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Power Prices Today: Growing More Unpredictable

Even the volatility is volatile. And that can play havoc with hedging.
Fortnightly Magazine - October 1 2002

emerge, because of the huge shifts in power demand that are possible in the short term, capacity constraints that can almost completely bind movements of power, and other factors that make wholesale power in the United States a most volatile price commodity.

An interesting development in the last year is the similarity of power and natural gas prices at Henry Hub natural gas market and its nearby power market Into Entergy. This is due not only to a continuing integration of these markets, but also to a downturn in the economy and to the availability of more marginal power generation capacity.

A glance at Figure 2 reveals that power prices may be well connected in eastern power markets. Yet, natural gas prices in these same markets, which are often highly correlated with the Henry Hub price, move much differently than power prices at times. Differences in natural gas and power markets were greatest in summer 1999, when constraints in moving power emerged, temperatures elevated significantly, and the ability to exert market power improved. Power prices increased significantly, yet natural gas prices hardly budged.

At other times, power and natural gas prices move in opposite directions, as they did in the fall of 2000 when high natural gas prices were sustained by tight supplies and power prices were pushed lower by weak demand. Yet when demand for power began to increase and natural gas supplies continued to be tight, both prices moved together. Then strong demand was followed by weak demand in both markets and both prices plummeted. By early spring of 2001, power and gas prices were again seeking an equilibrium. As is often the case, the search for equilibrium was disrupted by large and variable changes in demand for power during the summer.

Power and natural gas markets in the East are today better integrated then they were in the past. But power price levels in any one power market are still extraordinarily variable when compared to other commodity markets. This variability will continue to be a blessing to companies with astute traders and/or operationally flexible assets. But such movements in price levels will wind up being a bane to others at times, even those that consider themselves expert traders or risk managers. 2

#4-Volatility (Price Risk) Is Moving Over Time

Figure 2 shows significant differences in the size and timing of shifts in price level, according to whether you examine the data over months, seasons, or years.

Power prices increase in the summer, but much differently between years. In the late winter and early spring power prices decline, but for how long varies greatly. If changes in the price level could be well explained by daily deviations from normal temperature, humidity, generation outages, natural gas prices, and other factors that influence power demand and supply, then great progress could be made in determining price volatility, pricing, and selling a variety of price risk insurance models. However, models used to explain such behavior are most often very fragile and very imprecise. Naturally, this fact also helps explain why many merchant generators