Energybuyer.org

Forecasting Energy Pricing

(Combined Tips of the Month for January and February 2004)

PART 1: DO YOU REALLY WANT TO GO THERE?

As energy markets become more volatile, some energy managers are looking to wholesale market pricing forecasts for guidance with their retail energy budgeting. Such forecasts may be found in the form of futures pricing (e.g., NYMEX), forward market projections (e.g., Platt’s), from private energy consulting firms (e.g., Enercast), and government sources (e.g., DOE, ISOs, PUCs). Retail energy prices may, however, be only indirectly related to wholesale pricing, or may lag behind the wholesale market, making short-term projections speculative, at best.

How useful are such predictions? A lot depends on one’s sensitivity to wholesale market pricing and expectations for forecasts of them. While often inaccurate over the short term, such estimates may provide the type of quantitative information needed to develop and support long-term energy budgets.

Central Factors

Many issues enter into the relationship between wholesale and retail pricing. in general, the most important are:

how a facility buys its energy (e.g., through a utility or marketer)
where it’s located relative to the nearest wholesale purchasing point (i.e., a “hub”)
the facility’s energy usage patterns (e.g., how its consumption varies with time).

Wholesale pricing and forecasting data become more useful as a facility’s purchasing methods and usage patterns approach those of a small utility or wholesale energy marketer (i.e., having sensitivity to market fluctuations while maintaining a high load factor).

Market Distortion Mechanisms

Tariffs and contracts. Only major energy users (e.g., industrials, large campuses, and utilities) buy directly from wholesale suppliers. The rest of us buy from utilities or retail marketers, using either tariffs or contracts. When buying from a utility, wholesale pricing is just one part of the retail price developed under a regulated tariff. If buying from a retail marketer, a private contract may instead control energy pricing (though delivery cost may be subject to a tariff). Such agreements may mute or distort the impact of wholesale pricing before it reaches a customer.

Utilities may, for example, absorb large short-term price swings and then recoup them over a much longer time period, perhaps through a later general rate increase. Fixed- or tight-collared- price retail energy contracts immunize (and desensitize) customers from wholesale price fluctuations. On the other hand, some retail energy contracts and utility tariffs contain mechanisms (e.g., daily/monthly balancing, fuel adjustment clauses) that pass through all (or some portion of) wholesale price variations to monthly utility bills. The value of a wholesale price forecast may therefore depend on the type and degree of such pass-throughs.

Basis. Depending on the location at which a price is forecasted, the cost of interstate transportation (e.g., gas main piping or power transmission) may magnify that impact. When prices are forecasted for major pricing hubs (e.g., Henry Hub in Louisiana), “basis” (trading lingo for the cost to ship energy) must be added to the hub price. That charge varies greatly with seasonal demand and pipe/power line availability. Those in the Northeast saw their gas bills skyrocket when basis more than doubled the hub price during recent cold snaps. Any price forecast that does not reflect basis may have marginal value to such customers.

Load profile. Unlike many process-based loads (e.g., manufacturing) that are unaffected by weather, most facilities use energy based on occupancy and temperature. As a result, their load profiles rarely look like the neat blocks of energy priced in wholesale markets. Approximating a retail load profile using smaller blocks of various size and duration is possible, but may significantly raise the final price. A typical retail energy marketer handles such maneuvers for his customers, building into his price a fee for that effort.

Regulatory stability. Structural changes to both the regional and local regulatory landscapes have become common since the beginning of energy deregulation in the late ‘80s. The movement toward regional power markets fostered by FERC is leading to the sporadic spread of installed capacity (ICAP) markets and locational marginal pricing. While wholesale market pricing is available for those differentiated costs, they may still be subject to some regulatory intervention that limits the application of purely economic forecasting models. When regulatory instability becomes serious (as occurred in California and Ontario), all bets are off.

Taxation. Taxation will magnify whatever pricing is quoted since it is also not included in a wholesale projection. Where multiple levels of energy taxes exist (e.g., sales tax on top of a utility or gross receipts tax), this multiplier may be significant (e.g., up to 15% in some areas).

Energy marketers and utilities are able to use financial and other mechanisms to mute the impact of annual variations on their bottom lines. To some of them, each month is like a poker hand: a player may occasionally lose his shirt but, if he plays long enough, he’s bound to break even. Customers, however, do not have such latitude and must meet budgets or face serious consequences. When power and gas prices spike, wholesale price forecasts may become instantly irrelevant (see the EIA gas price forecast graphic below). The applicability of short-term forecasts may therefore be limited. If, however, one is looking at a multi-year contract or for general guidance on price direction, such forecasts may be useful.

Making Wholesale Pricing Forecasts Relevant

Before trying to secure or use wholesale price forecasts, determine to what degree such price variations impact you. To establish price stability, might it be acceptable (and easier) to simply pursue fixed price and/or long-term contracts, even if that raises your average price? If so, little is to be gained by trying to second guess the market.

