Energy prices are the most volatile of any commodities in the world and electricity prices are the most volatile of the energy complex. More volatile than crude oil, natural gas, gasoline or heating oil.
In this article we explain the meaning of volatility and its significance for consumers of electricity, natural gas, and other fuels such as residual fuel for commercial boilers, fuel oil and heating oil for commercial office buildings and apartment buildings.
Volatility is a statistical measure of the standard deviation of price movements over time. Volatility is not a function of price. Just because prices are high does not make them volatile. The price of gold per ounce is very high – over $1000 per ounce — but the volatility of gold is very low, under 5%. Prices of gold simply do not move that much over time.
By contrast, natural gas sells at a price of under $3 per million British thermal units (approximately a thousand cubic feet). But its volatility is over 60%. That is because the price of gas moves frequently; prices moves are often a significant percentage of the underlying price.
In order to assess volatility – i.e., standard deviation – we look at price movements over time. For example, we could look at the price of electricity at a given delivery point at the end of every day as quoted on Bloomberg, in the Wall Street Journal, or on the Chicago Mercantile Exchange. Or we could look at those prices at 5 minute intervals or at the end of every hour of every day as quoted at various delivery points and published by an Independent System Operator (see, e.g., http://www.iso-ne.com/isoexpress/web/reports/pricing/-/tree/lmps-da-hourly).
Here is a typical price series from the Northeast Power Pool for a July 22, 2015. The series covers a single LMP or locational marginal price zone – one of thousands in New England.
These prices are the ISO’s clearing price for this LMP zone at the end of every hour beginning 1 AM. As you see the prices range from $16.58/mWh to $40.69. In order to calculate the standard deviation, statisticians take the price differentials from hour to hour. These differentials can be set out in absolute terms ($/kWh) or in percentage terms.
These differentials are then mapped in a random distribution curve that captures the frequency of these price changes.
It’s interesting to note that while the prices move steadily, peaking during peak hours, the percentage of changes noted is large. Compare, for example, the US stock market indices. If the stock market were to move 30% from hour to hour you could expect a repeat of the apocryphal Great Depression tale of people jumping from Wall Street buildings.
In measuring volatility we determine the standard deviation of price movements. One standard deviation represents 2/3 of the outcomes. When we examine electricity over the course of a year we find that the volatility of electricity often exceeds 100%. This means that there is roughly a 2/3 chance – roughly one standard deviation in statistical terms – that the price of electricity will remain within a +/- range of 100% over the course of a year.
In other words, if prices remain within the range of +/- 100% 2/3 of the time that means that there is about a 1/3 chance that the price of electricity a year from now will be more than 100% higher or lower than it is today.
A 1/3 chance of price movements of greater than 100% is an enormous risk. If the volatility of electricity is 100% over the course of a year the daily volatility is approximately 7%. (Trust us when we say that volatility is proportionate to the square root of time: If you assume a volatility of 80%, say, and there are approximately 256 business days in a year, the daily volatility will approximate 80% divided by the square root of 256, i.e., 5%.)
Imagine if you arrived at an automobile dealer with the intention of checking out a car. Suppose the dealer tells you that the car you like costs $20,000. Normally you would say, “Fine, I will keep shopping and be back in a couple weeks.”
Now suppose the dealer goes on to say: “We look forward to seeing you. But bear in mind that our car prices change as much as 5% or $1000/day. If you come back in a couple weeks the price could be $35,000 – or it could be $10,000.”
Do you want to take the chance of paying almost double the price in a couple weeks? Probably not, particularly if there is more upside risk – prices could go to infinity, after all – then downside risk – prices could go to zero but probably won’t.
With electricity prices so volatile it is no wonder that consumers are attracted to fixed price electricity supply. Most businesses do not have the luxury of passing their electricity costs on to their customers. A pizza shop, for example, could be hit by a high natural gas bill at the end of the month. The owner cannot go back to his or her customers over the past month and say, “Remember that slice of pizza I sold you last month? Would you mind kicking in another quarter? It cost me more to make the pizza than I thought!”
Like prices themselves, volatility goes up and down. There are rare times when supply and demand factors reach a balance and prices do not change for long periods of time. Consumers should ask their brokers for an assessment of current volatility, i.e., the risk that prices may change quickly over the next few weeks or months. If volatility is high it may make sense to lock in all or a portion of one’s supply costs in order to avoid these risks.