The sleeping giant_-_when_energy_prices_awake_whitepaper

Ecova, Inc.

2013

THE SLEEPING GIANT:

WHEN ENERGY PRICES AWAKE

TABLE OF CONTENTS

EXECUTIVE OVERVIEW ........................................................................................................... 1

The Sleeping Giant: When Energy Prices Awake .......................................................................... 3

The Big Down Drivers from 2008-2012: Surging Gas Production, WEAK Economy,

and a Winter that Wasn’t ............................................................................................................. 3

Low Gas Prices Sent Gas vs. Coal Generating Competition Temporarily Into Turbo Mode ................. 4

What Comes Down FAST, Must Go back Up? ............................................................................ 6

U.S. Shale Gas Effect ............................................................................................................................. 7

Coal-Fired Generation Retirements: Make Way for More Gas Generation ........................................... 7

International Demands for US Natural Gas Emerge .............................................................................. 8

Electric Generation Balances Demand at the Low End of the Natural gas price Range ....................... 8

But Most Shale Gas Producers Require a Higher Price Point ............................................................... 9

Risks Inherent in the Close Connection Between Natural Gas and Electricity ...................................... 9

The Ill-Effects of the Extended Downturn on Corporate Risk Management ............................... 10

Time for a more Proactive, multi-pronged approach to addressing both rate and Usage ................... 10

Energy Procurement Decisions: Managing deregulated contracts in a riskier Market ................ 11

Consumption Controls: A New Emphasis on Energy Efficiency ................................................. 13

Conclusion: New Perspective on Energy Prices Requires Conscious Management .................. 16

| WHEN ENERGY PRICES AWAKE

EXECUTIVE OVERVIEW

On the heels of the 2008 Global Economic Crisis, much of the country enjoyed falling prices for electricity

and natural gas. The low-cost energy anomaly was largely driven by very weak demand from a slow

economy, combined with dramatic growth in the domestic supply of natural shale gas. For many

companies, this offered a welcome spot of relief in their third- or fourth-largest business operating

expense.

After hitting decade lows in early 2012, spot and futures prices for both wholesale electricity and natural

gas have climbed steadily in all US regions as economic recovery and rising use of natural gas for electric

generation have begun to take up the slack. Through 2016, significant shifts in regional energy

fundamentals will drive new price dynamics that bear close attention.

After a long, steady decline, energy prices are once again trending up.


As of mid-2013, the overall outlook for U.S. average retail electricity

price increases is a relatively mild 2% to 4% ($0.003 to $0.004/kWh

[kilowatt hour]) from 2012 to 2013, continuing into 2014. However, that

prognosis masks regional issues that will drive some sites to a year-

over-year increase of as much as $0.01 to $0.015 per kWh where

capacity prices, grid congestion, deregulated contracts or regulated

fuel cost pass-throughs allow retail prices to move more abruptly.

The natural gas retail markets will see even steeper hikes, with U.S.

average increases of 5% to 10% from 2012 to 2013 and continuing

into 2014. And, as with electricity costs, some sites will see much

steeper increases of as much as $1.00 to $1.25 per Dth (Dekatherm)

where regulations or contracting allow for quick pass-through of

commodity costs.

While natural gas typically accounts for only in the neighborhood of 20% of energy spend for commercial

users, this paper focuses significant attention on natural gas due to its expanding role as a primary price

driver in electric power generation.

In the following pages, we’ll explore the primary drivers that are shaping the short- and long-term energy

markets. We’ll drill down on the anticipated impact of these influences, and we’ll offer guidance on how

these trends affect energy procurement, pricing, and risk management.

Forward looking

companies with

significant energy

spend will need to

revise budget

expectations and

risk management

practices to

accommodate the

changing energy

price environment.


