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Fuel Market Implications for Electricity Pricing
June 2006
Those end users currently buying electricity in deregulated areas, or at least watching wholesale markets, have probably been dumbstruck by the rise in electricity prices over the past year or more. While there are many reasons for high electricity prices, including what many end users perceive as dysfunctional wholesale market design, one of the key drivers of electricity prices is clearly fuel input.
Most energy buyers – which means just about everyone in America – are aware of high gasoline prices, driven by world oil markets and the tight domestic refining industry, coupled with damage caused by hurricanes Katrina and Rita. Some, with an eye toward conspiracy theories, blame the oil industry for holding product off the market, but the real driver of oil prices is worldwide demand and limited supply. These same conditions exist domestically in the natural gas and coal industries. Demand is high, supply is snug and, as a result, prices have been driven upward. This is basic economics, the laws of supply and demand at work. The economy is relatively strong, demand for electricity and other fuels has been high, and new supply has been slow to come to market or non-existent due to government regulation of supply development.
What does all this mean for electricity pricing? The answer is higher than expected market prices. Neither utility owned nor merchant electric generating plants can generate electricity with high cost fuels and come out with low cost electricity. With coal having doubled in price over the past several years, oil having tripled from its lows in the $20 per barrel range, and natural gas having risen to a peak in excess of $15 per MMBTU before retreating to recent levels in the $7 range, electricity could not stay inexpensive for long. While we have plenty of hydropower and nuclear generation, the majority of electricity is still produced by burning coal, natural gas and oil, and the use of gas continues to increase. Using an assumed heat rate of 10,000 BTU per KWH generated, $7 natural gas produces $.07 per KWH electricity, and this is before ancillary costs, plus transmission and delivery. Given those kinds of figures, it’s easy to see the problem. Take into account the volatility of oil and gas markets and electricity buyers are being whipsawed on what seems like a daily basis.
Those customers buying power in states with deregulated electricity prices are seeing these prices today, but even those in states that remain regulated will be seeing these prices in their bills in the future. Regulation, in most jurisdictions, allows these increased fuel costs to be averaged out over time so the impact of higher costs occurs on a more gradual basis. Of course, as prices fall, these higher costs are prolonged and, at some point, the regulated price will be higher than current market price. It’s simply a case of “pay now or pay later” – higher fuel costs will be passed along to the customer in some way over some period of time, of that we can be sure.
As stated earlier, many industrials believe that wholesale and retail markets are improperly designed, and there is much to support this argument. Certainly, poorly thought out market design is a significant contributor to high electricity prices, with natural gas-fired generation often setting the price for all power generated in a given hour. But, even if we magically fix these market issues tomorrow, we will continue to see higher electricity prices than we would like until coal, oil and, in particular, natural gas prices return to lower, historic levels.
Compass Energy Services assists medium and large industrial and commercial customers with energy procurement and risk management strategies in both regulated and unregulated areas. Contact Compass for more information.
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