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The energy market likes to see itself as central to the economy -- and it is. However, the front month volatility of NYMEX natural gas contracts has been over 70% recently and the intraday volatility can exceed 200%. When does this risk become unacceptable to businesses and they vote with their feet?
One thing for the US energy industry to remember is that not all governments are taking the same approach as the US towards energy markets. Asian markets, for example, are taking a much more cautious approach to deregulation and are asking themselves if the US paradigm is appropriate. Crude oil markets are global -- the natural gas market isn't. Major consumption shifts can have large impacts on US natural gas market participants. The question of whether volatility can cause permanent impacts to consumption is not as far fetched as it appears.
The cost of energy can be anywhere from 75% or more of production costs (in the chemical to fertilizer industries) to less than 10%. However, a company with 10% of production costs still has major exposures. For example, in a 60% volatility market, this means that the market expects that the cost of energy could move over 3.75% -either direction in a day. The one-year volatility is around 30% - this implies the market expectation of the cost of the one-year strip could vary by over ten cents every day. For a 10,000 MMBtu per day consumer that is an expectation of a $365,000 shift in annual costs every single day.
Investment is driven by perceived risk/reward ratios. If other governments use market regulation to control risk and utility rate structures to subsidize industry, then they have lowered investment risk. While it is true that most regulators over collect the cost of capital investment for serving them from the industrial consumers, it is also true that many systems manage the volatility of energy prices for the industrial consumer.
In addition, I have written previously about the increased cost of risk capital in the energy business caused by the deregulation process. This cost easily exceeds $5-6 Billion per year. Add to this the fact that the deregulation of electricity prices changes the fundamental relationships in the ownership and management of the production options (use of generation assets) in a manner that has an undeniable upward pressure on the risk premium cost for hedging from the consumer side and you have a significant impact on investment decisions.
At some point the capital investor votes with their feet – and they already are doing so. While labor costs are a major point in the relocation of facilities, energy is inescapably another measurable pressure. At some point the discourse will reach the level where the nattering classes cannot be ignored. The question is – will the industry have any answers? Where are the stable market structure solutions?
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You raise some excellent points in this article but I'm not sure I agree with your premise that the degree of volatility we're seeing in energy markets is problematic. Setting aside some of the technical details like marked-to-market accounting, all this volatility has some positive attributes:
1) It gets energy consumers to think more seriously about limiting their exposure to volatility by hedging.
2) It sends short-term price signals that help deal with short-term supply/demand imbalances.
3) It motivates producers and consumers to think about storage options
Price stability takes away a lot of the anxiety that, if properly channeled, motivates buyers and sellers to protect themselves. When government gets involved, there's a real risk that sellers will focus on pleasing their regulators rather than focusing on customer needs. Similarly, when buyers depend on government action to protect them from market risk, the result is often special carve-out provisions that put the interests of narrow constituencies ahead of the common good.
I think government's involvement in energy markets needs to be limited to an oversight role that ensures fairness, transparency, and very severe punishment for manipulation and violation of the rules.
Richard McCann 10.28.04
Showing consumers the true cost of their resource use can only have a beneficial effect. Introducing regulation to suppress prices is just another form of subsidy where one group benefits from subsidies provided by other groups. The world's resource industries are full of these subsidies, and they invariably lead to overconsumption of those resources. If we could remove these subsidies, we would find the world environment much better off, and perhaps even the word's economy.
I agree with Mr. Ellis' point that government's role should be to look for market abuses. Unfortunately, our current government too often confuses unfettered volatility with these abuses and fails to step in where appropriate. Encouraging greater investment in deregulated markets requires just as much consumer confidence as it does investor confidence, and the FERC seems to have ignored this condtion.
Victor Bush 10.28.04
There is a fundamental difference in the way financial traders (i.e. hedge funds) invest for financial gain and the way the end users (commercial and industrial) buy a necessary commodity. If the commodity were not a necessity, that is if the buyer could chose to buy or not buy, then the current system works well. But if there is no substitute for the must-buy commodity, the dynamics are dramatically changed and the actual consumer of the commodity is put at a disadvantage. Are we actually seeing the true cost of the commodity or is it being skewed by short-term speculation?
Thomas Lord 10.28.04
The problem that I was pointing to is that hyper volatility (and 70% vol gets there) becomes an unacceptable business risk. Since senior managers - in many cases - do understand the optionality of their native risk, their response is to work to have the volatility reduced. If a government is willing to provide that risk management at a perceived lower cost - by spreading volatility over a broader period through annualized or longer rates - businesses will find that increasigly attractive as volailtiy increases. The first comments are correct IF ALL MARKETS ARE THE SAME STRUCTURE. The point was that the US competes with other regulated markets - there is discussion that Germany is looking at reregulating. At some point market efficiency is trumped by the willingness of companies to move to the lower perceived cost structure.