THE SLEEPING GIANT: WHEN ENERGY PRICES AWAKE

THE BIG DOWN DRIVERS FROM 2008-2012: SURGING GAS

PRODUCTION, WEAK ECONOMY, AND A WINTER THAT WASN’T

Energy exploration and production is a dynamic business prone

to boom and bust cycles, and the past decade has proved no

exception. After natural gas prices spiked in 2005 through 2008,

a wave of investment in advanced drilling technologies moved

into the industry, driving natural gas production up by roughly

10% between 2008 and 2011, while consumption grew by only

5% owing to a slow economy.

As gas production continued to surge into 2012 and minimal

demand for heating materialized during the 2011/12 “winter that

wasn’t,” markets reacted strongly to the record amount of gas

left in storage at the end of the heating withdrawal season, and

gas prices hit decade lows in April 2012.

US WORKING NATURAL GAS IN STORAGE

After a “perfect storm”

of global recession

and shale gas

expansion, a new wave

of environmental,

production, transport,

and international

demand drivers have

the energy market on a

bull run.


US NATURAL GAS ELECTRIC POWER PRICE

LOW GAS PRICES SENT GAS VS. COAL GENERATING COMPETITION

TEMPORARILY INTO TURBO MODE

As gas prices slid below $3.75, natural gas generators, which would normally be cost-competitive only

during peak parts of the day, or seasonally when electric use was high, gained a much more even footing

with coal plant generating costs. The fight was on across the board as generators bid to supply energy

into the grid. The charts below illustrate the increasing competitiveness from 2010 on the left to 2012 on

the right. With more aggressive bidding and a burgeoning fleet of natural gas-fired generators, electric

prices in most areas fell by around $10.00 to their decade lows.


SOUTHEAST HISTORICAL SUPPLY CURVE, SUMMER 2010-2012

SOUTHEAST HISTORICAL SUPPLY CURVE, SUMMER 2010-2012


WHAT COMES DOWN FAST, MUST GO BACK UP?

From March 2012 through mid-2013,

generators continued to burn natural gas

at unprecedented levels, taking up enough

production slack that storage and gas

prices moved back up into the $4.00 to

$5.00 range. This, in turn, eased some of

the fierce competition between coal and

gas generators, allowing electric prices to

come back up as well.

NET GENERATION FOR ALL SECTORS, MONTHLY

Summary of Energy Upward Price Drivers

Most “Dry” natural gas basins have been

declining in production

Coal-fired generation retirements

Electric generation balances demand at

the low end of the price range

Most Shale gas producer require higher

price points

More international demands for natural gas

Risks inherent in the close connection

between natural gas and electricity.


U.S. SHALE GAS EFFECT

Consider that at the turn of the century, shale gas accounted for only 1% of U.S. natural gas production.

By 2010, it surpassed 20%, and the EIA (Energy Information Administration) predicts that by 2035, 46%

of domestic natural gas supply will come from shale gas.

While the presence of massive North American shale gas fields has been known for well more than a

century, and the basic drilling techniques known for 20 to 30 years, directional drilling technologies have

only recently reached cost-points that meet commercial viability. Only within the last few years, increasing

experience with the technologies across many wells and shale basins and has resulted in increasing

confidence, which has tamped down “scarcity” concerns that likely contributed to the run up before 2008.

But, it is important to balance this against the reality that many of the large well-known conventional or

“dry” natural gas basins have been declining in production, even during periods of higher prices. Only a

few gas regions, most notably Marcellus, have been growing quickly enough to continue overall

production growth even during the last couple years of low prices.

Additional impetus for lower pricing has also been provided by higher prices for oil and natural gas liquids,

which are co-produced in a few regions. This has had the effect of providing a subsidy for natural gas

prices as drillers concentrate on the very best liquid rich regions, but the strategy is not widely

expandable beyond those top few regions.

COAL-FIRED GENERATION RETIREMENTS: MAKE WAY FOR MORE

GAS GENERATION

Because coal generating plants have such long life spans (often 30 to 75 years), decisions about capital

spending and competitive positions also happen on a long-term scale. A number of recent clean air

regulations require coal generators to comply with stricter emissions control levels. At the same time, they

see increasingly competitive positions of natural gas plants. Coal plants with weaker emissions controls

(often smaller, older units) are moving to retire rather than spend the capital for upgrades. Between 2011

and 2017, these planned retirements are expected to add up to approximately 40 GW (Gigawatts).


