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A Beginner's Guide to Understanding Energy Prices

July 15, 2016

Energy prices are constantly fluctuating, creating low price opportunities one day and costly spikes in prices the next. This has implications on your business’ ability to meet budgets—if you know what causes electricity prices to climb and fall, you can capitalize on opportunities to save money and brace for spikes that could drive your costs up.


Market intelligence is critical to successful procurement in all kinds of businesses, regardless of whether you buy energy daily or establish long-term fixed price contracts. Here’s a basic overview to help you understand what’s going on in the market, and how it could affect your business.


Energy Economics: How Supply and Demand of Natural Gas Drives Your Energy Prices

The energy market essentially follows the basic tenets of any free market—prices are set by the intersection of supply and demand. Demand is the aggregate power required by all consumers of electricity (everything from the toaster in your home to a conveyor belt in a factory) at any given moment. The vast majority of supply is made up of generators like nuclear, coal, and natural gas plants, as well as renewable resources like solar and wind. Both supply and demand can shift significantly on intra-day and seasonal time-scales, and these changes impact price (more on that later).


In regions run by Regional Transmission Organizations (RTOs) or Independent System Operators (ISOs) (deregulated markets), real-time energy prices are set by the cheapest resource available to meet the current level of demand. Although regulated markets work a little differently, the fundamental energy price drivers affect customers regardless of the type of market they are in. While natural gas is rarely the cheapest resource in absolute terms, generators still need it to meet system demand. As a result, it generally acts as the price-setting resource.


Since natural gas-fired power plants are the price-setting resource, factors that affect supply and demand for natural gas will have a downstream effect on electricity prices. If generators need to spend more on natural gas to generate power for customers, they will make up the difference by charging more for the power.


In general, factors that increase natural gas supply drive prices down, while those that increase demand drive prices up. Below is a simplified diagram of the market for natural gas. Demand is depicted as a vertical line to illustrate that it is not sensitive to price (that is, consumers do not necessarily choose to consume less of it simply when it gets more expensive).


Shifting the curves shows the importance of the intersection of supply and demand. Increase demand by moving the demand curve to the right and you can see that the new intersection of supply and demand results in a higher price.


Complicating matters is the fact that shifts in supply and demand can happen simultaneously, and often with opposite effects. When both supply and demand grow, the impact on pricing will be difficult to predict and really depends on which shift had the greater influence on the market. In addition, gas markets are subject to a variety of feedback loops, which also make forecasting future pricing challenging. For instance, a high price for natural gas today signals an opportunity to producers, who might enter the market, increase supply, and thus bring prices back down again at some point in the future.


What Factors Affect Demand for Natural Gas?

Weather extremes: Weather is the predominant factor that influences the demand for natural gas. In the summer time, high temperatures drive up use of air conditioning systems, which require massive amounts of power. To meet this demand for power, generators need to use more natural gas.


Similarly, plunging temperatures during the winter drive up demand for natural gas as well, but for a different reason. In addition to being a predominant source of fuel for electricity, natural gas is also widely used for home heat. Currently, limited pipeline infrastructure makes it difficult to move natural gas from one location to another. Since natural gas for home heating gets first priority (due to safety concerns), demand for natural gas during winter months can put pressure on supply in a given region and drive up prices dramatically.


Economic Drivers: The ebb and flow of the economy also shifts demand for electricity (and by extension natural gas) but at longer time scales. When the economy is growing, electricity demand from industrial and commercial facilities tends to grow with it over time.


Regulatory Changes: In recent years, regulatory changes, specifically those with the environment in mind, have bolstered natural gas as the preferred resource for new generation. While the shale revolution and fracking have certainly been the predominant drivers, regulatory developments are important to keep an eye on, as they can play a role as well.


What Factors Affect Supply for Natural Gas?

Gas in storage: Inventories of natural gas are the most prominent indicator of the health of the natural gas stocks. Surpluses in storage signal an abundance of natural gas and put downward pressure on prices in the near and long-term. Storage is also affected by weather. When temperatures are mild and demand is lower, less natural gas is withdrawn from storage. Just like inventory in any other business, surplus of inventory leads to lower prices in an effort to clear out excess inventory, and also signals to producers to slow production.


Net injections: Tied to storage, net injections of natural gas into storage during the refill season (April to October) indicate how much gas will be available to meet demand during the winter.


Production/Rig count: The natural gas rig count—the number of rigs drilling for natural gas—is tied directly to production. When production is greater than consumption, gas can be put into storage. However, low natural gas prices often make it uneconomical for some rigs to continue production. Rig count can be a useful indicator of current and future natural gas prices from the industry itself.


Natural disasters/Geo-political events/Legal challenges/Technological advancements: Revolutionary technology, environmentally focused policy initiatives, infrastructure-damaging natural disasters—all have been a part of shaping the current landscape of the US energy market. Like any commodity, natural gas is susceptible to a number of events that may occur locally, nationally, or even internationally. Many of them simply create uncertainty about its future availability, and that alone is enough to change prices.


Where Will the Market Go From Here?

Having a basic understanding of the forces that drive natural gas markets can help make sense of the ever-evolving energy market today. But the market is changing constantly. While natural gas is currently the preeminent force driving prices, for example, that wasn't always the case. What's true today may not be tomorrow. It’s important to stay current with market intelligence to understand the types of risks that volatile energy prices can impose on your energy budget.