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Price Risk Management: Electric Power vs. Natural Gas

Fortnightly Magazine - February 1 1996

marginal unit costs in electric generation. But, this relationship only allows for one-way, cross-commodity hedging (em i.e., hedging a power sector position by taking a gas market position.

Regional Integration: Dissimilar

Many gas-turned-power marketers are hoping that deregulation will establish a futures market so that they can function in the power business as they function in the gas market. This evolution may indeed happen. The most notable examples are trading of contracts for delivery in the West at locations near the California border.

Even so, whereas a disconnection of regional markets is the exception (em not the rule (em in the gas industry, this balkanization will occur more frequently in the power sector. The nation's electric transmission grid offers much less capacity for interregional connections than do the pipelines on the gas side. For example, gas pipeline capacity into the Northeast from the West South Central equals roughly three-quarters of the average demand for gas in this area. By contrast, electric transmission capacity from the coal-based industrial midwest (i.e., the National Electric Reliability Council [NERC] region known as ECAR) totals only 5 percent of the average demand levels in the Northeast (i.e., NEPOOL, NYPOOL, and the PJM Interconnection).

Three factors explain this discrepancy.

First, gas producing resources are concentrated to a far greater degree than generation resources. Hence, more long-distance gas transmission capacity is required. But coal is produced in over 20 states; nuclear and hydroelectric power is prominent in many others. Second, power transmission is several times more expensive on a per-Btu basis than gas transmission. As a consequence, it is easier to transport gas than power, and often almost as economic to transport coal as coal-derived power. Third, siting and permitting is much more difficult for power lines than for gas pipelines. New technologies to enhance power line capacity may ameliorate this constraint somewhat, but for the foreseeable future, power line siting is likely to remain a expected to be a significant problem.

Price Volatility: At Opposite Ends

Several factors cause volatility in a given power market. In the short run, the key factors include weather, which can strongly affect demand and hydro systems supply; fuel prices; and powerplant operations (e.g., outages of large units, such as nuclear power plants). In the longer term, electric prices can be affected by demand, regulations, and new technology. In addition, there is substantial uncertainty about the price of transmission capacity between regional markets. This uncertainty is tied both to regulations and supply and demand factors.

In the natural gas industry, however, most attention to price volatility is focused on basis

differentials between markets, driven by uncertainty in prices and capacity for transportation. Marketers encounter difficulty in attempting to apply short-run fundamentals to assess overall gas commodity prices.

Consider these general observations about the relative price volatility of electricity versus gas over time:

s Hourly. Power prices are quoted for hourly delivery and can double in the course of a day. Gas prices are generally quoted on a daily basis.

s Daily. The next day's power price could be two or even four times