By Steven Chambers, Constellation
Buying energy is a year-long endeavor, but it doesn’t have to be difficult. Having a good understanding of the market—including knowledge of how prices compare to historical benchmarks and key fundamental drivers that can influence future price trends — can help you make strategic decisions that can impact your bottom line now and for years to come.
Here are some guidelines Illinois energy buyers should keep in mind as they consider when and how to purchase energy throughout the year.
The Natural Gas Market
There is an increasing correlation between natural gas and power prices as power generation at a national level grows more dependent on natural gas-fired power plants. In Illinois the prices of 24-month forward contracts for wholesale power and NYMEX natural gas have shown a correlation of 80 percent over the past three years. The relationship between natural gas and power can be useful for you as power prices followed natural gas prices to multi-year lows earlier this year. However, it has also resulted in changing risks in the power market as any increase or volatility in natural gas prices can translate into higher power costs.
While the NYMEX prompt showed natural gas prices declining to a 17-year low this past spring, prices quickly rebounded amid the hottest cooling degree day on record. On Sept. 21, the NYMEX prompt month natural gas futures price broke through the $3.00/MMBtu mark for the first time since May 2015 and reached the highest closing price since early January 2015.
Several factors resulted in this rally of short-term energy prices, including:
Hot weather, which led to a significant year-over-year increase in natural gas demand in the power sector
The increase in natural-gas fired power generation on a national level. (This is the first year on record in which natural gas will account for more power generation than coal, according to the EIA.)
Record growth in natural gas exports via pipeline to Mexico this year
For energy buyers, natural gas demand growth presents a major upside risk for prices in the future. The key question about prices is whether the supply side of the market can keep pace with the growth in demand. Thanks to the “shale revolution” in the U.S. since 2009, dry natural gas production grew sharply through February 2016 when output peaked at an all-time monthly high of nearly 74 Bcf/day. Since that time, the decline in oil and natural gas prices to multi-year lows has caused producers to cut active drilling rig counts to 30-year lows, according to Baker Hughes. However, with natural gas and oil prices now rising off year-to-date lows, cash-strapped producers have begun to add drilling rigs back into service. This may lead to a rebound in natural gas supply in the next several months. According to the EIA’s most recent projections, natural gas production in 2017 is predicted to grow by 3 percent from 2016 levels.
Based on the trend in longer-term NYMEX prices this summer, the market seems to be betting that production will be able to keep up with demand for years to come. While prompt month natural gas prices have moved back above $3/MMBtu recently and prices for 2017 delivery have rallied 25 percent since the spring, outer year futures prices for 2018-2020 are trading below $3/MMBtu. They have also declined by three to 10 percent since the beginning of June. Longer-term natural gas prices have likely drifted lower on expectations that prices over $3 next year will incentivize producers to increase natural gas production in coming years. With natural gas prices for 2018-2020 now trading at a discount to short-term prices, many energy buyers have started to procure natural gas and power for extended contract terms to take advantage of long-term value in the market.
The Power Market
For power buyers in Illinois, the forward market is also providing long-term opportunities despite an increase in prices versus the all-time contract lows achieved earlier this spring. Forward power prices for 2017-2020 at the ComEd zone are now one to six percent higher than spring lows. In downstate Illinois, prices at the Ameren zone are within eight percent of all-time lows. However, as with the natural gas market, power prices are slightly backwardated with 2018-2019 calendar strips now trading below prices for 2017. In fact, the current price spread between 2017 and 2018-2019 prices is the largest seen for these contract terms. This unique price trend could present you with an opportunity to procure power for longer contract terms at a lower average energy cost.
Fall is a time of year that you may be paying close attention to energy price trends given expectations for a seasonal pullback in the market. Forward power prices have generally trended lower since power demand peaked in the second half of summer. However, this year’s seasonal price decline may be less dramatic than expected due to warm temperatures that have lasted into September, along with the rally in near-term natural gas prices. Thus, you may be inclined to wait until the spring shoulder season to make a decision about energy procurement. While the spring also tends to bring a seasonal low in prices, putting off a decision this year in hopes of lower prices next year may amount to a bet on the weather this winter.
What to Anticipate In the Coming Months
With winter around the corner, there are several upside price risks to monitor closely. The weather is one of the largest drivers of short-term energy prices, but it is also the least predictable far in advance. This year’s initial winter forecasts point to a colder winter than a year ago and possibly colder than normal for the northern tier of the U.S.
Compared to last winter when the Midwest experienced a few heavy snowstorms, long-term forecasters predict more frequent snowfall spread out over the season.
Natural gas storage inventories are also an important factor to consider. While storage inventories are likely to be sufficient to meet requirements this winter, a season of strong demand could leave natural gas stocks in a deficit to the five-year average level by next spring.
Last but not least, you should not forget the lessons learned from the Polar Vortex of 2013-2014. Sustained periods of cold weather can still lead to major energy price volatility as power generators and heating loads compete for natural gas supply. Though the energy market has made many advances to prevent a repeat of the Polar Vortex price volatility—including increased pipeline capacity, generator reliability programs, and greater coordination between pipelines and power generators—the risk cannot be ruled out. Consider winter budget protection a key building block of your energy risk management strategy.
Putting It All Together: Developing A Smart Energy Procurement Strategy
The energy market has undergone a period of transition this summer due to the impact of low prices and a hot summer. This has tightened the supply-demand balance in the market and worked off a lingering oversupply. The potential for a cold winter and natural gas demand growth represent material upside price risks in coming months, but these bullish short-term fundamentals have had a muted impact on long-term gas and power prices. In some cases, prices in the 2018-2020 timeframe are back within striking distance of their previous lows. There is still a lot of value in this energy market if you have the right energy management strategy in place. Constellation can work with you to develop an integrated energy management strategy that will allow you to achieve your goals this fall and for years to come. To learn more about how we can help, contact us today.