Volatile natural gas prices present significant challenges for developers of CHP projects – fuel price exposure typically leads end-users to demand shorter paybacks. Here, Paul Bautista reviews strategies that CHP project developers, owners and operators in the US could use to counteract volatility, including both physical and financial hedges.

The economics of CHP are greatly influenced by natural gas prices, wholesale power prices and retail electricity rates. When customers employ CHP, they reduce their electricity costs but increase fuel costs.

In the case of natural-gas-fuelled CHP, which is the industry norm, CHP users ‘trade’ the capital cost of equipment and the increased operating fuel costs for lower electric costs. Electricity savings must adequately exceed the increased natural gas and capital costs for project profitability. A term used to assess the interplay between fuel and electricity prices is ‘spark spread’. Spark spread is the difference between the cost of purchased electricity and the cost to generate from a fuel at a given energy conversion rate (heat rate). Average spark spreads vary by region, state and electric utility service territory. Site-specific spark analysis is affected by not only widely varying fuel prices but also electricity prices that are also influenced by gas prices. It is projected that power and gas prices will be even more strongly correlated.

There has been justified concern about the impact of significant volatility in natural gas prices on CHP markets over the past several years. Figure 1 shows the wide variation in prices for the past three years. From the perspective of a user considering installing CHP, or an existing CHP operator, price uncertainty often creates barriers to the installation of a project and poses an unwanted risk of exceeding operating budgets that needs to be properly managed.


Figure 1. Henry Hub natural gas prices for 2004-2006. Source: Nebraska Energy Office
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This article presents a brief overview of the current natural gas price situation, natural gas price impact on wholesale power markets, and retail electric rates.

Natural gas prices

The price of natural gas is set by a number of market and regulatory factors that include:

  • supply and demand balance and market fundamentals
  • weather
  • pipeline availability and deliverability
  • storage inventory
  • new supply sources
  • prices of other energy alternatives
  • regulatory issues and uncertainty.

Figure 2. Henry Hub natural gas spot prices (base case and 95% confidence interval). Source: Short-Term Energy Outlook, August 2006
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The current natural gas price situation is noticeably different from the price at the same time last year. Figure 2 illustrates the change in the Henry Hub spot natural gas prices and DOE’s Energy Information Administration’s short-term price forecast (Henry Hub is the pricing point for natural gas trading in the US). During a period of continued increased use of natural gas for power generation, there has been significant price volatility. Despite recovering from last autumn’s high prices (> US$12/mmBtu) and a mild 2005-2006 winter, current ‘moderate’ natural gas prices at $6-7/mmBtu are relatively high compared to the recent historical prices of $3-4/mmBtu.


Fluctuating natural gas prices have long been the concern of potential CHP users, but there are strategies to counteract this volatility (El Paso Corp.)
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A relatively warm winter weather and the large difference by which prices for future delivery contracts for the 2006-2007 winter months have exceeded spot prices account for much of the current high storage levels. Spot Henry Hub natural gas prices, which averaged $8.86/mmBtu in 2005, fell to an average $6.36/mmBtu in July 2006. The warm summer weather (causing demand for cooling/air conditioning) and the demand for natural gas for electricity generation pushed prices back up slightly in August. The DOE’s Energy Information Administration’s (EIA’s) Short-Term Energy Outlook projected the Henry Hub spot price to average $7.69/mmBtu in 2006. In actuality, the Henry Hub 2006 gas price averaged $6.94.

It is generally expected that the price of natural gas will remain relatively high. Forward gas prices are in the $7-10/mmBtu range through 2010. Even with current high storage levels, supply and demand balances are tight. This indicates another price spike is possible if there are drastic supply or demand changes, such as a major hurricane in the Gulf of Mexico (which was not the case this past hurricane season) or a severe winter.

Wholesale power prices

Wholesale power prices are greatly impacted by natural gas prices. While natural-gas-fuelled generation accounts for a relatively small percentage of US electricity generation (on the GWh basis), natural gas exerts a disproportionate influence on electricity prices in the wholesale markets because it represents the incremental generation in the most high demand hours. As price of the purchased wholesale power and retail real-time prices are increasingly based on spot power markets, the marginal cost of the most expensive marginal generation unit that sets the hourly price has a very significant effect on both hourly prices and long-term power contracts.

As shown in Figure 3, natural gas units are on the margin for a significant amount of time in Texas, Florida, California and the Northeast. This proportion is expected to grow. While this may provide an opportunity for highly efficient CHP, it has also caused many federal and state officials to focus increasingly on fuel diversity (such as clean coal, renewable energy and even nuclear) and some uncertainty on where spark spreads will ultimately be.


