The common mistake of the uninitiated is to look up spot prices for LPG at a commodity trading site and seeing no direct connection to tariff rate movements, conclude there is a conspiracy. The tariff is not rigged and the price of oil do have a significant impact on the cost of electricity. The relationship of the price of oil to tariff is a bit complicated. It requires of one to invest some time to understand.
I write this blog to explain tariff computation and the relationship to oil prices. It will be clear there is no rigging of the tariff rate using oil price movement to hoodwink the public.
Tariff composition:
The energy cost is the variable cost that is computed quarterly. This is the projected cost of electricity to be purchased in the market for the next quarter.
Imagine a new company wants to enter the power generation business and so it forecasts its selling price for the next quarter. It takes into account its capital cost (fixed asset depreciation), raw material cost (LNG. coal, nuclear fuels, etc) and factory overheads to arrive at its production cost. This is the Long Run Marginal Cost where capital cost are viewed as variable cost. Then it adds a gross margin to cover all operational cost and an ROI. In making this forecast, it takes into consideration expected price movements of raw materials.
That's basically what SP does when it computes the energy cost component (power generators' selling price) for the next quarter tariff. SP has to work within parameters set up by EMA and this will include factors like what ROI rate to use, what type of power plant to base on, which specific crude oil index to use, what exchange rate to use etc. Because 95% of power supply in Singapore comes from CCG (combined-cycle gas) plants, SP uses the most efficient CCG plant model in use in our market. This is the norm in contestable markets. This way, new entrants to the market will not be disadvantaged. Because it is a CCG plant, the fuel is LNG. Since SP is computing the energy cost for next quarter, it has to forecast LNG prices which is indexed to oil prices. It also has to forecast exchange rates because oil prices are quoted in US$. Fanciful modelling tools are used to do this.
The point here is computation of the energy cost component is a well-thought out formulated process, nothing whimsical nor sleigh of hand involved.
Oil prices vs LNG prices:
Crude oil is traded in a highly developed and liquid global market with well established benchmarks like Brent and WTI. Natural Gas is a pre-dawn market, sold and priced very differently in various global markets. There are basically 4 pricing systems for LNG :
1. Gas-on-gas (UK, Canada, US)
2. Indexed to substituted energy prices (Continental Europe, SE Asia)
3. Oil-linked prices (Japan, Korea, Taiwan)
4. Regulated (ME, Russia, China).
There are many reasons why it works this way for LNG but that is not the subject matter of this blog.
Singapore used to have PNG (supplied from Indonesian and Malaysian NG fields) but have now switched to LNG. The LNG price in Singapore is computed from crude oil prices and that's what SP does. That's the way the local market is.
What is the relation of crude oil and LNG? They are both fuel or energy sources which possesses heat content measured in Btu (British thermal unit). A barrel of oil is about 42 gal with about 5.8m Btu. 1,000 cubit feet of LNG has about 1.037m Btu. So basically 1 barrel of oil has about 6 times the energy in 1,000 cubic feet of LNG. It is on this basis LNG price is indexed to crude oil prices.
LNG spot prices and long term contracts:
This may come as a surprise to many. Spot prices being waved about in most commodity markets do not have anything to do with today's production. Asian LNG spot prices may have come down to about US$5 per mm Btu. This is irrelevant for current production. In power generation, for example, power producers have already locked up their LNG requirements in long term contracts months ago. In the case of PNG the supply contracts could be 10, 20 years.
SP computation of tariff is based on oil prices. The point here is even if it is based on LNG prices, spot prices is not the determinant factor.
Oil price outlook:
Brent crude oil average US$64pb in 2019 and market expectation for 2020 is mostly bearish. For example, the predictions for 2020 average price for Brent crude oil were -- US Energy Information Administration: Average at US$61pb, Goldman Sachs at US$63pb, JP Morgan $64.4bp, and Global Platts at US$65 first half then fall back to US$60.
These predictions were made early December when prices were at the lower US$60s. Prices after Christmas were already US$69+. The trendline for increase was already evident in early October when price was about US$59pb. Going into Q1, SP says oil prices are rising. SP takes the position of most market players that see a rising trendline for Q1 and Q2. What say SP skeptics, based on what market intelligence?
