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Forward Fuel Price ; Is it Fair?

8 October 2008

Introduction
EMA used forward fuel oil pricing (FFOP) quoted in July 08 for the next 3 months to peg electricity rate in Singapore; as a result, the electricity rate went up by 21%. This article will examine if this FFOP is a fair peg.

What is Forward Fuel Oil Price(FFOP)?
FFOP is quoted in a forward market just like the Futures market in New York Mercantile Exchange (NYMEX). But unlike the Futures market, the forward market is less price transparent because 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. For more details about forward fuel oil contracts, please refer to this article.

Why the High FFOP?
EMA explained that the FFOP quoted in July 08 for delivery of fuel oil between October 08 and December 08 is being used to determine the electricity rate for this period. As the fuel oil price increased sharply in July this year, there was a corresponding spike in the July forward fuel oil price for October 08 until December 08. This appears on the surface to be very fair to both the Power Generating Companies as well as the consumers.


Why July's FFOP Not Reflective?
Rightly speaking, if fuel delivery is for period between October 08 and December 08, it should reflect the present fuel oil price; however, this is never the case. Lets examine the oil prices quoted in the NYMEX (FFOP is not available) for delivery in Feb 09 and for delivery in Nov 08. One could immediately identify that these 2 quotes are almost identical.


Doubleclick for enlarged picture

Doubleclick for enlarged picture

Why So Identical ?
This is because the Oil Price for future delivery is always affected by the prevailing spot price. When the traders do not know what is in stored for them in the future, they would invariably use the present spot price as the base price.

What's the Implication?
The FFOP quoted 3 months ago will be forever lagging behind the spot or the present fuel oil price. If the oil price continues to climb, the electricity rate will become very reasonable; on the other hand, the electricity rate would become very unreasonable if the oil price continues to fall.

Is It Fair to Use FFOP?
On the surface, it would appear very fair to use FFOP to peg electricity rate because SP and the Power Generating Companies will take actual delivery of the fuel oil at the end of the period. On further examination, it would appear to be unfair to the consumer because:-

a) This FFOP rate is less transparent; for example, the NYMEX Futures for oil was quoted at US $ 147 per barrel at the peak of July 08 whereas the FFOP used to peg the electricity rate was quoted as US $ 155 per barrel. Whether the FFOP deal in July 08 was done at its peak is not known publicly;

b) FFOP contracts can be traded in the market. If SP and Power Generating Companies found advantages to trade the contracts, they can do so and buy cheaper oil from the spot market;

c) It is very common for oil consumption companies, such as airlines and power generating companies to hedge present fuel oil price against any future price variation. For example, SIA has been known to hedge its jet fuel oil price. With the correct hedge, they will never lose out and might even gain handsome profits. On the other hand, the consumers will never have any choice but the pay for the electricity rate.


Conclusion
The FFOP as a peg for electricity rate does not seem to be fair to the consumers who have no alternative but to pay for the electrcity rate.


Afternote:

1. EMA was referring to SWAP fuel oil pricing as Forward Fuel Oil pricing

2. The USD 155 per barrel should be read as SGD 155 per barrel

Related Articles

1. Confusion in the use of Forward and Swap Fuel Oil Pricing
2. Forward Fuel Oil Pricing Used By EMA

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