Hedging Power Prices

July 25, 2017

Retail electricity prices are primarily determined by wholesale futures contracts traded in the commodities markets (i.e., NYMEX and I.C.E.). Energy futures are extremely volatile because they are driven by ever-changing supply and demand fluctuations. Commodity traders tend to minimize investment volatility by “hedging” the risk of future adverse price fluctuations with futures contracts that lock-in the commodity’s price for a certain amount based on a specific date. As prices fluctuate over time, traders can either close out or hold their futures positions to make money or minimize losses.

Line graph showing 24 month rolling forward strip prices in Mass Hub by year

Unlike commodity traders, buying an electricity or gas contract commits you to the deal with no opportunity to resell or terminate the contract. You can, however, secure an electricity or gas contract years before it begins based on current future prices. This provides an opportunity to lock-in attractive rates when prices cycle to historical lows and hedge against the possibility that higher prices will prevail as your current contract expires.

Line graph showing 24 month rolling forward strip prices by year for NI Hub

There are two basic strategies for hedging electricity or natural gas contracts. One is to split your total load into several equal-sized blocks and contract for each block over sequential points in time. For example, if you split your annual load into 12 blocks, you could secure a block each month leading up to your current contract’s expiration date. This would average-out or smooth the market’s price fluctuations and hedge against acquiring the entire load when prices are spiking upward.

Line Graph showing 24 month rolling forward strip prices by year for North Zone

Line graph showing 24 month rolling forward strip prices by year for West Hub

The second strategy is to carefully evaluate price trends and estimate when prices are most attractive compared to their historical lows. For example, the accompanying charts show how forward power strips for wholesale electricity prices have dropped precipitously over the past few years as a general oversupply of natural gas has pushed energy prices down to historic lows. The current price for PJM Western Hub electricity, based on a 24-month rolling average of forward calendar strips is under $32 per megawatt hour (MWH), while this time last year (2016) it was almost $36/MWH. In 2015 it was just below $40/MWH and in 2014 it was around $44/MWH. The other charts show this same decline in current forward prices for the other regional markets. These price trends indicate that wholesale (and consequently retail) electricity prices for contracts starting in 2018-2015 are at historic lows, with some trending at all-time lows. Securing a future contract at today’s prices is one way of hedging against upward trends in future prices.