What is Happening in the Energy Markets?
by Mike Troupos
If 2020 was the year of hearing people talk about COVID19 constantly, 2021 is the year people are talking about inflation and the supply chain. It is hard to go through a day without hearing someone talk about supply chain issues or inflation. Unfortunately, the natural gas and electricity markets are suffering from price inflation as well.
Why is there inflation in 2021?
For most goods, issues in the supply chain are the main culprit driving up prices. New cars are much more expensive because the OEMs can’t get enough chips to build the vehicles needed to meet demand. If there is a shortage in supply, then prices inevitably go up. Other companies that produce their goods overseas are having difficulty finding cost-effective shipping to the United States, thereby driving up prices.
However, energy is different. When you talk commodities, they typically are at the base of the supply chain and aren't prone to supply chain shocks. Additionally, the United States has been a net exporter of natural gas since 2017, so the problem isn’t that we can’t get gas delivered to the United States. Electricity is also immune to international transportation issues because essentially, 100% of the electricity generated in the US is consumed in the United States.
What is driving up natural gas prices?
While we have established the mechanisms for energy price inflation are different than other goods, the fact remains that energy prices are up too. Let's start with why natural gas prices are up. In August 2020, the monthly gas price settled at $1.85/MMBtu. The August 2021 monthly settlement was $4.04/MMBtu – a 118% increase in one year. Many people don’t realize how linked oil and natural gas production are. Most Oil & Gas (O&G) companies are focused on drilling for oil; this makes sense as oil is generally more lucrative to extract than natural gas. However, the most significant byproduct of drilling for oil is natural gas. This is because the oil and natural gas are all mixed up underground, so if you are pulling one up, you end up getting both. These O&G companies capture and sell natural gas as an added revenue stream.
Oil demand is based heavily on transportation (think cars and airplanes), while natural gas demand is based chiefly on electricity production and space heating. Because transportation is still down from pre-pandemic highs resulting in less oil demand, O&G companies are extracting less oil and producing less natural gas. Conversely, natural gas demand won’t diminish because winter still happens every year, pandemic or not. I believe that if oil demand picks back up, we will see natural gas prices push back down. If oil demand never returns because of changes in the economy and technology, then high natural gas prices might be here to stay.
What about electricity prices?
Electricity is more complex than natural gas for a couple of reasons. First, you can't store electricity cheaply like you can natural gas, so supply and demand on the grid have to match at all times. Second, electricity is generated from many different sources, including natural gas, renewables, nuclear, and coal. The generation mix has changed dramatically since 2015, when coal accounted for the greatest percentage of generation in the US. In 2020, coal fell to 4th place behind natural gas, renewables, and nuclear. Renewables and natural gas both boomed between 2015 and 2020, with natural gas taking a dominant position as the largest source of electricity. In 2020, 40% of electricity generated was from natural gas – over double renewables – the next closest source. Because electricity generation is now so reliant on natural gas, electricity prices heavily correlate with natural gas prices.
What can we do about it?
Since 2015, electricity and natural gas prices have been flat to down, resulting in a low-risk environment. Many companies don't have a strategy for purchasing energy, and over the last six years, that has been fine because energy prices have been consistently creeping down. However, higher prices are likely here to stay, at least for the short and medium-term. Therefore, it is imperative to have an energy purchasing strategy.
What is your organization’s tolerance for risk in energy purchasing? If it is low, you should consider hedging most of your energy needs out 1-3 years. If it is high, you should still consider hedging out basis and transportation to ensure that you will be able to get the commodity. By generating a strategic energy plan, you can have more control over energy prices at your organization than you think. Don’t wait; be proactive!