Abstract

Energy prices are not decoupled. Evidence is given to show the relationship between various forms of energy prices. With the emergence of electricity futures, the markets will be able to infer a spot price for coal from the electrical equivalent of the oil refining "Crack Spread" called the "Spark Spread."

This evolution in the energy markets could lead to an implosion in energy contracts. There will be a master contract in BTUs and, in the refined form, KWHs. (After all coal and natural gas can be looked on as unrefined electrons.) There will also be markets for basis differential in terms of:

  1. Energy form — Natural gas, fuel oil, propane, etc.

  2. Energy quality — API gravity, sweetness, etc.

  3. Energy location - Transportation differentials.

Therefore, there is little need for separate categories of energy contracts.

This "Future of Futures" also implies that there may be little need for price forecasting except for those in the speculation business. The energy producing business can hedge 100% of its price risk in these markets. Those who say that their shareholders want to participate in price upside, must answer the question, "When have we seen any upside?"

Introduction

As Flumius Minor noted in 157 BC, "Anas Si pro similis aspicere - -". (For those who are Latina impaired, "If it looks like a duck - —.) Of course this first great energy economist was referring to the different forms of energy of the day; palm oil, cheap red wine, etc. He could have just as easily said, "A BTU by any other color is still a BTU". However, that form of descriptive poetry had not been invented at that time.

In today's market, Flumius' observation is readily apparent in that the consumer (residential, commercial or industrial) buys energy as a commodity (See Figure 1). The consumer is becoming indifferent as to the form of energy. He pays for the commodity of BTUs adjusted for form, quality and supply location.

Master BTU Contract

Contrary to popular opinion or wish, energy prices are not decoupled from one another. It is the contention of this paper that there is an implied Master Energy Contract for BTUs. In today's markets crude oil is the surrogate for that Master Energy Contract. For the purpose of analysis and explanation, this paper will use spot WTI as that contract. Oil prices have been, are, and will be quite volatile. (Figures 2 and 3) Some of the current volatility has even been self inflicted, such as "Just in time inventory", etc. (See Figure 4) However, that volatility, in a probabilistic sense, has been quite stable since 1986 as seen in Figure 5.

Interrelationships

Natural Gas. Figure 6 shows how natural gas tends to trade at a discount to oil. This ratio compares the delivered cost of each commodity on a heat equivalent basis to a hypothetical "city gate". (For the purposes of this paper, 1 bbl = 6.28 mmBTU, transportation for oil is $1/bbl and transportation for gas is $0.75/mmBTU.) For a given range of oil prices in Figure 3, there is a predictable range of natural gas prices. The relationship is not deterministic in that there is volatility of gas prices for any given range of oil prices. Table 1 gives these distributions that are also seen in the 3D probability distribution in Figure 7. (I.E., If oil prices are forecast to be between $22 and $24/bbl, we would expect gas prices to trade between $1.55 and $2.65/mm BTU as seen in Figure 8 which is a cut from the 3D distribution in Figure 7.)

As of December 31, 1996, WTI was at $25.93. From figure 3, we would expect "statistical" pressure on oil prices to decrease over the long term toward the mean value of about $19.50 unless there has been a fundamental change in the markets. If history is to repeat itself, we would expect gas prices to also come down from their levels of "irrational exuberance" to trade at a rate of between 0.7 and 0.9 of parity from Table 1.

To no one's surprise, when oil prices are low (mid teens), gas trades at close to parity on a heat equivalent basis with oil. The market sees oil vs. gas competition. As oil prices increase, additional supplies of gas become available. Gas prices also increase but at a decreasing rate, due to increasing gas to gas competition.

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