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Natural Gas Price Drivers

We have noted previously on this blog that natural gas prices have declined dramatically over the last three years. On January 19, 2012 the February futures contract settled at $2.32 per million Btus. This is lower than natural gas prices have been in a decade and we are in the winter heating season, a time when prices generally rise. Adjusted for inflation, prices have not been this low since late 1998.

Looking ahead, the graph below shows the evolution of the twenty-four month natural gas futures curve over the last year and a half. It may seem counterintuitive, but as the futures curve has dropped it has remained upward sloping. In other words, as natural gas prices have declined, the market has continued to expect prices to rise in the future.

Several readers have asked what the major influences on natural gas prices are. Natural gas is very much a commodity and, as such, its price at any point in time is subject to the economic interaction of supply of and demand for natural gas. For our purpose here we have identified a number of influences and grouped them into those that create upward pressure on natural gas prices and those that will continue to moderate natural gas prices.

Influences that could drive natural gas prices upwards:

– Economic recovery
– Coal fired power plant shutdowns
– Greater industrial use of natural gas
– The development of a US LNG export trade
– More restrictive regulation of hydraulic fracturing (fraccing or fracking)
– Natural gas well shut-ins
– Decreased drilling for natural gas and the shift to more profitable oil basins

Influences that will continue to moderate natural gas prices:

– Further development of shale gas reserves, particularly the Utica Shale in the Appalachian Basin
– Drilling to hold onto mineral leases

This list is certainly not comprehensive but should serve as a good starting point. We will discuss these influences in this and future blog posts.

The Avalon Advantage – Visit our website at www.avalonenergy.us, call us at 888-484-8096, or email us at jmcdonnell@avalonenergy.us.

Copyright 2012 by Avalon Energy® Services LLC

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Cape Wind

It was recently reported that a power purchase agreement between National Grid and Cape Wind was approved by the Massachusetts Supreme Judicial Court. National Grid is committed to purchasing half of the output of the project at a starting price of 18.7 cents per kilowatt-hour. This price will then escalate 3.5% per year for 15 years.

With this 3.5% annual compounding, the contract price will reach 30.3 cents/kWh in the fifteenth year. Over the term of the agreement, the average price from Cape Wind will be 24.1 cents/kWh. How do these prices for wind generated electricity compare to historical electricity prices in New England?

The above graph shows the daily price of electricity in NEPOOL over the period of time spanning 2001 through 2011 (blue line). NEPOOL is New England’s bulk electric power market. In New England, as is the case elsewhere, electricity prices exhibit considerable volatility. Over this eleven year period, daily electricity prices have been as high as 31.2 cents/kWh and as low as 2.5 cents/kWh, and have averaged 6.3 cents per kWh (red line).

Electricity prices in New England have been declining. Since the beginning of 2009, daily electricity prices have averaged 5.2 cents/kWh.

So, how does the cost of electricity from the Cape Wind project compare to historical prices in New England? In order to provide a visual sense, the two graphs above are reproduced below, each modified to have the same vertical axis scale. In both cases, the horizontal red line represents the historical average wholesale price of 6.3 cents/kWh.

Cape Wind’s website describes their project as consisting of 130 wind turbines that can produce up to 430 megawatts of electricity. Assuming a 25% capacity factor and the application of both the historical average NEPOOL price and the average Cape Wind contract price to the total projected output of the wind farm, the annual difference in cost is estimated to be $167 million.

The Cape Wind project represents a large, long position in what today is expensive electricity with a fixed escalator. This analysis is limited and does not reflect future price movements (up or down) in the cost of electricity associated with the existing and future fleet of generation in New England nor the environmental, social and operational costs and benefits associated with the existing and future fleet of generation and the Cape Wind project.

The Avalon Advantage – Visit our website at www.avalonenergy.us, call us at 888-484-8096, or email us at jmcdonnell@avalonenergy.us.

Copyright 2012 by Avalon Energy® Services LLC

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Best Friends? – Natural Gas and Electricity Prices

We have looked at historical and forward natural gas prices. How have electricity prices been behaving?

