Confabulations: "virtual cycling"
From a bookshop, pizza-slices and ice-cream to soybeans & pork-bellies
Following-on from last week’s question, here’s an attempt to argue that the answer is ‘no.’
Near Gasteig in Munich, a bookshop, a pizzeria serving creatively conceived slices, and an artisan ice-cream shop are located close together in neighbourly succession: delights associated to varying levels of energy-intensity. I was thinking about ‘virtual cycling’ while waiting for a pizza slice. The queue was real and passed by the bookshop with boxes of books on display outside. ‘Confabulations,’ a slim book by John Berger, caught my eye.
John Berger writes about our relationship with language. ‘Words, terms, phrases,’ Berger writes ‘can be separated from the creature of their language and used as mere labels. They then become inert and empty.’
The language we use should help us to make and develop meaningful connections. The term ‘virtual cycling’ suggests that there is something inherently special about BESS-backed trading in the electricity markets. This is not the case.
Berger reminds us that ‘time, as Einstein and other physicists have explained, is not linear but circular.’ Our activities are not ‘points on a line…rather, we are the centres of circles.’ The circles that surround us are ‘testaments addressed to us by our predecessors.’ It is worth aiming for language that emphasises circular links.
Rather than use the term ‘virtual cycling’ I think it is more valuable to build on language that connects BESS-backed energy trading to hundreds of years of history in the development of commodity markets.
Let’s say you know a lot about soybeans and think you know where prices are going. Then you might decide to buy and sell soybean futures. At the time of writing this you could buy “Aug 24 Soybeans” at around $12.37 per bushel. As per the CME’s contract specs, the method for final settlement is ‘physical.’ But of course you don’t want to have bushels of soybeans delivered to your front door. You want to speculate (or, as you might see it, provide a service to the world through your knowledge). So you buy and sell soybean futures according to your market knowledge without ever being involved with a single bushel of soybeans.
Buying back a short position or selling back a long position is standard procedure in commodity markets. This is called ‘offsetting’ a position (or ‘liquidating’ or ‘netting’ a position). It’s important to do this if you don’t want to get involved with the hassle of settling a contract once it expires.
No doubt almost everyone that gets involved in futures will eventually hear the tale about novice commodity futures traders having five-thousand bushels of soybeans or thousands of barrels of crude oil delivered to their front yard. Truth be told most traders never take delivery of a futures contract’s underlying instrument. While a trader may wish to speculate on the direction of live cattle, in my 31 years in this industry I don’t know one trader that took delivery of 30,000 Pounds of cattle. However, the futures market was designed around the delivery of commodities and entities like meat packers and refiners can choose to take delivery to meet their business needs.
Instructor in a video from CME Group Education Material
Commodity traders have been trading futures contracts and offsetting their positions before physical delivery for hundreds of years. At present, it is estimated that only about 3% of futures contracts are delivered.
Short-term electricity markets can be seen as very short-term futures markets. Trading in the electricity markets with access to a BESS for physical delivery is somewhat similar to trading soybean futures as a commercially savvy farmer with access to both soybean production and processing facilities.
The time-scales, products, and markets are different but the basic ideas are the same. So imagine that the soybean farmer works with a futures-trader to provide a service to the world through their expert knowledge in soybean price dynamics. Would it be useful for the trader to advertise their activity in offsetting speculative trades as ‘virtual soybeans’ or ‘virtual harvest cycles’?
The continuous intra-day electricity markets that we know say in Central Western Europe consist of hourly, half-hourly, and 15-min contracts, which can be traded up until 5 mins before delivery start time. Ever since the existence of these contracts, traders have bought and sold actively before ‘expiry’ just like traders in futures on rice, wheat, soybean, frozen pork-bellies, coffee, and so on have always done. It is normal for nearly all trades to be offset before expiry.
Battery Energy Storage Systems are highly responsive and flexible in delivering or taking delivery of energy. Backed by a BESS primed for physical delivery, a trader has the option of keeping a position open, letting it run to physical delivery. This gives the trader flexibility and options. Flexibility translates into higher revenues.
It would be disappointing if a trader only took positions for physical delivery. A BESS asset owner should be surprised to find out that a trader backed by their asset was not effective in continuously buying and selling 15-min contracts using their knowledge of price-dynamics. But does the asset owner care about how many times a BESS was ‘virtually cycled’? If so, why?
If one wants to understand how the revenues are generated, what the trading dynamics are, and how these change over time, then it might be informative to talk about “offset/netted MWh” and to analyse how this figure varies by product and changes over time and how it depends on market and technical parameters. In contrast, the number of virtual cycles has virtually no information content.
Figures that matter give revenue per “unit of asset employed or at risk.” Revenue per cycle, or revenue per reserved capacity, perhaps further normalised by volatility lead to meaningful measures. A Sharpe-ratio type measure could be conceived of in energy-market language as a ‘volatility capture rate.’
The term ‘virtual cycling’ masks the basic facts and dynamics of the commodities markets by suggesting that trading with BESS is special. Yes, BESS are special, because they are the most compact way of achieving symmetric flexibility for physical delivery. But that doesn’t change the way the markets work or how we should measure results.
As a concept or as a measure, ‘virtual cycles’ are not useful to understand the nature or the performance of trading strategies.
Reading/Links
Confabulations by John Berger https://www.penguin.co.uk/books/301519/confabulations-by-berger-john/9780141984957
EpexSpot’s Overview of Short-Term Markets
On settlement in the futures markets
Learning content, requires registration https://www.cmegroup.com/education/courses/master-the-trade-futures/expanding-your-futures-knowledge/master-the-trade-physical-delivery-vs-cash-settlement.html#
Fun myths/stories of accidental physical delivery
Offsetting/liquidating positions https://www.cmegroup.com/education/courses/introduction-to-futures/understanding-futures-expiration-contract-roll.html