Trieu, a loyal MR reader, asks:
I’ve recently received "lock-in" offers from my gas and electricity company. They’re offering me the "opportunity" to commit to the current price of gas and electricity for two years, instead of paying the fluctuating month-to-month rates. Naturally, this offers set off my scam alert. Are the energy companies signaling that they think energy prices are too high and will go down? Or do you think there could be something else behind the strategy?
If you draw a standard and supply diagram, you can see that fluctuating prices (with a constant mean) increase expected consumer surplus but decrease expected producer surplus. For instance as a buyer you’d rather have a price of 50 half of the time and a price of 200 the other half of the time, rather than 125 all the time; the opposite is true for the seller. That is one reason why the utility may prefer a lock-in.
There is also a "only the stupidest consumers will respond" effect. It costs the utility very little to make an offer favorable to themselves but unfavorable to the consumers. It’s worth doing even if only a few people accept. Given that utilities are regulated monopolies, you should expect conflict of interest to be high and thus decline most of their offers.
The most general response is simply that you should insure only against catastrophic events, and yes that sometimes includes your wife getting mad because you didn’t buy a product warranty on your latest purchase of toothpicks.
“For instance as a buyer you’d rather have a price of 50 half of the time and a price of 200 the other half of the time, rather than 125 all the time;”
This is true only if you have are able to time your purchases to take advantage of lower prices. For residential consumers, this is seldom the case. Nobody has capacity to store natural gas or electric power, nor are people able to defer consumption for a month to wait for lower prices. (Hourly price changes would be a different matter.)
However, in an industrial setting, where gas storage becomes an option (electricity is still too expensive to store), purchase price variablility can be highly advantageous. Even if you can’t forecast the future price, you can still build up or draw down reserves to improve profitability.
A while ago, I wrote a hypothetical problem on this subject… I’ll dig it up and post it here as a challenge for readers.
Energy prices are in contango over the 2 year term so the company is probably offering to buy futures and lock in the price theirs and yours(lower than you are paying them for fixed prices).
Unless you are a big enough buyer to also buy futures (ideally ~1 contract per month in use) you’re probably stuck accepting their markup.
It’s not all that different from Freddie and Fannie buying Swaptions and then offering a fixed rate mortgage at a spread to an ARM (they make a spread off the wholesale retail price of interest rate volatility, but their retail price is far lower than most consumers would pay to tap the wholesale market (because of trading costs and contract sizes).
Isn’t profit function convex in price? Then doesn’t it mean producers’ are better off with fluctuating prices than fixed?
Actually Aaron, consumers are so price-inelastic to heat, that they typically consume more heat when gas prices are high and less when prices are low. (Because cold weather drives price and demand at the same time…)
LOCKED IN, LOCKED OUT
For electricity, take the post-deregulated cost of generation as a ratio
of pre-deregulated generation and multiply it by the cost of consultants
and lobbyists who pushed deregulation through the legislative and
regulatory process.
Subtract out utility executive bonuses and the amount paid by
private equity firms for generation purchased for pennies on the dollar
from vertically integrated utilities, including the salaries of all auction
specialists from FERC and consultants who said price would decline.
Take the amount of new generation induced by deregulation as a ratio of
all existing generation that has changed hands at least once at multiples of the prior purchase price. Multiply
the result by the amount of retail wheeling attempted versus the amount
succeeded.
Multiply the latter by the former to get an index of competitive pressure
at the wholesale level.
Offer lock-in options at the retail level to provide an illusion of firm
service and how current prices were determined in a “competitive” market.
If the price is under a dollar, Jack should buy all he can (subject to the limit on inventory). If the price is over a dollar he shouldn’t buy any.
My apologies, tired cliché number two was supposed to be: “They are damned if the do, damned if they don’t”.
This would be a good topic for the folks at Knowledge Problem to contribute to.
I work as an energy trader for a company that offers fixed-price energy contracts. These contracts are designed for peace of mind and people on tight budgets. People or businesses on tight or fixed incomes that cannot afford a significant increase in rates (or are unable to pass on costs to customers) should look at these products. When a customer signs, the energy company will hedge their consumption in the forward markets (obviously aggregating volume and risks across multiple customers). The nature of these markets is that customers cannot easily put these hedges on themselves (although investing in the stock of a gas produced or power generator can be a good proxy). Margins in this business are not high (probably under 10% net of risks). As a previous poster noted, purchasing strategies of utilities vary widely. Some buy entirely in the spot market, some hedge significant portions, some run on a price lag.
For the typical consumer living paycheck to paycheck, a 50% increase in natural gas prices (something that has happened in recent history) is a catastrophic event.
Tyler said: “The most general response is simply that you should insure only against catastrophic events, and yes that sometimes includes your wife getting mad because you didn’t buy a product warranty on your latest purchase of toothpicks.”
It is not obvious that to lock-in prices would automatically mean buying an insurance. If most hedgers come from the supply side and want to hedge the risk of lower commodity prices, future prices will be lower than spot prices (normal backwardation), which means that it will be interesting for a consumer to lock-in prices.
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