The expected retirements of coal-fired electricity plants will accumulate to around 40 GW by 2017—a gap that will largely be filled by, natural gas-fired plants.

Using recent history as a guide (left chart above) much of the capacity will be taken up by adding natural

gas plants, or running existing gas plants for more hours and/or higher outputs. But, while the

accelerating coal retirements have made headlines, the significance of the impact on price has largely

been left to the imagination. We estimate that the gas required to replace the retiring plants would be

around 3 to 5 Bcf/day by 2017. In the context of overall natural gas demand across all uses, the effect

would contribute around 1% to 2% to annual gas demand growth. That is not hair-raising by itself, but as

we will see below, more demands continue to emerge.

INTERNATIONAL DEMANDS FOR US NATURAL GAS EMERGE

The FERC (Federal Energy Regulatory Commission) has approved at least one company, Cheniere

Energy Partners, to export LNG beginning in 2015. Around 20 other companies are in the process of

making similar requests, with around a dozen approvals totaling LNG export capacity of 5% to 10% of the

total U.S. production expected over the next few years. Additionally, several pipeline projects are slated

for completion in the 2014 timeframe that will increase capacity for export to Mexico from around 3.5

Bcf/day (only about 50% of which is in use currently) to around 7 Bcf/day, allowing ample spare capacity

for future export growth.

ELECTRIC GENERATION BALANCES DEMAND AT THE LOW END OF

THE NATURAL GAS PRICE RANGE

The overall net impression we have is that if gas prices fall much below $3.75, electric generation

demand for gas can increase by as much as 6 Bcf/day, as it did in 2012. And, as prices approach $4.00,

electric generation demand slackens, as it did in early 2013.


BUT MOST SHALE GAS PRODUCERS REQUIRE A HIGHER

PRICE POINT

We believe that prices below $4.00 do not allow sufficient return to maintain interest in drilling and well

completion capital costs necessary to support supply growth. At this price level, producers will continue to

drift toward oil and liquids-centric opportunities, and away from gas production. A range of $4.50 to $5.50

is needed to stimulate drilling enough to support continued production growth in the near term. That price

requirement will rise over time as locations offering the best return on investment, such as the currently

popular liquids-rich plays, become saturated.

RISKS INHERENT IN THE CLOSE CONNECTION BETWEEN NATURAL

GAS AND ELECTRICITY

Natural gas prices are volatile. Even when they are within a relatively low range, they jump around

significantly, so it is important to remember that level of volatility when looking at a smooth EIA projection

or futures curve.

HENRY HUB NATURAL GAS PRICE

EIA’s range is

good guidance,

but remember to

plan for volatility

along the way.


And, it is especially important to remember and communicate the potential for volatility to energy price risk

stakeholders when so much of the current media hype cycle on shale gas declares it a “Boom” or a

“Revolution.” Seemingly, the U.S. will soon be an energy independent net exporter, with 100 years of

natural gas supply and new prosperity. While each of these statements is potentially true in isolation, at

some point it is easy to begin to double count benefits, or assume that potential benefits are highly

certain. Ultimately, this tends to lead to a perceived “bust” or a “bubble pop” cycle that may focus on

imminent scarcity. Sentiments move markets in unpredictable ways that can defy underlying

fundamentals. This volatility risk is increasingly important to bear in mind as wholesale, and ultimately

retail, electricity prices become more tied to gas through fuel cost adjustments.

Overall, we are now in a period of recovering wholesale energy prices, as opposed to the market drops

that dominated the past few years. We can expect the emerging demands for natural gas, and varying

price-needs of natural gas market participants, to leave significant room for volatility.

Next, we’ll discuss how businesses can prepare for an anticipated increase in energy pricing by

communicating the risks associated with the status quo, mitigating that risk, and gaining control of costs

through decreased consumption.

