Energy update: prices are finally falling

  • Energy prices are falling sharply;
  • This will take time to filter through to most users, but will be modestly helpful to most and very helpful for some;
  • Suppliers will be in pain and private supply investments harder to justify;
  • The future of prices is uncertain.

After three and a half years of sky-high wholesale electricity prices and a seemingly irrevocable surge in wholesale gas prices, energy prices in Eastern Australia are heading down further and faster than many expected. Businesses should be aware of the trend and capitalize on it – but also keep their options open for a potential return to high prices down the track.

How did we get here?

Wholesale power prices began their surge in late 2016, when Engie’s announcement that they would close the large Hazelwood power station just five months later capped a series of closures that took the market from oversupply to tight supply. With substantial coal exiting and renewable investment still in a hiatus driven by the 2014 Renewable Energy Target review, gas-fired generators were more often the marginal suppliers who shaped the price in the National Electricity Market.

Those power market changes coincided with a surge in wholesale gas prices driven by the commencement of Liquefied Natural Gas exports from three giant projects in Queensland. These transformed the gas market: demand tripled, higher-cost resources were drilled to meet that demand, and international oil and gas markets became the dominant force in a previously-isolated domestic gas market.

The net result was that wholesale energy prices more than doubled, putting energy users under great pressure. But prices are now falling fast. The trend was in place before the COVID-19 pandemic, but is deepening because of it.

What’s happening now?

Gas prices in East Asia, home to the customers that underpin Eastern Australia’s LNG exports, are traditionally linked to oil prices. And oil prices have crashed, due to a combination of surging supply; difficulties among oil exporting nations in agreeing meaningful supply limits to sustain prices; and a pandemic-driven drop in demand as international passenger travel stops, drivers stay home, and the wider economy suffers. Oil prices have dropped by more than two thirds in recent months.

Figure 1: oil prices and implicit gas price

A range of Australian and international gas price metrics have dropped along with oil, moderated somewhat by the simultaneous fall in the exchange rate between the Australian dollar and the US dollar. A simple oil link, the widely-watched benchmarket price at the Wallumbilla supply hub, and the ACCC’s ‘netback’ metric all point to Eastern Australian gas prices around $4 per gigajoule, close to the historic average and far below the $8-12/GJ that has applied in recent years.

Figure 2: Australian and international spot gas price metrics

Meanwhile power prices are now at their lowest level since 2016, and the latest futures prices have them returning to $45-$55 per megawatt-hour (MWh) – roughly their level under the Gillard Government’s Carbon Pricing Mechanism.

Figure 3: wholesale electricity prices and futures (sources: AEMO and ASXenergy)

Prices had long been expected to fall as a belated surge in renewable energy investment finally filled the supply gaps left by the generator retirements of the past decade. But since November 2019 this fall has accelerated, driven by falls in expected gas prices and the increasing likelihood that the COVID-19 pandemic will damage energy demand along with the wider economy.

Figure 4: evolution of 2021 power futures contract price

Power prices are being driven down by; the addition of lots of renewable capacity, which is loosening the market most of the time (though summer peaks can still be tight, especially if major generators or pieces of infrastructure fail); the fall in gas prices, since gas generators still plays a critical role in price formation and their fuel costs are dropping; and the expectation that the pandemic and its economic aftermath will mean soft electricity demand.

What is the impact?

Energy users will benefit from the fall in wholesale prices, though not all at once or equally. Wholesale energy is just one component of energy prices, which also include network charges and retail costs; these other elements tend to account for a higher share of the bill for smaller energy users, and are broadly stable at present. Very few energy users have direct exposure to spot energy prices; most pay more stable prices set through contracts with energy retailers. Existing electricity contracts embody a long-standing expectation of declining electricity prices, but not one as fast as the decline we are now seeing. Greater reductions should be realized through users’ next energy contracts, rather than their current ones.

While most businesses and households are not very energy intensive, the coming decline in retail energy prices will be a small but welcome boost amid the serious challenges we all now face. For the most energy intensive businesses, especially in metals manufacturing, chemicals and building products, this fall will be a major boost – though expectations about future prices will be very important.

