2.7: Energy Pricing

Everyone likes to complain about energy prices or their monthly utility bill. Ultimately, energy is like any other product or service; prices are largely determined by the forces of supply and demand.

Most energy resources are traded in large quantities on commodity or wholesale markets. These markets operate similarly to stock exchanges. Someone wanting to buy or sell large quantities of oil or natural gas, for example, would go to the New York Mercantile Exchange or NYMEX, just as you would go to the stock exchange if you wanted to buy a share of stock in Apple or General Motors. End-use consumers (homes and businesses) generally do not buy directly from these exchanges because the exchanges require trading in very large volumes. (An oil contract on the NYMEX requires you to buy 1,000 barrels or 42,000 gallons and to pick up the oil in Cushing, Oklahoma.) Instead, end-use consumers purchase energy from various types of retail sellers (who would then purchase their supplies from the wholesale market). Gas stations and electric utilities are examples of these retail sellers. Retail prices are most often higher than wholesale prices, sometimes by substantial amounts. The retail price of energy commodities depends on transportation and delivery costs, as well as on how shrewdly retailers can find the best bargain on the wholesale market.

Oil and coal are global commodities that are shipped all over the world. Thus, global supply and demand determines prices for these energy sources. Events around the world can affect our prices at home for oil-based energy such as gasoline and heating oil. Oil prices are high right now because of rapidly growing demand in the developing world (primarily Asia). As demand in these places grows, more oil cargoes head towards these countries. Prices in other countries must rise as a result. Political unrest in some oil-producing nations also contributes to high prices – basically, there is a fear that political instability could shut down oil production in these countries. OPEC, the large oil-producing cartel, does have some ability to influence world prices, but OPEC's influence in the world oil market is shrinking rapidly as new supplies in non-OPEC countries are discovered and developed.

Natural gas is not as widely traded globally, since it is not easily transported across oceans. The North American gas market (U.S. and Canada) is relatively isolated from the rest of the world. Thus, increasing demand for natural gas in Asia, or political unrest in gas-producing nations, does not really affect our natural gas prices very much. This is why natural gas prices have been falling so rapidly – increased supply has not been matched with any increases in demand. If the U.S. and Canada were to start exporting natural gas to Europe or Asia (in the form of liquefied natural gas or LNG), that would probably increase the price of natural gas in the U.S., though experts disagree on how much.

Electricity pricing has undergone rapid changes over the past decade. Until the mid 1990s, the electricity industry was very tightly regulated and electric rates were set by state regulators. Utilities priced power based on the costs of providing service to each customer (plus some profit for the utility company), and these prices required explicit approval by state regulators. With the advent of electricity deregulation in the 1990s, about half of the U.S. states, including Pennsylvania, loosened regulatory restrictions on electricity pricing to encourage competition between electric generating companies and utilities. Your electric bill is broken down into two parts: prices for generation (energy) and delivery (wires, or “transmission and distribution” of electricity). The wires charges continue to be regulated and set by the state Public Utility Commissions. Generation prices are determined through regional wholesale electricity markets where many companies compete to sell electricity to utilities. The electricity market that serves Pennsylvania, PJM Interconnection, is the largest in the world, in terms of number of customers served. Generators from as far west as Chicago and as far south as North Carolina compete to sell electricity to utilities and consumers in the Mid-Atlantic region.