Natural Gas: Understanding Price Volatility | TPI Efficiency Energy News

NATURAL GAS MARKETPrice Volatility

The term “price volatility” is used to describe the price fluctuations of a commodity. Volatility is measured by the day-to-day percentage difference in the commodity’s price.

The degree of variation, not the level of prices, defines a volatile market. Since price is a function of supply and demand, it follows that volatility results from the market’s underlying supply and demand characteristics. Therefore, high volatility levels reflect extraordinary supply and/or demand features.

Basic energy prices (natural gas, electricity, heating oil) are generally more volatile than prices of other commodities.

One reason energy prices are so volatile is that many consumers are extremely limited in their ability to substitute other fuels when the price of natural gas, for example, fluctuates. In addition, residential customers usually cannot replace their heating system quickly–and it may not be economical in the long run.

So, while consumers can substitute readily between food products when relative prices of foodstuffs change, most do not have that option in heating their homes.

Volatility provides a measure of price uncertainty in markets. Firms may delay investment and other decisions or increase risk management activities when volatility rises. The costs associated with such activities tend to increase the costs of supplying and consuming gas.

What Causes Volatility In Natural Gas Prices?

Major factors affecting volatility in gas markets include:

Weather Changes: Weather is a strong determinant of short-term demand. Unexpected, prolonged, or severe changes in weather can cause fluctuations in the amount of natural gas that end users demand. Weather changes can also affect supply and distribution capabilities, affecting the amount of natural gas available for end users.

Production/Imports: The amount of natural gas produced and imported makes up most of the natural gas supply available for consumption. Changes in the amount of gas produced or imported can significantly impact prices.

Storage Levels: Storage provides the critical buffer between demand and current supply (production and imports), and is often used as an indicator of the relative supply and demand conditions in the natural gas market. Storage is needed during times of high demand, and as a result, market participants may compare current storage levels with current or future demand in evaluating gas markets.

Delivery Constraints: Constraints may occur or be removed along the pipeline delivery system, which may change supply and distribution capabilities, resulting in fluctuations in the relative amount of available natural gas. Possible examples include:

Operational difficulties (production valves freezing, equipment breaking down, etc.).
The existence of pipeline or delivery bottlenecks.
The implementation of new transmission routes.

Market Information: A lack of timely, reliable information regarding the previously mentioned causes of volatility can cause price shifts as market participants are forced to base their trading decisions on rumors and speculation.

TRENDSSeasonality And Storage

In examining daily spot prices and the corresponding volatility index at the Henry Hub market center in Louisiana from January 1995 through October 2003, it becomes apparent that the natural gas market is subject to significant fluctuations in the level of volatility. However, two notable trends exist. First, a degree of seasonality is noticeable within the time series data. Second, volatility tends to be correlated with the level of natural gas in underground storage.

Between January 1995 and September 2003, the highest levels of volatility in each year occurred during the winter heating season (November through March). Also, the average monthly volatility index figure for all winter heating season months was nearly 104 percent over the entire time series. However, the average for all other months was only about 49 percent. This trend shows that the winter heating seasons were likelier to experience heightened natural gas spot price volatility.

This result is not surprising because the cold winter months create a situation where natural gas demand often surges unexpectedly while natural gas supply has less flexibility. Because space heating is an absolute necessity for most people during the winter and the substitution of alternative heating sources is, under normal circumstances, not economically or logistically feasible, much demand for natural gas during the winter is insensitive to changes in price.

On the other hand, natural gas production and imports usually cannot supply all of the gas necessary to meet the excessive winter demand. Storage levels dwindle, constraining those operators’ capability to react to market fundamentals changes (i.e., price, weather conditions, etc.) over time. The cumulative effect of inelastic supply and inelastic demand creates a situation in which any change in market fundamentals (i.e., shifts in supply or demand) will tend to generate large swings in price.

The relationship between storage levels and volatile price action is significant. The data indicate that when storage levels during any winter heating season were unusually high or low, volatility in the spot market tended to increase. Perhaps the best example is the winter heating season of 1995-1996. The average volatility index value for that winter was nearly 242 percent, the largest of the nine observed winter heating seasons. On average, storage levels during the 1995-1996 heating season were about 27 percent less than the previous 5-year average, the most remarkable average percent difference below the last 5-year average observed in the time series.

On the other hand, volatility also can be high when storage levels are unusually elevated. For example, in December 1998, storage levels were approximately 20 percent higher than the previous 5-year average for that month. As a result, that month’s volatility index reached a peak of almost 196 percent, the fourth highest monthly value on record. The high volatility reflects a rapid price decrease and recovery during that month.

CASE STUDY The Volatile Winter of 2002-2003

Volatility levels during the winter of 2002-2003 were noticeably elevated, although not unprecedented. (The 2002-2003 heating season was the second most volatile behind the 1995-1996 heating season.) Several underlying factors behind the generally higher volatility levels prevailed for the winter of 2002-2003. Major supply side factors included weak production, low imports, and inadequate storage inventories, while demand factors included higher prices for fuel oil and other substitute fuels and frigid weather.

Natural gas suppliers faced three significant realities during the winter of 2002-2003. First, natural gas production in 2002 was about 3 percent below 2001 levels, a result of a lower rate of new well completions (new well completions were 27 percent lower in 2002 than 2001) and the natural production decline as producing wells aged.

As a result, utilization of productive capacity is estimated to have exceeded 90 percent, which is a tight supply situation typically resulting in higher prices. Second, net imports of natural gas were down about 3 percent in 2002. Although imports increased, growing exports were sufficient to result in a net decline. Lastly, because a freezing winter led to massive storage withdrawals, the level of gas in storage in the United States at the end of February 2003 was more than 40 percent lower than February’s 5-year average (1998-2002). The resulting supply situation was one in which natural gas suppliers were constrained in their ability to react to changes in the marketplace.

The demand side of the market introduced its own set of challenges. In addition to the typical seasonal demand increase, additional upward demand pressures were caused by colder than average temperatures throughout the country, which caused consumers to use more gas than average for heating purposes.

For example, the 2002-2003 winter experienced about 3 percent more heating-degree-days than average. Also relevant was that fuel oil prices and other alternative fuels were relatively high during this period. For example, the average monthly price of West Texas Intermediate Crude oil during the 2002-2003 heating season was nearly 6 percent greater than the 2000-2001 heating season’s average price and 52 percent more significant than the 2001-2002 heating season’s average price.

With supply and demand extremely inelastic during the winter of 2002-2003, any movements in either side of the market would necessarily produce exaggerated price shifts. Therefore, it should be no surprise that volatility levels spiked during this period.

How Does Volatility Affect Consumers?

The impact of price volatility varies among consumers based on their overall service needs and purchasing practices. Prices to residential customers tend to be much more stable than for commercial and industrial users. Residential customers see less price variation because their bills reflect average monthly fees, which do not fluctuate as much as daily prices. Also, many residential customers stabilize their monthly bills by participating in yearly budget plans provided by their local gas distribution companies.

Further, most residential prices are within the jurisdiction of State agencies, and regulatory provisions generally tend to mitigate the impact of market conditions. On the other hand, electric power plants and other large volume consumers often rely on short-term market purchases or arrangements without fixed price terms. These consumers are willing to risk price fluctuations because of cost savings and their ability to switch to other fuels if necessary.