[BETA] Fortnightly

What do the first months of trading say about the spread between spot markets and futures prices?

ust over nine months ago the New York Mercantile

Exchange opened trading in the first-ever electricity futures contracts. As occurred

previously in oil and gas, futures trading in electricity

promises to play a central role in

commodity markets (em markets that are gradually evolving as competitive.

Electricity futures also provide a valuable tool for managers at utilities or other power producers. Futures convey critical information about the value of power that buyers and seller can exploit to raise profits and boost returns for shareholders. That being said, the trading of futures is not necessarily a prerequisite for understanding the market or the signals it sends about the value of power. Futures prices, however, should command attention (em not only from the operations and marketing staff at the major utilities, but also from electricity consumers.

It is the price of futures contracts that offers useful information on such decisions as when to buy or sell, and on what terms.

Timing Power Supply Decisions

The price for power varies by month of delivery. In a competitive market, the price differential between months will fluctuate with current supply and demand conditions, sometimes dramatically. Knowing the premium

currently paid for well-timed capacity provides an important key to maximizing profit. How high is that premium now?

To answer this question analysts look to the cash-futures basis (em to the difference between (a) the cash or "spot" price paid for immediate delivery and (b) the futures price quoted currently for delivery during the month ahead. For example, Figure 1 shows the one-month, cash-futures basis as it developed this past summer. Throughout April and May the basis for delivery in June remained positive, indicating that the futures price lay below the spot price; buyers were not yet ready to pay a premium. However, a premium did develop in June for delivery in July, as can be seen by the fact that the basis turned generally negative. The premium that developed in July for August delivery was the highest of the season.

Of course, industry participants need not restrict their horizons to looking only one month forward. Examining futures prices for contracts to deliver two, three, and more months out make it possible to identify the premium paid for capacity available several months forward.

Attention to the cash-futures basis enables a utility to manage operating and supply decisions for maximum return. A utility with hydroelectric capacity must often decide when and how much water to release. Holding onto the water gives the utility the opportunity to sell power at high prices in the event of unpredicted outages or surges in demand. Futures prices reveal the premium paid currently for assured supply in the future; they can be used to calculate the value of water stored in the reservoir for comparison against the return to be earned from an immediate release.

Granted, many factors other than price may determine or constrain the rate of water release. But where economics matters at all, data from