The term “price volatility” is used to describe price fluctuations of a commodity. Volatility is measured by the day-to-day percentage difference in the price of the commodity. The degree of variation, not the level of prices, defines a volatile market. Since price is a function of supply and demand, it follows that volatility is a result of the underlying supply and demand characteristics of the market. Therefore, high levels of volatility reflect extraordinary characteristics of supply and/or demand.
Prices of basic energy (natural gas, electricity, heating oil) are generally more volatile than prices of other commodities. One reason that energy prices are so volatile is that many consumers are extremely limited in their ability to substitute other fuels when the price, of natural gas for example, fluctuates. Residential customers usually cannot replace their heating system quickly--and in the long run, it may not be economical to do so. So, while consumers can substitute readily between food products when relative prices of foodstuffs change, most do not have that option in heating their homes.
Volatility provides a measure of price uncertainty in markets. When volatility rises, firms may delay investment and other decisions or increase their risk management activities. The costs associated with such activities tend to increase the costs of supplying and consuming gas.
What Causes Volatility In Natural Gas Prices?
Major factors affecting volatility in gas markets include:
Weather Changes: Weather is a strong determinant of short-term demand. Unexpected, prolonged, or severe changes in weather can cause fluctuations in the amount of natural gas that is demanded by end users. Weather changes also can affect supply and distribution capabilities, which can affect the amount of natural gas that is available for end users.
Production/Imports: The amount of natural gas produced and imported makes up a majority of the natural gas supply that is available for consumption. Changes in the amount of gas produced or imported can have significant impacts on prices.
Storage Levels: Storage provides the critical buffer between demand and current supply (production and imports), and is often used as an indicator of the relative supply and demand conditions in the natural gas market. Storage is needed during times of high demand, and as a result, market participants may compare current storage levels with current or future demand in evaluating gas markets.
Delivery Constraints: Constraints may occur or be removed along the pipeline delivery system, which may change supply and distribution capabilities, resulting in fluctuations in the relative amount of available natural gas. Possible examples include operational difficulties (production valves freezing, equipment breaking down, etc.), the existence of pipeline or delivery bottlenecks, and the implementation of new transmission routes.
Market Information: A lack of timely, reliable information regarding the previously mentioned causes of volatility can cause shifts in prices as market participants are forced to base their trading decisions on rumors and speculation.
Trends: Seasonality And Storage
In examining daily spot prices and the corresponding volatility index at the Henry Hub market center in Louisiana from January 1995 through October 2003 (Figure 1), it becomes apparent that the natural gas market is subject to significant fluctuations in the level of volatility. However, two notable trends exist. First, a degree of seasonality is noticeable within the time series data. Second, volatility tends to be correlated with the level of natural gas in underground storage.
Between January 1995 and September 2003, the highest levels of volatility in each year occurred during the winter heating season (November through March). Also, over the entire time series, the average monthly volatility index figure for all winter heating season months was nearly 104 percent while the average for all other months was only about 49 percent. This trend clearly shows that the winter heating seasons were much more likely to experience heightened natural gas spot price volatility.
This result is not surprising in that the cold winter months create a situation where natural gas demand often surges unexpectedly while natural gas supply has less flexibility. Because space heating is an absolute necessity for most people during the winter coupled with the fact that the substitution of alternative heating sources is, under normal circumstances, not economically or logistically feasible, much demand for natural gas during the winter is insensitive to changes in price. On the other hand, production and imports of natural gas are usually unable to supply all of the gas necessary to meet the exaggerated winter demand, causing storage levels to dwindle, which over time constrains the capability of those operators to react to changes in market fundamentals (i.e. price, weather conditions, etc.). The cumulative effect of inelastic supply and inelastic demand creates a situation in which any change in market fundamentals (i.e., shifts in supply or demand) will have the tendency to generate large swings in price.
The relationship between storage levels and volatile price action is very important. The data indicate that when storage levels during any winter heating season were at unusually high or low levels, volatility in the spot market tended to increase. Perhaps the best example of this is the winter heating season of 1995-1996. The average volatility index value for that winter was nearly 242 percent, the largest of the nine observed winter heating seasons. Storage levels during the 1995-1996 heating season on average were about 27 percent less than the previous 5-year average, which was the greatest average percent difference below the previous 5-year average observed in the time series. On the other hand, volatility also can be high when storage levels are unusually elevated. For example, in December 1998, storage levels were approximately 20 percent higher than the previous 5-year average for that month. The volatility index for that month reached a peak value of almost 196 percent, the fourth highest monthly value on record. The high volatility reflects a rapid price decrease and recovery during that month.
Case Study: The Volatile Winter of 2002-2003
Volatility levels during the winter of 2002-2003 were noticeably elevated, although not unprecedented. (The 2002-2003 heating season was the second most volatile behind the 1995-1996 heating season.) There are a number of underlying factors behind the generally higher volatility levels that prevailed for the winter of 2002-2003. Major supply side factors included weak production, low imports, and low storage inventories, while demand factors included higher prices for fuel oil and other substitute fuels, and unusually cold weather.
Suppliers of natural gas faced three significant realities during the winter of 2002-2003. First, natural gas production in 2002 was about 3 percent below 2001 levels, a result of a lower rate of new well completions (new well completions were 27 percent lower in 2002 than 2001) and the natural production decline as producing wells aged. As a result, utilization of productive capacity is estimated to have exceeded 90 percent, which is a tight supply situation typically resulting in higher prices. Second, net imports of natural gas were down about 3 percent in 2002. Although imports increased, growing exports were sufficient to result in a net decline. Lastly, because an unusually cold winter led to massive storage withdrawals, the level of gas in storage in the United States at the end of February 2003 was more than 40 percent lower than February’s 5-year average (1998-2002). The resulting supply situation was one in which natural gas suppliers were constrained in their ability to react to changes in the marketplace.
The demand side of the market introduced its own set of challenges. In addition to the typical seasonal demand increase, other additional upward demand pressures were caused by colder than normal temperatures throughout the country, which caused consumers to use more gas than normal for heating purposes. The 2002-2003 winter experienced about 3 percent more heating-degree-days than normal. Also relevant was that the prices of fuel oil and other alternative fuels were relatively high during this period. For example, the average monthly price of West Texas Intermediate Crude oil during the 2002-2003 heating season was nearly 6 percent greater than the 2000-2001 heating season’s average price, and 52 percent greater than the 2001-2002 heating season’s average price.
With supply and demand both being extremely inelastic during the winter of 2002-2003, any movements in either side of the market were necessarily going to produce exaggerated price shifts. It should therefore be no surprise that volatility levels spiked during this time period.
How Does Volatility Affect Consumers?
The impact of price volatility varies among consumers based on their overall service needs and purchasing practices. Prices to residential customers tend to be much more stable than for commercial and industrial users. Residential customers see less price variation because their bills reflect monthly average prices, which do not fluctuate as much as daily prices. Also, many residential customers stabilize their monthly bills by participating in yearly budget plans provided by their local gas distribution companies.
Further, most residential prices are within the jurisdiction of State agencies, and regulatory provisions generally tend to mitigate the impact of market conditions. On the other hand, electric power plants and other large volume consumers often rely on short-term market purchases or arrangements without fixed price terms. These consumers are willing to risk price fluctuations because of cost savings and their ability to switch to other fuels if necessary.