As anyone in procurement can tell you, electricity is the most volatile commodity you will ever buy. One day, energy prices increase. The next day, they drop. This constant cycle of up-and-down price changes makes energy commodities extremely difficult to purchase. What if prices drop after you’ve locked in your rate? Or, perhaps even worse, what if you wait and prices only go up?
When dealing with this level of volatility, the best thing you can do as an energy procurement professional is to understand what causes these prices to go one way or another – and learn to use that information to better plan and structure your procurement.
The number one factor in determining the price you will pay for energy as a retail customer is the price your supplier pays for that energy on the wholesale market. As such, the best way to begin the energy procurement process and develop a buying strategy is to understand the market drivers that affect the wholesale cost of energy. And since much of the cost of electricity is driven by natural gas costs, it’s important to understand the factors that drive the price of natural gas.
Market Drivers for Natural Gas
Let’s go back to Economics 101 for a moment. One of the first things you learn in an intro-level economics class is that the price of anything you purchase – from gasoline to food to consumer goods to electricity – is heavily driven by supply and demand. If supply is high and demand is low, the price goes down. When supply is down and demand is high, the price goes up. Eventually, after some back and forth, supply and demand will even out and prices will stabilize.
As we head into the spring of 2015, natural gas prices are dropping to lows we haven’t seen in years – especially for future delivery in 2016 and 2017. Simple economics would tell us this price drop is a result of high supply and lower demand.
But what will it take for demand to catch up with supply, thereby turning the tables and pushing current low prices back up into the high range?
To answer that question, let’s investigate the market drivers that have helped create the current supply/demand equation – and the factors that will shape our direction in the future.
An Unprecedented Supply
The United States is currently sitting on a historically large supply of natural gas. This increase in supply is the result of two major developments:
1. Increased production. Thanks to new developments in horizontal drilling and hydraulic fracturing – or “fracking” technology – U.S. operators can now access previously inaccessible supplies of natural gas buried deep inside shale formations. Some of the highest-producing areas – such as the Marcellus Shale in Pennsylvania that currently produces ~17 Bcf/d, up from less than 2 Bcf/d five years ago – are capable of producing several billion cubic feet of natural gas per day. Additionally, this new production is now much closer to the traditional demand centers in the Northeast, which may reduce transportation costs.
Natural gas production from the Marcellus shale formation in the Appalachian basin increased to 14.4 billion cubic feet per day (Bcf/d) in January 2015, accounting for more than 36% of shale gas production and more than 18% of total dry natural gas production in the United States, according to EIA’s Natural Gas Weekly Update.
2. Increased transmission. Historically, natural gas has moved from southern states to northern ones – but the dramatic increase in northern natural gas production has led to an increase in transmission from north to south. The industry has seen an uptick in both the construction of new north-to-south pipelines and pipeline reversal projects (aka “backhaul”), in which existing south-to-north pipelines are repurposed to move natural gas and oil north-to-south.
Natural gas is, literally, moving in directions we’ve never seen. The increased supply – combined with the increased transmission of U.S.-produced natural gas – means that the demand for natural gas has been growing more slowly than supply as of late.
A Gradual Shift in Demand
While we are currently in a market where supply is dominating the equation and leading to lower natural gas prices, this situation is likely to change and demand is certain to catch up. In any industry, when consumers have access to cheaper goods, they will buy those goods until the price increases level off demand – many times swinging the pendulum the other direction.
We are already beginning to see key shifts in demand that will likely affect natural gas prices in the near future:
• Power plant generation is switching from coal to natural gas. Natural gas is now cheaper than coal. As a result, many older coal-fired power plants are being retired and are being replaced by natural gas. More than 4,700 MW of new natural gas-fired power plant capacity is expected to come online in 2015. Another 40.5 GW of announced coal-fired power plant retirements that will be replaced by gas-fired generation are expected to add 1-2 Bcf/day of natural gas demand by 2020.
And because natural gas burns much cleaner and creates less air pollution than coal, this trend is also supported by the EPA. The result? We are looking at a dramatic increase in the amount of electricity produced by natural gas – and this trend will greatly increase the demand for natural gas.
• Increased LNG exports: As the U.S. continues to produce huge quantities of natural gas, the demand for natural gas in places like China and India are expected to increase dramatically over the next several years. This means that the U.S. is poised to become a major exporter. In fact, we are already seeing an increase in permits for liquefied natural gas (LNG) export terminals, which convert natural gas to liquid form for shipping overseas.
There are currently five LNG export facilities totaling 9.2 Bcf/day of export capacity under construction, with an additional 4 Bcf/day additional capacity in approved projects.
Secure Your Supply Now
When you understand the factors that drive energy prices one way or the other, you can adjust your strategy and make better purchasing decisions.
When it comes to natural gas prices, it seems that we are nearing the end of the era of extremely low prices. Although we are still in an environment where supply far exceeds demand, the evidence suggests that the natural gas supply/demand equation is poised to begin tilting in the other direction.
Bottom line: If you are an energy procurement professional, it may be smart to evaluate market research and industry intelligence, and begin locking down your energy needs sooner rather than later. Take advantage of the natural gas market being at the far end of the supply/demand spectrum, and do what you can to lock in the best possible price before the volatile market inevitably swings back in the other direction.