Why Are Natural Gas Price Forecasts So Wrong?

(c) 2010 F. Bruce Abel

And the same can now be said of electricity.

Map of Pyrenees tale!

Jan 22, 2010
Why are gas price forecasts so wrong?
The 2009 Integrated Energy Policy Report of California Energy Commission first caught my eye when it predicted that there will be no need for LNG imports (either directly or via Sempra Energy's Ensenada terminal in Mexico) thanks to shale production.
But the report also addresses a key problem of natural gas: volatile pricing:
Past efforts to forecast natural gas prices have been highly inaccurate compared to actual prices, even when price volatility was largely dominated by traditional, physical market factors. Additionally, as the United States continues moving toward a carbon‐constrained existence, future greenhouse gas policies will further complicate these efforts, likely rendering future natural gas price forecasts even less accurate and more uncertain.
UK market participants, especially Ofgem, need to take the next sentence on board:
The uncertainty associated with predicting major input variables and the resulting natural gas price forecasts bring into question the value of producing date‐specific, single‐point natural gas price forecasts.
Simply put there is so much going on in the variables of natural gas price forecasts (i.e. the forward curve of prices that the vast majority of UK consumers have little choice but to accept), that predicting future prices is impossible. I could fill a page or two alone listing the known unknowns of natgas pricing. But of course it's the unknowns that then come and bite us in the butt.
The solution? Possibly, to stop even trying. In formulating this counter advice a tip of the hat to Nobel Prize laureate for Economics in 2003, Daniel Kahneman, father of behavioural economics, who would immediately identify those who seek a fixed priced gas contract as suffering from the syndrome he describes in his Map of the Pyrenees tale.
Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region
They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees." According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless.
We need to ask some questions. First, lets ask ourselves why is it important to have a fixed price. Or to put it another way, what do we fear and what outcome are we seeking to avoid by accepting a fixed price?
Secondly, lets look at the difference between a fixed price and a floating price closely linked to wholesale prices that changes monthly. Perhaps the premium for "security" is fair and transparent.But how do we know when no one provides a benchmark?
Thirdly, lets look at how wholesale prices translated into retail prices today.
Lastly, do we have an alternative to fixed prices? How can we get one?
I'll get back to the answers in detail soon. But for now, let's ask if predictions as practiced in the commodity markets are about as valuable a portent of future price as reading the entrails of a sacrificial lamb? Point number one:The main influence on natural gas prices is weather. But how do we predict prices when we can't even get close with weather:
The UK Met Office is debating what to do with its long-term and seasonal forecasting after criticism for failing to predict extreme weather.Some experts say the Met Office should stop longer-term forecasting.
The one sure variable we can all agree on is that the biggest impact on short term wholesale gas commodity movements is the weather. Predicting the weather falls off rapidly as time recedes.We've seen that predicting weather even a month ahead is practically worthless in temperature forecasts. If weather predicting is without value, then a major component of gas forecasting is as well. Oil prices used to be better, but right now oil is 100% up on this time last year and gas 60% down. With the gas oil link most likely permanently an ex-factor in price prediction, what's left?
So why should end users continue to get talked, scared or just plain suckered into taking long term prices? The fact that in the UK they don't have much of an alternative explains a lot. Which I'll revisit in depth at another time.