By Steven Chambers of Constellation, the IMA’s energy partner . . .
As we officially kick-off summer, your thoughts may be drifting towards July 4th BBQs and impending summer vacations. After a chilly and rainy spring, we don’t blame you. Before you go into vacation-mode, you may want to think about your energy strategy and if it’s ready for potential price volatility this summer.
Given the sustained low energy price environment of the past few years, combined with two consecutive mild summers, energy buyers may be unprepared for an increase in weather-driven volatility. Customers on an index power product that have not locked in fixed prices for 100% of their summer usage have at least some financial exposure to potential higher prices. Due to the uncertainty around summer temperatures and a recent increase in natural gas prices, price spikes in the index power market are never out of the question.
With this in mind, let’s look at what drives index prices, review recent day-ahead market trends and take a look at what to expect this summer.
Index Market Fundamentals
The index power market is a spot market in which prices are determined by electricity supply and demand on an hourly basis. In PJM and MISO, there are two index power markets: day-ahead and real-time.
The day-ahead market is based on operating conditions 24 hours ahead of power flow and is used to create a financial schedule of supply and demand that is physically feasible. The real-time market, also known as a “balancing” market, is based on actual operating conditions in the hour of power flow. Customers on index may be able to take advantage of favorable market conditions, but they also must have a level of risk tolerance to accept variability in monthly energy costs.
Index market prices can be impacted by a variety of supply and demand factors. As shown in the chart below, annual trends in the day-ahead market are heavily influenced by natural gas prices. In today’s power markets, natural gas-fired power plants are “on the margin” in a large number of hours. This means the marginal cost of gas-fired units sets the hourly price where supply meets demand, especially during on-peak hours.
Lower gas prices could lead to lower index power prices if fuel costs decline for natural-gas fired generators. This is the trend we saw during the first five months of 2016. Spot gas prices at Henry Hub averaged $1.94/MMBtu, or nearly 90 cents (-31%) below year-ago levels. Lower gas prices led to a 21% year-over-year decline in average Midwest day-ahead power prices from January to May.
While natural gas prices determine the annual level of prices, temperatures are the primary driver of monthly price volatility over the course of a year.
Using ComEd as an example, the chart below shows the annual trend of monthly average index prices since 2010. As the lines show, day-ahead prices in a given month don’t show much of a distinct pattern from one year to the next. Yet, on average over these years, the bars show a clear seasonal pattern where prices are highest in the summer and winter due to seasonal demand factors. In 2010 and 2011, when the summer weather was hotter than average, prices were higher. In years with mild summer temperatures, such as 2014 and 2015, prices were lower than average.
This chart also shows the risk of price volatility during cold winters as power generators and residential heating load competes for natural gas supply.
Recent Trends and How to Prepare for this Summer
Despite weak day-ahead prices in April and May due to shoulder month power demand and low natural gas prices, index prices are on the rise in June. Gas prices have recently hit a ten-month high. Cooling demand has ramped up in the early part of summer.
As of June 23rd, the average day-ahead price across the major Midwest power markets has increased by nearly 10% (~$2.25/MWh) since May 2016. If gas prices continue to strengthen this summer as the market tightens, expect day-ahead prices to follow suit.
Weather patterns will also continue to drive index price volatility this summer, as they have in the past. Even in a low gas-price environment, index prices can exhibit weather-driven increases. In 2012, the last year when gas prices were near current levels, day-ahead power prices saw a big increase in July as temperatures reached triple digits. In the ComEd zone, day-ahead prices reached over $100/MWh in 22 hours during the month. This year, ComEd day-ahead prices hit $68/MWh on June 20th, the highest hourly price of 2016 (the same day PJM load reached its year-to-date peak).
Price spikes during the summer months are usually a result of not only hot temperatures, but higher prices due to increased cooling needs. In the previous two summers there was a lack of price volatility driven by mild temperatures. However, this year, probability favors a return of at least some hotter weather. Current forecasts suggest that the hottest temperature variances this year are likely to occur in the second half of summer as a La Niña pattern develops.
Managing Your Energy Budget
Customers in the Midwest concerned about a return of higher index prices this summer should be aware that prices in the forward market are still within 5-10% of the all-time contract lows set earlier this year. You can take advantage of market opportunities such as this, but to achieve your business goals, you may consider a longer-term solution. By thinking and acting long-term, you can have the security of a fixed price and the flexibility to respond to market conditions. Fixed price doesn’t always fix the problem. http://blogs.constellation.com/energy4business/fixing-your-price-doesnt-always-fix-your-problem But a blended strategy with a long-term view can. Contact your Constellation Business Development Manager today to discuss your options and review your energy risk management strategy.