Generally, the prediction is by January 2020, oil prices will increase due to efforts by governments to support the climate agenda. You may blame Greta Thunberg for this. This is due to the International Maritime Organization (IMO) enacting Annex VI of the International Convention for the Prevention of Pollution from Ships (MARPOL Convention), which lowers the max sulphur content of marine fuel used in ocean-going vessels from 3.5% of weight to 0.5%. But prices will be driven down again in the later part of the year to end with averages that is lower than 2019's US$64pb due to high global inventories.
The point here is the next quarter tariff is based on forecasted oil prices and that's something that cannot be read off energy indexes online. That's SP's call.
Correlation of oil prices to LNG prices:
In the early days, LNG started off at discounts to oil prices as governments tried to encourage more conversions to cleaner fuel. Traditionally, it was naturally indexed to oil, which is still the basis used in many Asian countries. It's stability of course depends on the correlation between the two. US EIA collated some data which show a correlation of +- 26% but there are warp factors which can lead to divergent price movements, such as the past few weeks with oil going up and LNG going down.
LNG trading market is still evolving and with growing importance of NG as fuel it may well overtake oil in terms of volume. An universal LNG benchmark index delinked from crude oil is the way forward, but that is still far in the future.
Direction of Singapore:
The government has moved to develop the market and all the necessary infrastructure that will enable Singapore to delink LNG prices from crude oil. In 2016, LNG spot index SLinG (Singapore LNG IndexGroup) was launched on SGX, settlement prices for LNG futures and swap contracts were published by the SGX. SLinG represents FOB spot prices for LNG delivered in Singapore. One LNG storage terminal has been built with another on the way. Singapore has successfully wooed all sorts of traders and players in the LNG industry to open offices here.
There were other games in play in this huge gamble of making Singapore a LNG trading hub. The Baltic Exchange was acquired and SLinG indices were listed in a few markets. In 2013 Temasek set up a subsidiary Pavilion Energy tasked to acquire LNG assets in a big way, both upstream and downstream such as LNG shipping, gas fields, etc.
Low volume of Singapore's LNG consumption stands in the way. One fundamental pre-requisite for a commodity market is liquidity which Singapore lacks. The government has moved to create the market ahead of creating liquidity, putting the horse before the cart in an extremely high stakes game. Early 2019 it has withdrawn the SLinG index due to low participation. Pavilion splashed US$1.3b in 2013 on 2 NG wells in Tanzania belonging to Ophir Energy which were written off in 2016 - no gas deposits were found. (Pavilion CEO Seah Moon Ming moved on to Chairman SMRT, from one job with zero experience to another) .
So it looks like SP will continue to compute tariff based on oil-linked price for LPG for a long time more. A gas-to-gas model is still a piped dream for the moment.
Vesting contracts :
There is one more complicated aspect to explain the tariff computation. Vesting contracts are mechanisms normally intended for the purposes of containing market power. A power company who is a predominant producer can influence prices simply by withholding production. This is known as market power. To reduce this power, the company has to contract with SP at an agreed price for a certain load. Thus the balance of the company's output is reduced and it can no longer influence prices in the market.
Vesting contracts were meant to be temporary mechanisms. It's no longer required when there is no more dominant producer. By 2013 power supply was evenly spread over a few power companies. A new vesting contract was implemented to promote the use of supply from the newly commissioned LNG Terminal. This LNG vesting contract applied to new plants coming on stream after 2013 which included Hyflux.
Some definitions are helpful before going further. Power companies supply the market by auction every 30 minutes. The successful ones generate and feed their output into the Grid at various Nodes. There are nodal charges which they add on to their cost. Power companies get paid on their Nodal Price which is their auctioned price plus nodal cost. The weighted nodal cost of all power companies for that 30 minutes supply is the USEP (Uniform Singapore Electricity Price). The USEP + some administration charges is the Wholesale Electricity Price for that particular 30 minutes supply. SP and all retailers purchase at the same wholesale electricity price.
Under these vesting contracts, the power company commits the next quarter's supply for an agreed load at the energy cost computed by SP. This is the Vesting Contract Price, or Strike Price. The difference between the Nodal Price of the power company and the Strike Price is settled between the 2 parties. If the Strike Price is lower, SP pays the power company the difference. If the Strike Price is higher, power company pays SP. So basically, vesting contract is also a way for SP to hedge against energy cost higher than what was forecasted.
In hedging, SP should gain sometimes and loose sometimes. The gains are credited back to consumers and losses are recouped from customers. SP adjust for such hedging gains or losses of one quarter by adding or deducting it to the next quarter's Energy Cost component of the tariff.