Figure 3. Percentage of time that natural gas generation is the marginal generation unit. Source: FitchRatings
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Retail energy rates

The end of electricity rate freezes in states that have gone through restructuring has produced some interesting results and high-profile political battles. New retail electric tariffs will begin to reflect the high costs of fuel and their impact on the costs of generation in restructured regions is severe. State legislatures and public utility commissions (PUCs) have proposed ways to mitigate the impact of the pending increases such as ‘phase-ins’, forestalling rate freeze expiration dates and ‘re-regulation’. Table 1 presents a sampling of new or pending rate increases.

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Risk management and natural gas prices

Classic management approaches to risk are well documented and used in many industries. They include the following four broad approaches to risk:

  • avoidance – includes not performing an activity that could carry risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on potential gain
  • mitigation/reduction – involves methods that reduce the severity of potential loss
  • retention/acceptance – involves accepting the loss when it occurs. Risk retention is a viable strategy for small risks. All risks that are not avoided or transferred are retained by default.
  • transfer – means causing another party to accept the risk, typically by contract.

Some ways of managing risk fall into multiple categories. The strategies for natural gas price volatility risk fall under risk reduction. Specifically, options for CHP users include fuel-switching capability, long-term contracts, and financial hedges. It needs to be emphasized that stability and predictability of prices is the objective, not reduction, of prices. Proven management strategies do not eliminate risk but rather reduce it.

Fuel-switching capability

Consumers’ responses to price changes vary by type of customer and application. Residential and commercial gas customers show very little price elasticity in the short term. However, industrial and CHP customers with dual-fuel capability can respond to price changes by switching fuel sources based upon the relationship between the gas price and the alternative fuel price.

New CHP systems or CHP plants that are scheduled for a major upgrade/modification can be installed or upgraded with dual-fuel capability. This does come with extra capital costs in addition to potential environmental compliance costs that may result from running for an extended amount of time on fossil fuels other than natural gas in non-emergency circumstances. Storage of the alternate fuel is also a requirement.

Dual-fuel capability is not available on all types and sizes of CHP equipment. Some larger reciprocating engines and industrial gas turbines have the capability to operate on both gas and liquid fuels. Performance and emissions will vary and are optimized to one type of fuel. Recent natural gas prices and customer demands for fuel flexibility may result in additional product offerings.

Long-term physical natural gas contracts

Long-term supply contracts are an option to some medium- to large-sized CHP users. This strategy is the forward physical purchase of gas over an extended period (1-5 years). Terms for payment are a projected averaged cost of natural gas through the period, such as higher near-term gas prices averaged with lower long-term gas prices.

Energy marketers are capable of offering supply products that provide customers some protection against price volatility. Typical long-term service offerings require a commitment on the part of the buyer of at least one year. When confronted with fuel volatility, most new CHP projects negotiate terms of fuel supply contracts that provide acceptable levels of predictability for at least the period of time that allows for payback of capital costs.

The economics to install a CHP system has less fuel price risk in regions (such as the Northeast, California and Texas) where there is tight correlation between electricity and natural gas prices. In these regions, increases in the cost of gas are reflected in corresponding increases in the cost of electricity. The increased value of the electricity produced offsets the additional cost of fuel input. The risk for CHP may come in conditions where there are high gas prices and stable, modest electricity prices. In this case the electricity produced by the CHP unit is less economic than grid power.

Financial hedges

Financial hedges (such as futures and options) are contractual vehicles that convey rights and obligations to buy or sell a commodity at a specified price. These financial derivatives are a method of reducing price risk with a relatively modest transaction price. Over the past 10 years the use of financial hedges has grown dramatically.

The basic concept is to utilize existing financial tools to guard against conditions that will negatively affect your operating budget. Basic hedges include:

  • swap contract – a bilateral agreement with a party that agrees to guarantee a ‘fixed’ price of gas for you
  • futures contract – a financial tool that limits your upside price exposure
  • options contract – a financial tool that can limit upside and downside price exposure (‘puts’ are a hedge against falling prices, and ‘calls’ are a hedge against rising prices).

Possible purchasing strategies using hedges are summarized in Table 2.

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Even a well planned hedged approach is not without risks. For example, a sound plan may indeed result in lower natural gas prices if the market prices are higher than expected; however, it can also result in above-market prices if the price of gas drops due to factors such as weather. There is good likelihood that the overall cost of a hedged fuel purchasing strategy will be above-market price as it will be below. Figure 4 illustrates various hypothetical risk reduction strategies and the resulting average fuel price. The CHP user pays for the added value of predictability and stability, not lower costs. In fact, over the long term the expected cost of a hedged gas purchasing strategy will be slightly above the market price of gas over the same period.


