you charge for lifeboats as the Titanic sank? And would charging more save any lives? Financial chaos pales in comparison to loss of human life but creates its own set of unintended consequences.
Looking to Europe
The energy shortage Europe faces today is different than Texas in February 2021. One a sudden act of nature and the other a slow-moving consequence of policy, geopolitics, and the pandemic.
Yet when I look at European natural gas prices today, I am reminded of Oklahoma gas prices mooning on February 12th, 2021.
Natural gas prices have been on the rise in Europe for well over a year. Of course, power prices follow in lockstep as power plants must recoup the cost of fuel.
The dramatic increase in energy cost over the last year suggests a serious and growing crisis of energy availability. The parabolic ascent over the past several weeks suggests a scramble to cover short positions, physically and financially5. Power generators are seeking to lock in fuel supply and offload power at commensurate prices. Industry needs firm energy supply to make production decisions. Governments and utilities must ensure their citizens will have heat and light.
All of these interests are competing with each other today to ensure they don’t get caught short tomorrow. In an environment of physical supply constraint, inelastic demand, and forced covering, prices go vertical. This scramble will have unpredictable consequences for participants throughout the energy value chain, from producers all the way down to individuals paying power bills. A brutal financial war will determine who ends up in the dark. It is a no-win situation; go broke buying energy, or freeze.
We do not know for sure whether there will be forced energy shortages in Europe this winter. Geopolitics and weather will have significant influence and are hard to predict. But the price action in these markets suggests desperate supply shortages today and for the foreseeable future6.
Whether by price exclusion today or forced rationing tomorrow, there won’t be enough energy to go around. The financial fallout may come first.
An OCN is a forewarning from the system operator of tight market conditions ahead, allowing generators to secure fuel, defer scheduled maintenance and be prepared to operate.
By ERCOT’s own reliability planning, there should have been plenty of adequate supply to handle peak demand in winter months. Winter storms bring elevated demand and can cause unplanned outages, but nothing that couldn’t be tackled with the spare capacity at this time of year
Eventually peaking at $1,000. Even without blackouts, a 100x surge in gas prices would lead to a 100x surge in power prices as gas generators would need to cover the exorbitant fuel costs.
Even generators that were owed windfall profits ended up not collecting the full amount from ERCOT, as customers simply could not pay their bills.
Financially, forward market prices are not a “prediction” of where prices may be a year from now, but are used to determine risk, exposure and collateral needs today.
The best hope is that the explosion in prices in the last several weeks was mostly driven by a positive feedback cycle rather a deterioration in underlying supply expectations, and therefore more likely to quickly revert.