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Why electricity tariffs are over-priced

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This will come as no surprise to some, but for others it’s a different story. Singaporeans are grossly over-paying their electrical bills. Here’s why. Earlier in late June, I wrote that it made no sense for electricity tariffs to be pegged to fuel oil when a whopping 80% of power generated here derives from natural gas. As mentioned earlier, the state media justified pegging tariffs to fuel oil prices by claiming there isn’t any natural gas benchmark, even though there is.

To justify such a peg, one should be able to provide good evidence that oil prices are strongly correlated with natural gas prices ie. the ratio of oil to gas prices should be rather stable. Unfortunately, that is far from the case. Seeking Alpha has an article based on this WSJ report highlighting the startling disconnect between oil and natural gas prices.

In particular this graph alone says it all:

Ratio of Oil to Natural Gas prices

Update 28th Aug: This graph on a more recent Seeking Alpha article goes even further back to 1986:

1986-2009 oil-to-gas prices

As you can see, the data provided goes all the way back to 1993, and it isn’t difficult for anyone to observe that over the years the ratio of oil-prices to gas prices have fluctuated wildly. Not only does this makes a mockery of the state media and establishment’s claim that the next most natural benchmark would be oil prices (even though the fact that 80% of power generated derives from gas makes that claim ludicrous enough), the article goes on to highlight that the intrinsic value of the oil, if one assumes that we may compare on the basis of energy content, would only be six times that of natural gas. In reality though, oil prices have long fluctuated between 6 and 12 (!!) times that of natural gas and has actually got as high as 24.1 times (according to the WSJ):

A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would tend to to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded between 6 and 12 times the price of natural gas.

That’s changed in recent months. Natural gas prices have fallen to $3.00 per MMBtu, weighed down by new supply and weak demand. Oil prices, however, have stubbornly increased to more than $70 per barrel. That’s down sharply from the $100+ prices of last year, but up sharply from the $40 – $50 range earlier this year.

Oil futures were heavily speculated on last year, which resulted in prices as high as US$140 a barrel. In other words, Singaporeans are paying the price of heavy speculation by Wall Street because of an ill-thought peg between tariffs and oil prices. If the Obama administration and the CFTC does nothing to curb speculation, we should all expect electrical bills to rise even without an accompanying increase in usage or natural gas prices.

Just to emphasise on the latter point, James Hamilton over at Econbrowser has a similar post on this. He notes that for the earlier part of the current decade, oil and gas prices were correlated but of late the prices have diverged quite significantly:

Oil and natural gas pricesThe two prices tended to move together in the early part of the decade, but have diverged significantly over the last few years, with natural gas today selling for 1/3 the price of oil in terms of BTU content.

The blue line above denotes the price of natural gas while the black one oil prices. It’s interesting to note that Hamilton himself believes that the gap would narrow largely due to rising natural gas prices. To prove his case, he performs a statistical regression which you can read all about on his blog.

At the moment though and as also noted by the Seeking Alpha article, natural gas prices are still continuing to fall. The NYT reported on Aug 21st that gas prices have reached their lowest in seven years due to over-supply and weak demand:

HOUSTON — Natural gas prices plunged on Thursday to levels last reached in 2002 after an Energy Department report showed that the amount of gas in storage had hit a record high for this time of year.

The sharp price decline of natural gas, to below $3 per thousand cubic feet from a peak of over $13 last summer, has been caused by a drop in demand from factories and homes because of the recession, coupled with a big expansion of domestic production over the last few years.

It’s probably not too difficult to predict that natural gas prices would rise over the next several months as demand picks up and more speculators jump onto the bandwagon. The only question is whether natural gas prices would rise as quickly as oil prices. If they don’t, then Singaporeans will continue to pay the price of unjustifiable exorbitant electricity tariffs.

Written by defennder

August 26, 2009 at 5:42 PM

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