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Market Fundamentals

Electricity is a very unique commodity, for the simple reason that in its current state, power cannot be stored. Other commodities have the ability to be produced, and stored in their usable form. Because of the fact that inventory levels can be drawn on when market conditions merit, there is a good measure of market transparency and stability (with other commodities). Natural gas on the other hand is storable, and storage levels are currently robust in the North America. New technologies for exploration and production, including fracking have contributed to a fundamental surplus of additional natural gas. With a weak economy, companies are not producing widgets, or storing finished goods, which has led to a fundamentally weak demand picture for natural gas. This environment has led to relatively weak commodity prices over the past few years. That being said, factors such as weather cause instant changes to the demand picture for electricity. When it is hot, people crank up their air conditioners. When it is cold, people use natural gas to heat their residences or places of business. For this reason, there are generally speaking three conditions used to describe patterns of demand for electricity and natural gas in the calendar year. There is the Winter Period (Dec – Feb), Shoulder Season (Mar – May and Sept – Nov), and Summer Period (June – Aug). Different parts of the country obviously are effected in their own unique way, weather to a large extent being the determining factor. But generally speaking, the Summer and Winter Periods experience tremendous market volatility.

Volatility translates to higher prices due to the uncertainty of the supply and demand picture. This is why there are two distinct products (and other product variations within them). For those customers who are less risk averse and want price and budgetary stability, we recommend locking in your power price using a Fixed Price Product. For those customers who want to take advantage of volatility, we recommend a more popular index based product (Variable Product), where the price of your supply fluctuates with the market conditions.

For most electricity markets in the US, natural gas is the fuel “on the margin”. What this means is for each additional kwh of electricity that is needed to balance the system (remember, electricity cannot be stored), natural gas is the fuel that produces that additional unit of power, so the price of the electricity is correlated to the price of natural gas. Natural gas is also a much more transparent market with respect to pricing (remember from above, natural gas has a high amount of storage, and a high amount of supply yet to be produced in North America). The markets have great transparency on the price of natural gas will be in the future.. Natural gas forwards are one of the most highly traded commodities. When charted, they are a great predictor of what electricity prices should look like in the future. Please note, natural gas markets and for reasons stated above, electricity markets in the UK behave very differently than they do in North America. The lack of storage and the lack of supply of natural gas that is accessible in the UK create extremely volatile market conditions.

An important distinction one should note is that the charts above represent NYMEX future settlements for natural gas at the Henry Hub delivery point, which is located in Erath, Louisiana. There is a transportation cost (“Basis”) to get the natural gas to your home or place of business. This Basis differential will be different depending on your local distribution network.

The Electricity and Natural Gas Transportation System is like a Hi-way

Just like cars need to travel on a hi-way to get from Point A to Point B, electricity and natural gas need to travel across a system to get from where it is produced to your home. When problems occur in the system, we get brownouts, or more extended blackouts. Most of us remember the major power outage that occurred across the Midwest and North East in 2003. This happened due to a major failure of the system grid, or hi-way. Electricity could still be produced at the power plant; it just could not make it from the power plant to your home or place of business. The transmission system, or hi-way is an industry that remains regulated by your local utility. Powermyrewards has nothing to do with getting the commodity to your home or place of business. However, the system grid has a significant impact on the market for the supply of the commodity. When the system is congested, it leads to challenges associated with getting the commodity from the place where it is made to the end user, the customer.

When the hi-way is congested, you cannot get from Point A to Point B in your car. You need to find an alternate route, causing your car to burn more fuel, and increasing the cost of your transportation. Electricity and natural gas are no different. Customers in the North East saw this in the winter season of 2012. They all saw tremendous price volatility in their electricity and natural gas. Those customers who chose a Variable Price over a Fixed Price product saw the effects. If you were on a Fixed Price Plan, you should not have seen any impact. To break it down into basics, market conditions caused a stress on the gas transportation system, more specifically the Algonquin Transportation System. Natural gas was curtailed in the system, and power plants were paying more for the fuel to supply the additional electricity that was required on the margin, translating to higher prices for electricity in the overall North East markets.

Market conditions and increased volatility in price are in our opinion driven by supply and demand factors, weather, and transmission system constraints. Obviously there are other factors that can affect market conditions.

Wholesale Supply and Market Heat Rates

By far, the biggest component of your power and gas supply is the cost of that supply in wholesale markets.  Just like any other commodity, wholesale costs are driven by supply and demand.  The "Supply Stack" is a term commonly used which refers to the generation resources in your local utility area.  Based on real time demand, the demand levels are met by the most cost efficient resources available at that time.  Traditionally, nuclear, solar, wind, and other renewables will be used to satisfy demand when available, followed by fossil fuels such as gas and coal fired generation.  This will largely set the cost of power in the wholesale markets, based on those fuel costs as well as other variable costs to product a unit of electricity.  Market Heat Rates is a calculation that correlates the price of wholesale power in a given utility with the price as gas in that service territory, because as mentioned above, most of the deregulated markets in the US have gas as the marginal fuel source.  When these supply and demand functions come out of line such as in periods of hot weather or other market imballances, the correlation breaks down.  With stable Heat Rates, one can expect consistent relationships between the price of power and the price of gas at the wholesale level.

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