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Running the Numbers: What Drives US Power Prices?

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Understatement alert: Electricity markets are complicated. And of all of the nuances within the marketplace, there is a single element that is the most important — commodity prices determine electric power prices. In places like Singapore and Japan, it is the price of crude oil and liquefied natural gas (LNG). In Europe, swings in coal prices are mirrored in the electricity prices. And in North America, natural gas is the primary driver.

Over the last two years, the correlation between prompt Henry Hub (the U.S. natural gas benchmark) movements and the daily movements of year-ahead U.S. power contracts has averaged 86 percent. In simple terms, this means that as natural gas prices rise so do power prices and the same is true in reverse.

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The chart above shows four price lines. The green line is the Henry Hub benchmark and the three other price lines are electricity benchmarks across the U.S. The California Independent System Operator (CAISO) Benchmark, the Midcontinent ISO (MISO) benchmark for Indiana and Electricity Reliability Council of Texas (ERCOT). These three electricity markets are different in many ways and in fact the grids are not physically connected, yet all three markets share the same pattern. As natural gas prices slowly declined from 2014 through early 2016, the electricity prices all moved in the same downward trajectory. As gas prices have steadily risen throughout 2016 so too have CAISO, MISO and ERCOT prices. This is the visualization of the gas-to-power correlation. Yet, the conclusion isn’t as intuitive as one may think.

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Many might look at the generation mix of the ERCOT grid (the chart above) and see that on the whole, coal power plants are generating more electricity than natural gas. A similar trend exists in many markets across the U.S., where natural gas is not the main fuel in the generation mix, and yet electricity prices move with natural gas prices, rather than coal or nuclear or crude oil prices. So why is this the case?

There are two primary reasons. First, coal and nuclear generators typically played the role of base-load generation sources, meaning they run most of the time and are therefore less affected by electricity demand than natural gas plants, which have typically been peak-load generators. This means gas plants turn on and off more frequently depending on demand, and the prices these plants bid into electricity markets are therefore more sensitive to price fluctuations in the gas market than coal plants are to fluctuations in the coal market.

The main reason, however, is because natural gas is often the marginal fuel source. Natural gas prices change more dramatically than coal prices from day-to-day and, because turning gas into electricity is often more expensive than coal (but less expensive than crude oil products), it is the gas price variation that is inevitably seen in power market movements. The chart below illustrates how the Henry Hub gas price has a higher volatility than the Powder River Basin (PRB) coal price.

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So when it comes to understanding why electricity prices move the way they do, follow the gas market and most of the intel needed for North America can be found. I.e., natural gas prices have an impact that reaches far beyond the fossil fuel industry. For renewable generation, gas prices will often be the key factor guiding the system’s overall grid price.  Furthermore, with long-term renewable power purchase agreement (PPA) deals on the rise around the world, power price forecasts are becoming more important than ever. In the U.S., that means natural gas price has a prominent role in key energy decisions, even when those decisions involve going green.

Interesting article? There’s more where that came from on the NEO Network.

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