Figure 4. Hypothetical hedging strategies. Source: University of Illinois Chicago Energy Research Center (https://erc.uic.edu/)
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Conclusions

The past year has seen a notable reduction in natural gas prices from the third quarter of 2005. However, the price spikes of the past few years and the tight supply and demand balance are evidence that price volatility will be an issue for the near to mid term. Natural gas price volatility creates uncertainty and concern in the minds of potential CHP candidate sites, who may delay decisions to purchase equipment or make. Such delay may result in lost market opportunities and economically marginal projects not being pursued.

These concerns can be managed through the use of proven strategies and within the context the party’s own financial goals and risk tolerance. Physical and financial hedging components should be included in gas purchasing strategy.

These methods allow CHP developers and owners to mitigate but not eliminate price risk. These risk reduction methods come with costs (both actual and opportunity costs – they do require management and attention) but do provide the added value of predictable and stable fuel costs for CHP.

In addition to the physical and financial options discussed for CHP systems, technology improvements that broaden the available portfolio of cost-effective and clean multi-fuel CHP equipment and that enable the opportunity for fuel flexibility will help potential CHP users reduce the risks of natural gas price volatility.

Bibliography

  • American Gas Association, Avoiding the Wild Ride: Ways to Tame Natural Gas Price Volatility, November 2003
  • American Gas Association website, https://aga.org/
  • American Public Power Association, Long-Term Strategies are Key in Achieving Stable Natural Gas Prices, March 2006
  • Bautista, P., Garland, P., 2006 Combined Heat & Power Action Plan Positioning CHP Value: Solutions for National, Regional and Local Energy Issues, September 2006.
  • Bryant, P., Houston Business Journal, ‘Volatility of natural gas prices shifts focus to third-party suppliers,’ April 11, 2003
  • College of New Jersey Website, https://tcnj.edu/~powplant/
  • The Edison Foundation, Why are Electricity Prices Increasing?, prepared by the Brattle Group, June 2006.
  • Energy Information Administration website, https://eia.doe.gov/
  • United States Combined Heat and Power Association website, #/
  • University of Illinois at Chicago Energy Research Center website, https://erc.uic.edu/ngworkshop.htmL

Paul Bautista is the Managing Director of Discovery Insights LLC, Maryland, US. e-mail: paul.bautista@comcast.net

US college adopts CHP fuel management strategy

The College of New Jersey has a CHP system that consists of one 5.2 MW dual-fuel (natural gas and #2 low-sulphur oil) gas turbine and a duct-fired heat recovery steam generator (HRSG) (capacity of 12,700 kg/hour unfired and 18,100 kg/hour fired). The College developed a fuel management strategy with the goal of minimizing its risks of curtailment of fuel supply and high fuel cost. They make use of fuel-switching capability, financial hedges, and rider to its interruptible gas tariff.

The CHP gas turbine/HRSG system and three additional packaged boilers that are part of the College’s central utilities plant are capable of running on dual fuels – natural gas and #2 fuel oil. The HRSG duct burner fires on natural gas only. The College purchases tariff gas and futures contracts for both its natural gas and oil requirements as part of its purchasing strategy.

The College purchases the majority of its utility needs in the form of interruptible natural gas from PSE&G under a Cogeneration Interruptible Gas tariff (CIG). Because of the low transportation component in this rate it has continued to provide the most advantageous cost and delivery terms. This cost, however, is subject to a commodity cost component, which is highly subject to real-time market conditions. There is no option within the CIG rate for customer-owned and transported gas. This potential price volatility can cause unanticipated budget overruns when natural gas unit prices increase.

Circumstances beyond the control of the College, such as hurricanes in the Gulf of Mexico or warm winters, can be the catalyst for both price spikes and unexpected drops in demand for natural gas. This unexpected volatility in the market makes it difficult to make accurate fuel budget projections.

In order to reduce its fuel price risk the College will take a financial hedge position using NYMEX futures. The NYMEX futures will enable the College to cap its price risk for the volatile months of November through March. This is described as a ‘buyer’s hedge’, or long hedge position, and is a conventional practice of large consumers of natural gas to protect themselves from rising prices. The hedged natural gas operating costs, based on NYMEX future settlement prices, are more predictable by capping price during the critical months. Minimal funds are required to be held in reserve as a contingency.