The graph above shows the monthly average of electricity prices at PJM West (a trading hub where electric generation is concentrated) spanning the 131 month period of time of January 2001 through November 2011. Like natural gas, electricity prices peaked during 2008, declined, recovered somewhat, and then declined again. The relationship between electricity prices and natural gas prices can be seen better in the graph below:

Please note that in this graph electricity prices have been converted to cents per kilowatt-hour. When plotted together, electricity prices and natural gas prices seem to track closely, and the reality is that they are closely related. In the Mid-Atlantic, electricity prices and natural gas prices are strongly correlated. Natural gas fired generating units are usually the marginal units called upon by the grid operator and, as such, set pricing in the wholesale markets. So, generally in the Mid-Atlantic, as natural gas prices go, so go electricity prices.

While electricity price and natural gas prices tend to move together, the relationship between the two does change over time.

The graph above shows the correlation on a rolling 24 month basis. Over this period, the correlation between electricity and natural gas averaged 71% but has been as high as 97% and as low as 21%. The weakest correlation was during 2008, when natural gas prices moved upward more vigorously than did electricity prices. After having moving up to 97%, the correlation has been declining over the last two years.

In the above graphs, you can see how over the last two years, electricity prices have recovered more strongly than natural gas prices, leading to declining correlations between the two.

The Avalon Advantage – Visit our website at www.avalonenergy.us, call us at 888-484-8096, or email us at jmcdonnell@avalonenergy.us.

Copyright 2012 by Avalon Energy® Services LLC

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Natural Gas Prices – Looking Ahead

We have looked extensively at historical natural gas prices, both nominal and real. What does the market tell us about where natural gas prices may be headed in the future?

The above graph shows the monthly “forward curve” for natural gas at four different points in time. The forward curve represents the collective thinking of many, many market participants, both hedgers and speculators, who put real money on the line. While we know with a high degree of probability that actual natural gas prices will differ from those predicted by the forward curve, the forward curve is the best indicator of future prices that we have. Of course, the forward curve changes on a minute by minute basis as market sentiment changes.

The lines on the graph represent the market’s expectations for the price of natural gas for each of the following 24 months as of points in time during July 2010 (blue line), January 2011 (green line), June 2011 (yellow line) and, most recently, December 2011 (red line). Prices are expressed in dollars per million BTUs ($/mmBtu). These four points in time span approximately 18 months.

What do these curves tell us? Two observations stand out.

First, in each case, the curves are upward sloping, meaning that as of each of the four points in time, the market has expected natural gas prices to rise in the future. This is known as contango.

Second, over time, the forward curves have shifted downwards.

In fact, if we take the average price of each forward curve, over the 18 month period, as shown in the table above, the curves have declined by 30%, from $5.20/mmBtu to $3.64 mmBtu. This is a dramatic drop.

Looking at the July 2012 delivery month, eighteen months ago the market expectation for this month was $5.37/mmBtu (blue line). At the end of December 2011, the expectation for the same month was $3.24/mmBtu (red line).

It may seem counterintuitive, but while natural gas prices in the forward market have declined, the market still expects prices to rise in the future. Whereas during July 2010 natural gas was trading at $4.59 for the prompt month (the forward month nearest in time) and at $5.37 twenty-four months out, at the end of December 2011, the market was trading at $2.99 for the prompt month and at $4.42 twenty-four months out.

What does the forward market say about natural gas prices beyond 24 months?

The above graphs shows the same four forward curves as above, but extended out to 60 months. The curves continue to be upward sloping, indicating that the market expects natural gas prices to rise.

Looking at the July 2015 delivery month, eighteen months ago the market expectation for this month was $6.07/mmBtu (blue line). At the end of December 2011, the expectation for the same month was $4.52/mmBtu (red line).

The most recent forward curve indicates that the market continues to expect natural gas prices to rise, specifically from $2.99 per mmBtu to $5.28/mmBtu over five years.

The Avalon Advantage – Visit our website at www.avalonenergy.us, call us at 888-484-8096, or email us at jmcdonnell@avalonenergy.us

Copyright 2012 by Avalon Energy® Services LLC