If your firm does not accept that option, the next step is to determine if your utility, ISO, marketer, or PUC may have already developed such forecasts, perhaps as part of a recent rate filing, or as required annually by your PUC. Note, however, that such data may be dated by the time you read it, and may represent the total price impact on the utility’s purchasing portfolio rather than the pricing to be seen in a fuel adjustment charge.

To gauge the impact on retail pricing, determine that part of a facility’s energy bill directly affected by changes in wholesale pricing. Under many utility tariffs, that may be just the monthly fuel adjustment charge passed through to customers when the utility incurs a cost above the base price built into its tariff (available from the utility and/or PUC). Historical data covering how that monthly charge has varied over the last few years may provide an indicator of the locational and seasonal sensitivity of that charge. Recent experience with high wholesale natural gas rates in some areas has, for example, demonstrated how some utility electric rates may be impacted by a utility’s fuel mix, generator heat rate, and procurement practices (e.g., proportion generated versus that bought on the spot market from a regional power pool). Use data from recent years in which weather was relatively normal (i.e., close to the 30-year climate average) to make the results useful for an average future.

Using past actual wholesale pricing for the same months at the nearest pricing point, calculate the differential impact due solely to wholesale variations (i.e., no tariff changes during that period). Such monthly differentials may then be added to the prices found in a wholesale monthly forecast for that same pricing point to determine how the fuel adjustment charge may vary each month in the coming year. Add those numbers to the other components in the tariff pricing (e.g., delivery, distribution, etc.) to create a price curve reflecting total utility pricing.

Multiply those numbers by your facility’s expected monthly consumption (and demand, if appropriate), using 30-year average temperatures (available from the National Climatic Data Center (http://www.ncdc.noaa.gov). For greater accuracy, use a temperature forecast covering the same time period (available from NCDC or private sources, such as http://www.weatherbank.com) When input into a simplified computer or mathematical model that corrects for such factors, the end result should be a forecast of month-by-month energy bills.

If buying from a marketer, discuss how wholesale pricing impacts your contract pricing. Depending on your goal (e.g., budget surety, or lower annual cost), you may wish to consider ways to decrease or increase your sensitivity to wholesale market pricing. Ask him to walk you through his price formation process. Most marketers have a portfolio of fixed, indexed, and spot priced contracts under which they procure energy for their customers. Knowing the approximate mix may help determine how his price will change when your contract is renewed. In the end, however, merely requesting seasonal quotes may be sufficient to see where pricing is headed.

If looking for a long-term (i.e, over 3 years) projection, attention should also be given to more global factors such as the price impact due to importation of some fuels. As natural gas native to North America becomes harder to find and more expensive, for example, we should expect greater importation of liquified natural gas (LNG). As we have seen with imported oil, it is then possible for the value of the dollar relative to other currencies to impact energy prices. Likewise, the construction of new pipelines, transmission lines, and nearby power plants may also have a significant impact not seen in short-term wholesale price projections.

PART 2: THE CRYSTAL BALL GAZERS CLUB

Here's our crystal ball to review sources of wholesale price forecasts.

No-Cost Forecasts

Long-term national projections are done by the Energy Information Administration (EIA) division of the U.S. Dept. of Energy. For a projection through 2025, go to http://www.eia.doe.gov/oiaf/aeo/gas.html

For a short term outlook, go to http://www.eia.doe.gov/emeu/steo/pub/contents.html

While regional and national projections often differ widely, a graph of historical national and your state’s overall energy pricing (which is typically dominated by electricity) may be found at http://www.eia.doe.gov/emeu/states/_states.html. Follow the instructions on the page to get information about your state.

If your state’s energy pricing has consistently tracked national pricing, the EIA projection through 2025 may act as a workable projection for overall energy pricing. Note, however, that variations among utilities in the same state are masked when viewing statewide average prices.

The National Institute of Standards and Technology (NIST), a division of the U.S. Department of Commerce, annually publishes its Supplement to Handbook 135 which providew price escalators and indexes for all census regions by energy source and end user type. Find it at http://www.bfrl.nist.gov/oae/publications/nistirs/327318.pdf

Each state’s energy office may also have local projections. Find links for those sites at http://www.naseo.org

Various regional bodies (such as NERC councils and planning agencies) concerned with energy offer forecasts (both wholesale and retail) for markets in their areas.

Utilities also develop multi-year projections for fuel costs as part of rate filings with your state’s public utility commission (PUC). Start by asking your utility account rep where such documentation is available from the utility. If that doesn’t work, check your PUC’s web site for document archives relevant to your utility. Its filing may be available either on the web or via a document request to the PUC. To find a utility’s web site, call your account rep or go to http://www.utilityconnection.com/page7a.html

Some energy trade associations (e.g., American Petroleum Institute at http://www.api.org) also offer occasional (though often loosely focused) projections. Look for those relevant to the particular energy source of interest to you (e.g., power, natural gas).

Since this industry remains in constant flux, use Google or another search engine to find forecasting options that are readily available. Enter “natural gas price forecast” “service” into the search field; substitute “electric power” or other energy source for “natural gas” as desired.

