Natural gas price volatility for ultimate consumers can be mitigated by distribution companies to some degree, but there is no way to totally mask the volatility engendered by short supplies for the next three to five years, according to an American Gas Association (AGA) paper issued last Thursday.

The fact of the matter is “the gas bubble is gone,” AGA President David Parker said in introducing the report. As long as the excess supply existed, customers had a smooth, low-priced ride. However, the supply short-fall has increased prices overall, and in the winter when heating load kicks in there are fewer dual-fueled industrial customers who can cushion the demand surge by switching fuels.

To the contrary, the growing demand sector represented by power generation that also must meet consumers’ needs, is inflexible. The only market more volatile than the gas market is the electric market, which, when it has to deliver power, “will pay anything for gas,” said Paul Wilkinson, AGA vice president of policy analysis.

The paper, “Avoiding the Wild Ride: Ways to Tame Natural Gas Volatility,” is based in part on an in-depth study done for the American Gas Foundation (AGF), “Natural Gas and Energy Price Volatility” also released Thursday. The latter was sponsored by the Energy Department’s Oak Ridge National Laboratory and prepared by Energy and Environmental Analysis Inc. (EEA). Both reports are available on the AGA website

The AGA paper offers methods of attempting to mitigate current gas price volatility, while the foundation study goes beyond today’s supply shortfall to conclude that, price volatility is expected to increase in the future, “without structural changes in the natural gas and electricity markets,” despite the addition in several years’ time of large supplies of LNG and Alaskan natural gas.

From 1985 to 2000 the wholesale price of gas averaged around $2.00 per MMBtu and between $5.00 and $6.00 for the retail customer, the AGA report said, with less than 10% fluctuation in prices. In the last few years wholesale prices have averaged in the mid-$4.00 range, jumping 50% from the first quarter 2000 to 1Q 2001, declining 30% for 1Q 2002 and rising again 20% in 1Q 2003.

AGA’s local distribution company (LDC) members are doing what they can in the way of using storage, financial hedging and fixed price contracts to smooth some of the wholesale market volatility, but they run into problems with state regulators who, using hindsight to review their strategies, disallow costs.

For that reason, while an AGA survey found 70% of LDCs had long-term contracts (more than one year) in their portfolios, 62% of those contracts were indexed to first of the month spot market prices. With deregulation the change in the market structure and regulatory oversight has made long-term fixed-price contracts “rare.”

Hedging has increased, however, while few LDCs hedged prior to 1995, during the 2002-2003 winter heating season 69% of gas utilities surveyed by AGA used financial instruments, the report said. It noted that “the transaction cost of financial hedging tools can often be less than physical hedges, contributing to their appeal.” But, that cost will be relatively high for hedging beyond a year because of the market’s lack of liquidity, the ERA report said.

What is not appealing is the “regulatory risk” if, for instance a utility hedges at a price higher than the market actually achieves due to a warmer than normal winter, and regulators disallow the higher costs. “In any given period, there is a roughly equal chance that the cost of the hedged natural gas portfolio will be above the market price as there is that the cost of the hedged portfolio will be below the market price.”

What the hedged portfolio does guarantee is a stable price, and certainty and predictability is what consumers value most. The paper urges regulators to pre-authorize hedging and long-term fixed-price contracts in order to allow the LDCs to offer their customers the much-prized certainty.

AGA also urges measures to increase supply, such as developing new supplies and eliminating environmental roadblocks to production and to dual-fuel facilities, which can switch to oil when gas supplies are tight.

In 1995, about 26% of industrial consumption and 35% of power generation consumption could operate on gas or oil. But the National Petroleum Council study issued recently found only 5-10% of industrial consumption and 20-25% of power generation consumption is switchable today. And even some of those that are switchable are only allowed to operate using oil for short periods because of environmental restrictions.

For the longer term there is the need to encourage projects to bring in LNG and Alaskan gas as major new supplies for the U.S. market, the AGA report said.

The EEA study also blamed “the vast majority” of the natural gas price volatility post-1999 on a lack of excess supply and a limited demand response to price changes. “With limited fuel flexibility and little reserve supply and delivery infrastructure, large price movements are inevitable….Barring structural changes, natural gas markets will be at least as volatile or more volatile in the future.”

An additional, smaller factor adding to volatility are the effects of commodity trading techniques on short-term prices. “This effect can be seen empirically in the natural gas futures market and the Henry Hub ‘cash market’ price. The impact of these forces on the Henry Hub reference price sends ripples through cash prices throughout the North American market.”

Another factor is market imperfections and market designs that allow for market manipulation. In the past “a lack of liquidity or concentration of trades in the hands of a limited number of large market participants added to volatility in various regional markets,” the EEA report said.

To reduce volatility requires strategies and policies to incentivize increasing supply or decreasing demand. A return to long-term contracts would “be an effective method of financing” development of new supply and infrastructure. But, any action would have to be directed by government, since individual companies acting alone would not have a market impact.

Regulatory action would have to guarantee cost recovery for new supply projects, but the general population, which “does not understand the fundamental causes of energy price volatility and is more likely to attribute price movements to market manipulation and profiteering,” is not likely to support added costs.

The other strategy is to “manage” volatility through the following methods:

The above elements can be “combined into an effective price-hedging program, that includes:

The American Gas Foundation report notes “it is quite difficult to enter into bilateral forward contracts more than a few months out in either the physical or financial energy markets,” due to the collapse of the major energy trading companies. “There is a lack of market liquidity and a lack of creditworthy counterparties that limits the number of long-term contracts,” and increases the cost of long-term hedges.

The overall picture is not likely to get better in the future. Over the long term “frontier” supply sources such as LNG, Alaska and new areas in Canada, are expected to increase supply, but, the EEA report states, they are not likely to reduce volatility, since, because of the huge investment and the need to spread costs, they are expected to flow regardless of market conditions.

Demand volatility will increase because of an increase in weather-sensitive and power generation load. “Without structural changes in natural gas and electricity markets, the analysis conducted in this study effort concludes that natural gas markets will remain volatile, with potentially even larger price swings in the future.”

The EEA report suggests demand side changes such as establishing minimum amounts of dual-fuel capacity for natural gas-fired generating facilities; implementing electricity demand response programs as part of the structure of regional transmission organizations (RTO); and implementing dynamic pricing for price sensitive electricity and retail gas customers

Structural changes on the supply side could include:

The principal authors of the EEA study are Bruce Henning, Michael Sloan and Maria de Leon.

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