How Electricity & Gas Providers Set Prices And How to Buy Smarter!
By Carolyn Cantrell
If you buy electricity, you are a “Futures” trader!
As self-storage property owners or managers, you might not consider yourself a commodity “futures” trader. However, if you buy Electricity or Natural Gas in a deregulated market, you are a “Futures Trader.” And, if you aren’t aware of the futures market for natural gas, you are missing out on the opportunity to “buy low” and “sell high.”
Here’s chart of natural gas prices over the last 10 years:
Those ugly “highs” in the market cause both the price of natural gas and electricity to cost a lot more! The better news is that those lovely “lows” can reduce the cost on both utilities. It makes intuitive sense that the cost of natural gas on the market affects the price of natural gas; but, why would it affect the price of electricity?
The reason is simple. Power plants often use natural gas to run the generators (although there are nuclear, coal, and other fuels used in the United States as well). Nuclear and coal plants have fairly stable fuel costs, while the price of natural gas is extremely volatile.
In many markets, the real-time, hour-ahead and day-ahead market prices for electricity are set by a process called locational-based marginal pricing, known as “LBMP.” The LBMP is set as power plants offer to supply power to the grid.
Coal-fired power plants, being relatively inexpensive to operate, bid into the market at a low rate. Nuclear power plants find it difficult to turn their power plants on and off and are eager to keep their power flowing into the grid, so they typically will bid into the market at a relatively low price as well. Natural gas-fired power plants find it easy to turn on and off their plants at a moment’s notice, and only want to operate if they can be assured of making a profit on their fuel consumption, so they bid into the market at rates that move in step with natural gas spot market prices.
As the grid operator measures demand on the grid, power plants are called on to supply power into the grid in the order of their bids, low cost to high. As the last (highest cost) unit of power is called on to serve the grid’s needs, all of the power plants called on to supply power end up being paid the cost that the last power plant has bid into the market. This means that if the natural gas-fired power plants are the last plants in, they set the price for all the power consumed on the grid.
The result of all this is that if the price of natural gas moves up, the price of electricity will rise too. Fortunately, as we have seen over the past few years, if the price of natural gas falls, so too does the price of power.
Since we know that the price of natural gas change our cost of both utilities, does that mean we need to wait (and hope) that the gas market will go down before we sign a contract? Absolutely not. In fact, waiting and hoping is probably not the best strategy for any purchase. If the prices are cheaper for next year’s electricity, and we can lock in a price now without having to pay for it until we use that electricity, it is one of the best operational decisions you can make—especially if you can even lock in a price for more than one year.
Electricity is only pennies per Kilowatt Hour! But, storage facilities often use a lot of kilowatts
Example: A storage facility consumes 1,000,000 kilowatt hours per year, hence, the real world price difference could be as follows:
Buying at 14 cents per kilowatt hour
$0.14/kWh x 1,000,000 kWh (usage per year)
Buying at 5 cents per kilowatt hour
$0.05/kWh x 1,000,000 kWh (usage per year)
That’s a dramatic savings per year, and this is an extreme example of possible differences in contract rates due to market movement. However, whether the market is more or less volatile, the example does show that market movements in natural gas prices have a direct and constant effect on electricity.
It also makes sense to keep an eye on the market all year long so that you buy at opportune moments, not just at the same time each year when the contract comes up for renewal. Storms in the Gulf of Mexico, war in the Middle East, stock market movements, and general national economic performance can all have an impact on energy commodity prices, so it pays to watch for market movements that occur when certain types of news items take place.
$0.0502/kWh vs. $0.0568/kWh
What are these numbers? This is a range of electricity contract rates offered on a recent day by a set of 18 electricity suppliers willing to serve commercial customers in Texas. Using the 1,000,000 kilowatt hours (kWh) usage per year example above, this range of rates has the following impact on the bottom line:
$0.0502/kWh x 1,000,000 kWh (usage per year)
$0.0568/kWh x 1,000,000 kWh (usage per year)
If there was a difference in the quality of electricity that the property received, we might consider an additional $6,600 a year as a reasonable charge. However, there is no difference in the quality of electricity, regardless of the price you pay!
Real estate value is determined by factors including the market capitalization rate. At a 10% cap rate, the increase in the property value from going with the low cost provider is a healthy $66,000.
The cost savings and increase in value accrue to the building owner simply by exercising care and attention in the process of electricity procurement. Competitive electricity and gas supply cost negotiation is possible in the following states:
New Mexico – gas only
Arizona – new market
Do it the Right Way — Seek Guidance from a Professional
Getting guidance from an energy procurement professional in this complex purchase is highly advisable. To choose an energy consultant, as with any other professional, I recommend a review of their current portfolio, list of providers that work with the consultant, and references from long-term clients.
In summary, a good electricity purchase can provide lower operating costs, budget certainty, and a financial asset to your self-storage property.