Private Sources

Other projections are available, but are from private sources and are not cheap. Platt’s Price Forecasting Service, for example, focuses on this issue. Take a look at http://www.platts.com, (especially Megawatt Daily and Gas Daily).

Other consulting services providing wholesale price forecasts of various types:

http://www.ballonoffconsulting.com (Ballonoff Consulting Service)

http://www.energyonline.com (LCG Consulting)

http://www.gelbercorp.com (Gelber & Associates)

http://www.cera.com (Cambridge Energy Research Associates, Inc.)

http://www.argusonline.com (Argus Media)

http://www.enercast.com (First Enercast Financial Information Products)

Most large wholesale energy marketers and trading brokerages (e.g., Tractabel) offer selected forward price quotes. Several firms (e.g., Peace Software, NewEnergy Associates) also offer computer models for developing wholesale price forecasts.

The Usual Caveats

Be wary of those who try to forecast using mainly “stochastic” (i.e., statistical) methods. Such processes are very good for understanding the broad principles (e.g., rate of regression to an average price) but they are rarely accurate in predicting the height and width of a major spike, which can make a monthly or seasonal energy budget irrelevant in a fortnight. If developing pricing for a large sampling of facilities, however, such methods are more likely to be right than wrong.

Exercise care when using models supported primarily by economic theory that emphasizes market “fundamentals” such as weather and regional energy supply. Such models fail miserably when confronted by human intervention. The 1998 Midwest price spike, the California 2000-2001 experience, and recent winter natural gas pricing have shown us that the fundamentals don’t predict the magnitude and duration of a price “heave” that may also reflect market power, group greed/fear, and the exponential pricing behavior that seeks to maximize short-term profit taking. As various federal and state investigations have found, slow-acting regulatory and oversight mechanisms fail when action is needed within hours or days.

While it appears that FERC’s effort to clean up reporting of phony wholesale trading claims is having some impact, too much dependence by any model on trade reporting may also lead one down a dangerous road.

Become Your Own Price Prophet

Here are a few general rules that always seem to work.

When you see volatility among energy “experts,” expect volatility of energy pricing.
Understand that wholesale energy pricing is unrelated to any “cost of service” or logical proportionality. Once the margin between supply and demand of any commodity gets tight, all gloves are off.
Customers see the fuel supply “glass” as half full and think that should keep prices reasonable, while suppliers see it as half empty, thereby raising the value (and possible selling price) of what’s left.
Keep an eye on the rate at which a change (e.g., rise or fall in demand) is occurring, and not the absolute amount or value of a commodity. Traders seek to be part of accelerating trends since doing so may yield the fastest short-term returns. Such action maintains and accelerates a price move even when the “fundamentals” indicate there’s no good reason for it.
Watch for trends and/or structural changes that may abruptly alter retail cost without being visible in the usual daily/seasonal market data. Zonal/locational pricing and installed capacity requirements are among such changes, both of which may result when a region joins or forms an Independent System Operator (ISO).
Events are gradually raising the price “floor” for some forms of energy. Dwindling U.S. and Canadian gas supplies may, for example, raise the cost of the cheapest gas, while continued growing demand (e.g., from new gas-fired power plants) will increase the percentage of LNG in the mix (always more expensive than wellhead gas). The end result is higher average prices for those forms of energy.
Always bet on shortsightedness, ignorance, and greed. Energy policy and markets in this country are presently quite fragmented, resulting in mistakes, conflicting efforts, insufficient funding and direction, and opportunities for short-term manipulation.

Remember the wild cards that may quickly and deeply impact regional and/or national energy pricing: economic recovery or stagnation, inflation, and changes to the international value of the dollar.

A Few Reality Checks

Predicting the future is not yet a science. You’re fooling yourself if you think a single prediction will be accurate. Even with lots of money, computers, bureaucrats, etc., results are often wildly erroneous. When a prediction must be specific (i.e., covering a single zone for one year), accuracy often suffers. Longer and broader forecasts, using a good predictive methodology, have provided results better than guesswork.

Ask yourself how you will use the resulting predicted pricing. Unless input to a reasonably good model that shows how your facility responds to other changes (e.g., climate), errors in the other half of the cost equation (i.e., consumption) may undo the best forecast. Many end users, for example, continue to proportionate degree-days with no accounting for balance point temperature or regression modeling to factor out non-climate-related usage (e.g., line/equipment losses, domestic hot water, process loads).

If you really need budget certainty, pay for it - not with purchase orders for reading tea leaves, but by pursuing contractual, financial, and technical mechanisms (e.g., fixed price power and fuel contracts, securing part of your load by buying futures, and installing load-leveling and consumption-controlling equipment). Use the same tools used by smart utilities and energy marketers. To learn more about weather risk management tools, for example, go to http://www.wrma.org. Otherwise, all you’re really doing is gambling with the company’s money.

Energywiz, Inc.
Adding New Dimensions to Energy Services ^SM