I would agree that short-term speculation is skewing US market volatility. However, the ability to moves markets is likely to encourage - not discourage - speculative action. THE SOURCE of the cause is not as critical as the result - though I would argue that companies not in the energy business are even more likely to seek regulated markets if they believe speculators have the upper hand.
Len Gould 10.28.04
Thank you for initiating this important discussion with a well-presented article. I've nothing againsts fair free markets, and maybe the (for end users) many negative and ?? positive outcomes of this deregulation thing ARE just conicidental ....
Edward Reid, Jr. 10.28.04
Price stabiity has both costs and benefits. Federal wellhead price controls resulted in stable natural gas wellhead prices and in natural gas shortages. State regulation of utilities results in rate stability and, as you stated, some "funky" (but politically correct) cost allocation distortions. Deregulation, to the extent that it has actually been permitted to occur, has reduced some of the traditional stabiity which resulted from regulation. Restructuring, to the extent that it has actually been permitted to occur, has further reduced traditional stability while adding significant flexibility to the restructured markets.
I believe we make the mistake of assuming that, since we can purchase energy on the spot market, we must therefore do so. There is still no law against customers and suppliers entering into long term energy contracts, when it is in the interests of both parties. Firm supply contracts plus firm transportation contracts equals stable price and reliable delivery, probably at prices very similar to rates resulting from the traditional ratemaking process.
There is also nothing to prevent customers from exploring for and developing their own natural gas supplies and arranging to have the gas transported to them. This approach internalizes the E&P risk, but also the potential rewards.
Customers today can opt to take as much price and delivery risk as they wish, or to minimize their risks in a variety of ways. This "brave new world" is not as simple as the old regulated environment, but it sure allows customization of service and price.
Thomas Lord 10.28.04
You know I agree with the premise that efficient markets make for more efficient choices - though sometimes the definition of "efficient" requires more work than just throwing the doors open. The problem I was focusing on is that an open market with high volatility may be considered much less attractive for the energy user than a regulated market next door. If the inefficiency costs are - for the consumer - considered to be a lower risk than the volatility risks and cost, then investment may shift. You can customize all you want but have nothing if the customers go elsewhere or, potentially worse, the customers may say that they feel the costs of inefficiency in regulated retail rates - as opposed to wholesale - are considered lower than the operating, working capital and hedging risks. The market has proven that regulated retail rates can coexist with open market wholesale rates. That is the "risk" to open markets.
John Sodergreen 11.2.04
I think one could argue that if not for the latest spate of price volitility, or for that matter the general level of volitility that will always follow the power and gas markets, the recovery we're all enjoying right now would have been pushed back a couple years. Last time I checked, all that juicy new liquidity from the financial services sector and from so-called hedge funds has brought this market back to life -- almost dispite itself. They wouldn't be here if not for the volitility. Energy users at this point, I believe, know the drill; it's a tough market out there, has been for a decade. They can either learn to manage risk themselves, or have somebody else do it for them. Just like any other commodity market. The idea that regulated retail markets can co-exist with open market wholesale may be the reality, but it is hardly the optimum model. A zillion studies out there tell us that the patchwork market is a bad idea, and everybody suffers. This is pretty clear. The two models co-exist because they have to. And the market has somewhat adapted itself, as it always will. But, this co-existance I'd more liken to a cease-fire in the Kashmir, than how it is described here. Capital investors aren't going anywhere; or at least they're not running away. As the saying goes, and in the case of any business, "you places 'yer bets, you takes yer chances."
Rick Devaney 11.2.04
Tom: I think that your points are well taken. However, I don't understand why everyone is overlooking the regulator of volatility, NYMEX. NYMEX has done all that it could to encourage volatility in the Natgas Contract by raising or eliminating caps on daily contract price movements. NYMEX could easily and simply control the volatility of the the Natgas Contract by installing prompt month daily caps and lowering the caps on the out months. Simply done, no governmental interference, and satisfied consumers. But wait! It's the paper traders that run NYMEX, not the physical traders! The paper traders make money from volatility, so I guess NYMEX will continue to encourage volatility.
Moral of the story: Anyone who cedes pricing of their sales or purchases over to someone else, especially someone else who doesn't share their pain nor their success, gets what they deserve. The utilities, consumers, and producers wanted price transparency. They now have it at the cost of volatility. That was their bargain with the Devil.
PS: Where is the hue and cry for transparency in OTC basis (e.g. transportation) trading? I guess the utilities wanted transparency in what they buy, not what they sell........ or is it fool me once shame on you, fool me twice shame on me?
Len Gould 11.5.04
An interesting article: http://www.darandcompany.com/Gas%20Professionals.htm