In case you didn’t notice (but I know those of you in the Northeast did), last week was some of the coldest winter weather in the Northeast since 1875. Not surprisingly, such a cold wave puts a strain on heating energy supplies, including natural gas. This Catallarchy post by Doug Allen, and its attached comments, address the market response: natural gas prices rose, and those prices will be passed through to at least some extent to retail customers. In responding to someone whose understanding of economics seems tinged by politics, Doug makes a very important point:
Why arificially keep heating costs low? Why encourage some people to blast the heat at 75 degrees and walk around their house in t-shirts, gobbling up what little supply there was already? By raising natural gas costs, people will learn to conserve and do more with less. For example, cut the thermostat down a few degrees, make sure closet and attic doors are shut, throw another blanket on the bed, etc. High prices force consumer conservation, leaving a little more “heat” for everyone.
Some other important facts and interpretations on this topic, most of which come from insights of industry experts I met with today at a Center for the Advancement of Energy Markets meeting:
-Natural gas markets are healthy, robust, and liquid, and have been for quite a while since deregulation in the 1980s. That means that buyers and sellers use forward contracts, financial hedges, and other instruments to manage price risk.
-One feature of healthy competitive markets is the optimization of inventories in storage. If there is a cold spell of unanticipated depth and/or duration, then the binding constraint is not supply, it’s storage. The natural gas price volatility seen in the markets in the past week reflects the unexpected demand relative to the hedges in place and relative to inventories.
-Price spikes last week did not persist, because both wholesale and retail natural gas consumers (certainly large consumers, even if not residential consumers) responded by cutting demands for natural gas that were of lower priority than heating. Electricity plants that are dual-fired found it economical to switch from natural gas to oil, for example. But it looks like all of the demand reduction was voluntary, and led to suppliers who have interruptible pipeline contracts choosing not to import natural gas, thus making the pipeline capacity constraint not bind.
Conveniently enough, the Federal Energy Regulatory Commission recently released a study of New England’s natural gas transportation and storage infrastructure.
Winter is the peak natural gas use period in New England. From December through February, much of the regionís pipeline system is fully loaded. While this situation is not unique to this region, it reduces the opportunity for New England to access natural gas from underground storage in New York and Pennsylvania. The absence of underground storage in New England, in combination with the inability to access storage in New York and Pennsylvania, makes New England dependent on its limited above ground storage, pipeline imports, and liquefied natural gas (LNG) to meet peak winter demands.
But the robustness and liquidity of markets, as well as the combination of supply response and active demand response to prices, mean that enough natural gas was available to satisfy the high heating demands on it last week. The prices at which these demands were satisfied may look high to those looking for a political angle, but simply put the fact is this: given unexpected conditions and the hedges in place to smooth out price effects from expected conditions, these high prices are the most competitive prices that can be had in this situation.
It may be little comfort to Doug’s “Jane” that if these high natural gas prices persist, then those who can make money off of delivering natural gas to New England consumers will make investments that enable them to do so, both in increasing supply and in increasing delivery and transportation infrastructure. Those investments will increase supply relative to demand (ceteris paribus, of course), and thus reduce prices. Thus, as Doug notes, high prices induce conservation on the demand side, but they also serve the very important role of inducing investment on the supply side.