The points to note on these vesting contract adjustments are :
- Due to overcapacity, power companies are forced to bid low in the auction market. This has caused Nodal Prices to be consistently lower than the Strike Prices. Which means SP has been the payer of vesting contract differences for decades. S$ billions have been paid out by SP over the years.
- The load vested were initially less than the aggregate of SP customers' purchases. As more and more of SP customers switched over to electricity retailers, the same vested load in time exceeded SP customers' load. This began sometime in 2019 Q2.
- How does SP split the vesting contract difference (hedging cost) to consumers? The cost is split between the (A) aggregate load of SP customers and (B) which is the balance of vested load less (A), proportionately.
- Who pays the hedging cost? SP customers pay their share of the cost 3(A) in the following quarter's tariff. SP bills retailers their share of the hedging cost for the load in 3(B) which the latter in turn charge to their customers. Since the 3(B) cost is split to a bigger customer base, retailers' customers bear a smaller burden at the moment. It is SP customers who bear a high burden.
- SP in effect hedges all their electricity sales. Thus SP Services makes neither profit nor losses in their electricity sales services.
Power companies pricing:
Power companies do their number crunching and bid to supply the market. They differ from the way a new entrant coming into the market and SP forecast their energy cost in 4 fundamental ways:
- Power companies compute every 30 minutes which is the auction schedule.
- Unlike the new entrant coming into the market, or SP computing the energy cost for the next quarter, the fuel cost of power companies is not forecasted, but based on their supply contracts. Since the fuel is purchased forward some time ago, the LNG spot price may not be representative of their actual cost.
- Power companies look at their variable cost of production, namely raw materials and variable production overheads. This is their Short Run Marginal Cost which views capital cost as a fixed cost. Pricing their production below the SRMC means negative cashflow and suicide. If they price upward of SRMC they recover capital cost (depreciation), then operations cost, and the rest is the net profits.
- How much above their SRMC will power companies price themselves is a matter of market competition. Currently, due to excessive over capacity, power companies are bidding low to get despatch for their plants. In the past decade, power companies have been running huge losses.
The point in this is that for years, tariff for each quarter has been warped by the vesting cost adjustment. This condition will persist as long as the over capacity situation remains.
What explains the S$1b profits of SP:
So if SP Services does not make any profits from sales of electricity because they are fully hedged, why is the group showing S$ billion profits each year? The group's main profits come from SP PowerAssets which manages the power Grid (transmission) and from foreign operations. (Read my blog here).
Tariff up, Municipal gas down?
For Q1 SP raised electricity tariff but lowered cooking gas rate. There is no anomaly. LNG and municipal gas are different animals. LNG is natural gas, containing mostly methane. This is used for electricity generation, industrial stock and bunkering. Municipal or Town gas is used for cooking. Singapore's municipal gas is produced by City Gas Pte Ltd at its Senoko Gasworks. Municipal gas was previously produced at Kallang Gasworks which relied on coal. Senoko Gasworks uses naptha. Municipal gas contains mostly carbon monoxide, some hydrogen and methane. Electricity and cooking gas rates have no corelationship since raw materials and production are different.
Conclusion:
Tariff computation is a formulated process laid down by EMA. LNG price is oil-linked because it is the way the market works for Singapore. Whether it is fair or not is a tough call because there is a 26% correlation of oil-LNG prices and prices have been divergent sometimes. At this point they are moving in opposite directions to Singapore consumer disadvantage. But at other times, the reverse could occur.
Looking at LNG spot prices, the tariff does not make sense and one wrongly concludes SP is pulling a fast one. This is erroneous because LNG spot price movement has no bearing with the way LNG cost is computed for power generation. Power companies use their long term contract cost, SP uses a complicated forecasting formulation, based on oil prices, in a scientific manner.
Vesting contract adjustments further warp the tariff computation. The over capacity in the market results in SP being consistently a payer in the vesting contract differences which is passed on to their customers by pricing it into the tariff for the next quarter.. SP sells electricity on a fully hedged basis and thus makes no profits or losses. Consumers who have not switched to retailers bear a high burden of the hedging cost.
Any criticism of tariff over-charge should be directed at the transmission cost. SP Group has amassed huge sums of profits out of transmission. The question to ask is therefore, did these profits flow to Temasek, or retained in SP PowerAssets to fund power infrastructure maintenance and development. Are power infras funded internally, or from national budget?