Managing Natural Gas Volatility: The Answer is Blowin’ in the Wind

The recent shale gas boom has gained the reputation as our energy savior: clean, domestic, cheap, and plentiful. But, the attractiveness of today’s low natural gas price can cause us to overlook a serious risk: volatility.

Natural gas is one of the riskiest commodities around, historically bearing twice the volatility price risk of oil. While this is common knowledge among industry professionals and commodity traders, the long-term risk often goes ignored, despite previous attempts to put a price tag on volatility.

(For a more detailed assessment of this topic, download our discussion paper)

Why This Matters

According to RMI Chief Scientist Amory Lovins, “we must not set our sights too low and end up with a 20-year plan instead of a 21st century goal.” This logic on the importance of long-term strategy is the driving force behind RMI’s Reinventing Fire, a vision and roadmap for a 150 percent bigger 2050 U.S. economy requiring no oil, coal, or nuclear energy, and one-third less natural gas.

Without accounting for the volatility risk of natural gas, wholesale power-producing renewables don’t appear very competitive without the support of tax credits (expiring at the end of the year for wind) and renewable portfolio standards, whose incentives are less substantial than in the recent past. Investing in gas over wind without consideration of volatility would be like chasing yield without regard to risk—something a prudent investor would never dream of.

As U.S. natural gas supply grows and liquefied natural gas export terminals come online, our economy becomes more and more dependent on the success of shale; changes in natural gas prices could greatly impact the broader market. Historically speaking, natural gas tends to move opposite the market (that’s a negative beta for the finance geeks out there). As natural gas prices rise and the market falls (remember 2008?), consumers take a significant hit.

So how can we fairly compare power-generating technologies such as wind and gas? How can we make smart decisions at the utility level to select new resources that serve our energy needs today, without creating bigger cost issues just a few years down the road?

Step 1: Quantify Willingness to Pay

In order to properly compare natural gas with renewables, a volatility risk premium must be added to the price of natural gas. Wind, for example, is typically contracted over 20-30 years through power purchase agreements that offer price certainty for both the producer and consumer. Natural gas long-term contracts however are nearly non-existent due to regulatory constraints.

Adding an appropriate long-term risk premium to the price of natural gas would allow for apples-to-apples comparison of two very different cost structures and methods of power generation. But, quantifying that premium is the tricky part. There may indeed be value to diving down that deep, quantitative hole to model out scenarios that employ complicated option strategy pricing mechanisms and value-at-risk calculations, but first, why not take an empirical view of what utilities are already paying to manage their natural gas exposure?

Just like any organization that faces risk, utilities spend money on hedging (swaps, options, and other short-term contracts).

Exactly how much they spend is the result of a very careful planning process. Hedging budgets rely on two key inputs: risk tolerance and available cash. Even if we devised a theoretically all-telling magic number to value risk, a utility might not care to fully de-risk, or they might not have the funds to do so. Plus, the public utility commission would need to approve an increased budget that accounts for this new premium. So, let’s consider a more practical route—one that doesn’t require increased budgets or major changes in regulation—and incorporate what’s already being spent on natural gas volatility risk mitigation.

Step 2: Re-assess Energy Options

Once we know what a utility is paying to hedge natural gas, whether it’s limited ($0.50/mmBtu) or substantial ($2.00/mmBtu), we can add this to the price of their purchased gas for a much more accurate comparison to wind PPAs:

By simply including the cost of hedging to pare up two very different risk profiles, we can see that wind becomes competitive with combined-cycle gas years sooner than commonly believed.

Step 3: Unleash the Benefits

Utilities and ratepayer advocacy groups can integrate a full assessment of long-term gas volatility in petitions to PUCs to gain approval for new wind investments that will serve as a hedge and protect customers. Utilities can demonstrate that redirecting a portion of their current hedging cash flows into wind PPA contracts can reduce volatility risk without increasing their annual hedging budget. If employed nationwide, this strategy could have substantial implications for the future of domestic wind development.

Large commercial customers can also take advantage of wind’s hedge value by signing direct PPAs to realize a reduction in overall risk exposure. Google, for example, has already signed two wind PPAs with NextEra Energy to power its data centers in Iowa and Oklahoma. While residential utility customers cannot individually sign onto wind PPAs, they can participate in green power programs that reduce their exposure to fluctuating fuel prices. Although many utilities offer green rates, customers should be on the lookout for programs like Austin Energy GreenChoice, which specifically exempts them from increases in fuel costs.

Although natural gas prices are depressed and volatility is lower than usual, enough volatility remains to present risks to consumers at all levels: utilities, industrial and commercial customers, and residential customers. Many utilities are already paying to hedge against the risk of an unexpected upward swing in prices in the near-term, but remain exposed in the long run.

Managing long-term natural gas volatility, it turns out, can actually be aided with increased wind development even without renewal of the federal Production Tax Credit and RPS pricing support. Turns out that Bob Dylan guy was on to something.

Note: If you and/or your organization is interested in further exploring this topic with RMI, please contact Dan Seif at RMI at dseif@rmi.org.

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