Is It Hot Enough For You? And What Is the Effect On Electricity Prices?

Even though not completely over, the summer of 2016 will be one to remember. Most people would think of the Rio Olympics or the current political circus, but as an energy nerd I will remember the heat. Cooling Degree Days is a measure of the day’s temperature to the energy demand of air conditioning. The higher the Cooling Degree Days the more energy is needed to keep us comfortable. The Cooling Degree Days on record for the summer of 2016 have already placed it as the third hottest on record and could outpace the hottest set in 2011. This hot summer has increased demand on PJM (the independent grid operator) to levels not seen in years.

Typically when extreme weather events occur the energy markets react with increased prices. Even short term events (e.g. polar vortex) can cause long term forward markets to respond. So you would think that these markets were screaming during the third hottest summer on record right? Well, surprisingly the answer is no. In fact, pricing is hovering just above all-time lows in the forward electricity markets and the daily average index broke $40 only four days this entire summer. What does this type of benign pricing reaction say about the fundamentals of the market today?

Econ 101 would suggest that the market is fairly inelastic, which means that the responsiveness in demand is not creating an equal or greater change in price. Living through the energy markets of the 1990’s, this seems completely foreign to me. Have the market fundamentals changed so much that long term price elasticity has been impacted?

Let’s start with the basics of our supply situation. The nearby Marcellus and Utica shale production regions are providing an abundance of natural gas. The producers in these regions are continuing to crank out production despite forward natural gas prices just above $3.00 per MMBtu. More than ever, this gas is being used to generate electricity. In fact, the Energy Information Association reported that for the first time ever, natural gas was pulled out of storage during the summer for power generation burn. In addition, natural gas fired generation output will outpace coal fired generation for the first time ever on an annual basis. Even with the increased demand for natural gas, NYMEX prices for the coming month did not break $3.00 per MMBTU and storage inventories continue to be above the five year highs.

All this natural gas generation creates another over supply situation with coal. Coal fired generation is still a huge contributor to our generation portfolio. However, the displacement of some of these units to natural gas is creating coal pile inventories that are now above the five year maximum even as coal production is well below five year lows. This over-supply is keeping a lid on coal pricing.

So if both fuels used to make a majority of our power is over supplied then the only major thing left to create bullish price movement would be a shortage of generating units themselves. Reserve margin is a measure of generation available above forecasted peak demand.  PJM calculated the required reserve margin for this summer to be 16.4% driven by their peak forecast. Based on PJM’s 2016 Summer Outlook Report, the amount of reserve margin on hand was nearly double at 28.3%. This high reserve margin is further evidenced by the fact that no emergency demand response events have been called anywhere in PJM this summer.

I guess the answer is pretty clear. The over supply of natural gas, coal inventories and generating reserves is definitely having an impact on prices. Even during the extreme heat this summer, electricity prices could not make any meaningful bullish run.  This is great news for buyers of energy as this is not likely a short term effect but rather a fundamental change in the price elasticity of the electric market in Ohio.