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The term “price volatility” is used to describe pricefluctuations of a commodity. Volatility is measured by the day-to-daypercentage difference in the price of the commodity. The degree of variation,not the level of prices, defines a volatile market. Since price is a functionof supply and demand, it follows that volatility is a result of the underlyingsupply and demand characteristics of the market. Therefore, high levels ofvolatility reflect extraordinary characteristics of supply and/or demand.
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Prices of basic energy (natural gas, electricity, heatingoil) are generally more volatile than prices of other commodities. One reason that energy prices are sovolatile is that many consumers are extremely limited in their ability tosubstitute other fuels when the price, of natural gas for example, fluctuates.Residential customers usually cannot replace their heating system quickly--andin the long run, it may not be economical to do so. So, while consumers cansubstitute readily between food products when relative prices of foodstuffschange, most do not have that option in heating their homes.
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Volatility provides a measure of price uncertainty inmarkets. When volatility rises, firms may delay investment and other decisionsor increase their risk management activities. The costs associated with suchactivities tend to increase the costs of supplying and consuming gas.
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What Causes Volatility In Natural Gas Prices?
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Major factors affecting volatility in gas markets include:
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Weather Changes: Weatheris a strong determinant of short-term demand. Unexpected, prolonged, or severechanges in weather can cause fluctuations in the amount of natural gas that isdemanded by end users. Weather changes also can affect supply and distributioncapabilities, which can affect the amount of natural gas that is available forend users.
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Production/Imports: Theamount of natural gas produced and imported makes up a majority of the natural gassupply that is available for consumption. Changes in the amount of gas producedor imported can have significant impacts on prices.
Storage Levels: Storageprovides the critical buffer between demand and current supply (production andimports), and is often used as an indicator of the relative supply and demandconditions in the natural gas market. Storage is needed during times of highdemand, and as a result, market participants may compare current storage levelswith current or future demand in evaluating gas markets.
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Delivery Constraints:Constraints may occur or be removed along the pipeline delivery system, whichmay change supply and distribution capabilities, resulting in fluctuations inthe relative amount of available natural gas. Possible examples includeoperational difficulties (production valves freezing, equipment breaking down,etc.), the existence of pipeline or delivery bottlenecks, and theimplementation of new transmission routes.
Market Information: Alack of timely, reliable information regarding the previously mentioned causesof volatility can cause shifts in prices as market participants are forced tobase their trading decisions on rumors and speculation.
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Trends: Seasonality And Storage
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In examining daily spot prices and the correspondingvolatility index at the Henry Hub market center in Louisiana from January 1995through October 2003 (Figure 1), it becomesapparent that the natural gas market is subject to significant fluctuations inthe level of volatility. However, two notable trends exist. First, a degree ofseasonality is noticeable within the time series data. Second, volatility tendsto be correlated with the level of natural gas in underground storage.
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Between January 1995 and September 2003, the highest levelsof volatility in each year occurred during the winter heating season (Novemberthrough March). Also, over the entire time series, the average monthlyvolatility index figure for all winter heating season months was nearly 104percent while the average for all other months was only about 49 percent. Thistrend clearly shows that the winter heating seasons were much more likely toexperience heightened natural gas spot price volatility.
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This result is notsurprising in that the cold winter months create a situation where natural gasdemand often surges unexpectedly while natural gas supply has less flexibility.Because space heating is an absolute necessity for most people during thewinter coupled with the fact that the substitution of alternative heating sourcesis, under normal circ*mstances, not economically or logistically feasible, muchdemand for natural gas during the winter is insensitive to changes in price. Onthe other hand, production and imports of natural gas are usually unable tosupply all of the gas necessary to meet the exaggerated winter demand, causingstorage levels to dwindle, which over time constrains the capability of thoseoperators to react to changes in market fundamentals (i.e. price, weatherconditions, etc.). The cumulative effect of inelastic supply and inelasticdemand 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 inprice.
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The relationship betweenstorage levels and volatile price action is very important. The data indicatethat when storage levels during any winter heating season were at unusuallyhigh or low levels, volatility in the spot market tended to increase. Perhapsthe best example of this is the winter heating season of 1995-1996. The averagevolatility index value for that winter was nearly 242 percent, the largest ofthe nine observed winter heating seasons. Storage levels during the 1995-1996heating season on average were about 27 percent less than the previous 5-yearaverage, which was the greatest average percent difference below the previous5-year average observed in the time series. On the other hand, volatility alsocan be high when storage levels are unusually elevated. For example, inDecember 1998, storage levels were approximately 20 percent higher than theprevious 5-year average for that month. The volatility index for that monthreached a peak value of almost 196 percent, the fourth highest monthly value onrecord. The high volatility reflects a rapid price decrease and recovery duringthat month.
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Case Study: The VolatileWinter of 2002-2003
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Volatilitylevels during the winter of 2002-2003 were noticeably elevated, although notunprecedented. (The 2002-2003 heating season was the second most volatile behindthe 1995-1996 heating season.) There are a number of underlying factors behindthe generally higher volatility levels that prevailed for the winter of2002-2003. Major supply side factorsincluded weak production, low imports, and low storage inventories, whiledemand factors included higher prices for fuel oil and other substitute fuels,and unusually cold weather.
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Suppliersof natural gas faced three significant realities during the winter of2002-2003. First, natural gas production in 2002 was about 3 percent below 2001levels, a result of a lower rate of new well completions (new well completionswere 27 percent lower in 2002 than 2001) and the natural production decline asproducing wells aged. As a result, utilization of productive capacity is estimatedto have exceeded 90 percent, which is a tight supply situation typicallyresulting in higher prices. Second, net imports of natural gas were down about3 percent in 2002. Although imports increased, growing exports were sufficientto result in a net decline. Lastly, because an unusually cold winter led tomassive storage withdrawals, the level of gas in storage in the United Statesat the end of February 2003 was more than 40 percent lower than February’s5-year average (1998-2002). The resulting supply situation was one in whichnatural gas suppliers were constrained in their ability to react to changes inthe marketplace.
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Thedemand side of the market introduced its own set of challenges. In addition to thetypical seasonal demand increase, other additional upward demand pressures werecaused by colder than normal temperatures throughout the country, which causedconsumers to use more gas than normal for heating purposes. The 2002-2003winter experienced about 3 percent more heating-degree-days than normal. Alsorelevant was that the prices of fuel oil and other alternative fuels wererelatively high during this period. For example, the average monthly price ofWest Texas Intermediate Crude oil during the 2002-2003 heating season wasnearly 6 percent greater than the 2000-2001 heating season’s average price, and52 percent greater than the 2001-2002 heating season’s average price.
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Withsupply and demand both being extremely inelastic during the winter of 2002-2003,any movements in either side of the market were necessarily going to produceexaggerated price shifts. It should therefore be no surprise that volatilitylevels spiked during this time period.
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How Does Volatility Affect Consumers?
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Theimpact of price volatility varies among consumers based on their overallservice needs and purchasing practices.Prices to residential customers tend to be much more stable than forcommercial and industrial users. Residential customers see less price variationbecause their bills reflect monthly average prices, which do not fluctuate asmuch as daily prices. Also, many residential customers stabilize their monthlybills by participating in yearly budget plans provided by their local gasdistribution companies.
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Further,most residential prices are within the jurisdiction of State agencies, andregulatory provisions generally tend to mitigate the impact of marketconditions. On the other hand, electric power plants and other large volumeconsumers often rely on short-term market purchases or arrangements withoutfixed price terms. These consumers are willing to risk price fluctuationsbecause of cost savings and their ability to switch to other fuels ifnecessary.
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