Figure 5: Reanalysis of ABS data on business energy spend as a percentage of value added. The orange bars represent the price increases most businesses will have seen over 2017-20, and which may now be reversed

The price falls will have major effects on energy suppliers, and ultimately on the level of supply. Investment in new gas supply is likely to halt for some time: prices are now well below the marginal cost of new production, and exploration and development budgets are being slashed by oil and gas businesses worldwide. With respect to electricity, low prices combined with the continuing growth in the market share of renewables may accelerate the closure of some old coal generators. And recent renewables investments may provide disappointing returns over the next few years, as price falls exceed expectations. This pain may be worn by merchant developers or the holders of power purchase agreements, including some energy users, depending on specific contractual arrangements.

New power investment faces big question marks including the crisis itself and the plausible post-crisis level of demand, major changes expected to market rules and the continuing absence of credible durable climate policy for the electricity sector. Some stakeholders are pushing for a pause on the Integrated System Plan, to reassess transmission needs in light of the crisis and impacts on expected demand. The reasonable fear is that locking in new infrastructure based on pre-crisis demand forecasts may consign users in to paying for infrastructure they won’t need for some time, if ever. On the other hand, individually-reasonable decisions to scale back investment in response to a crisis can collectively make a crisis deeper and more enduring. As ageing generators retire and grow less reliable, the energy system still needs considerable investment to successfully incorporate the new renewable resources that will most likely replace them.

What happens next?

The future of energy prices is very hard to predict, and there are many factors at play:

  • The depth and length of the pandemic and associated global recession will, play an enormous role, and is highly uncertain.
  • Oil producing countries are trying to restrain production levels to support higher oil prices. Discipline in these efforts has historically been hard to maintain, and the headline supply cuts recently agreed by OPEC and Russia are far short of the fall in global demand so far.
  • The fall in new investment in oil and gas will reduce supply over the longer term, and unconventional resources like coal seam gas and shale require a higher tempo of reinvestment to sustain supply than conventional resources. The impacts on supply will lag, and thus may coincide with recovering demand post-crisis.
  • Future closures of electricity generation could put little pressure on power prices if managed well, with adequate prior preparation and investment – or repeat the Hazelwood experience if chaotic.
  • While renewable energy costs are low and falling, it is not yet clear which cocktail of complementary flexible resources will be best or how low the associated costs may be able to go.
  • Energy costs and the future of the energy system could be reshaped by policies for economic recovery in Australia and overseas. The size and makeup of past Chinese stimulus packages raised demand and prices for Australian energy commodities, for example.

It looks plausible that Eastern Australian gas prices ultimately return to their pre-crisis highs, whether because international oil prices recover or because maintaining domestic supply adequacy requires higher prices. Electricity prices may be able to stay relatively low if technology, policy and market design work together well, but this is far from certain.

What should you do?

Businesses should take a look at their current electricity and gas contracts for price and duration, and consider their next contracts. While prices look low today, users may not be in a position to lock these in through multi-year contracts while economic conditions are so dire – particularly where take-or-pay provisions may be part of negotiations.

Energy efficiency and productivity options continue to be worth exploring. The fall in energy prices reduces the immediate value of many such investments – though not all, as better energy management can cut peak network requirements and associated charges, not just overall energy consumption. But the current crisis means that some sites are unusually quiet and able to be upgraded without disrupting other activities. And in the longer term, efficiency is likely to remain a good investment. Gas-to-electricity fuel switching options may make the best sense, at least where sites have relatively steady demand rather than seasonal peak needs that may require costly electricity network upgrades to service.

Assistance and resources are available to inform these decisions:

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Tennant is Principal National Adviser – Public Policy at Ai Group. He has worked heavily on climate and energy issues, advising Ai Group’s Leaders’ Group on Energy and Climate Policy and developing reports on natural gas supply, energy prices and energy efficiency. He also works on a range of issues related to manufacturing and innovation. Previously he was an adviser in the Department of Prime Minister and Cabinet, working on fiscal policy, stimulus and infrastructure.

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