THE ILL-EFFECTS OF THE EXTENDED DOWNTURN

ON CORPORATE RISK MANAGEMENT

From late 2008 until late 2012, almost any short-term approach to either fix energy prices or ride the spot

market would have resulted in decreased costs year-over-year. As a result, traditional risks associated

with purchasing electricity and natural gas were hidden, and conversations about potential to miss budget

on overall cost were pretty rare. A general feeling of complacency around risks crept in among energy

buyers and budget stakeholders.

TIME FOR A MORE PROACTIVE, MULTI-PRONGED APPROACH TO

ADDRESSING BOTH RATE AND USAGE

With a high-level understanding of how energy market dynamics have shifted, energy cost stakeholders

are better positioned to take an appropriate perspective on energy costs moving forward, and able to

value procurement, budgeting, and energy consumption cost and risk reduction strategies more fully.

Companies that tackle the challenge aggressively, via multiple paths, will have the greatest success.

Below, we offer some suggestions for several areas of focus.


ENERGY PROCUREMENT DECISIONS: MANAGING

DEREGULATED CONTRACTS IN A RISKIER MARKET

Assessment of exposure to the risk of riding spot pricing should take into account the impact of price

volatility that differs between regions. This must be done with careful consideration of the physical

footprint and consumption of sites within those regions. The decision to ride spot pricing in Texas, the

North East, or New England, for instance, could result in the one-day loss of an entire month’s energy

budget. On the other hand, contracting for a substantial double-digit fixed rate increase for the upcoming

season could be hard for stakeholders to swallow. Thus, we suggest energy managers ramp up the

communication of what’s coming and lead an ongoing conversation on what to do about it. For instance:

Share energy market price intelligence widely. Finance, C-Level, and Field Operations engineers

all benefit from common understanding of the trends.

Include intelligence on both national and regional trends.

Recalculate and maintain current estimates of the organization’s VaR (value at risk), the

measurement of the risk of loss at various probable future price levels on the energy contract

portfolio.

As energy market intelligence is understood and these discussions become more commonplace,

revise documents guiding acceptable levels of risk with key stakeholders.


Managing for Energy Budget Risk - Recommended Actions

Work with budget stakeholders to review deregulated contracting style impacts on budget

certainty. The same contracting styles that lead to consistently beating budget over the last

few years, will likely become a liability as markets reverse. A reassessment of VaR might

lead to the determination that the organization should set limits on the amount of variability

within the current budget year.

Review variance and reforecast budgets more frequently to quickly identify regions or sites

where rates are changing, and clarify quickly whether the changes are temporary or will last

throughout the rest of the budget period .

Recalculate price impacts on capital budget cases for efficiency projects. As the cost per unit

increases, the ROI on capital cases also increases. In particular, give renewed attention to

reviewing capital cases for efficiency projects in congestion-prone, market-driven, and active

regulatory regions.

While a complex exercise that requires skill and commitment, properly preparing for energy market

volatility and rising energy costs is a wise use of time and resources. For some businesses, the

application of market expertise to procurement and contract decisions can have substantial impact on

budgets in the near term. That said, while rate and contract negotiations are the starting point of the

energy management continuum, energy efficiency programs create impressive and long-lasting

opportunities to mitigate the risks of increasing energy costs.


CONSUMPTION CONTROLS: A NEW EMPHASIS ON

ENERGY EFFICIENCY

While the terms green, sustainability, and energy efficiency conjure up

altruistic thoughts, they also pave the way toward clearly defined and

substantial financial benefits—you don’t pay for energy you don’t use.

Therefore, energy consumption reduction will undoubtedly take on new

relevance as energy prices climb. In a business environment where

investment decisions are made almost exclusively on the promise of

ROI, low- and no-cost opportunities to save energy, water, and waste

costs via sustainability initiatives present businesses with a significant

opportunity for measurable savings. Some of these steps to combat the

inevitably rising energy costs we’ve discussed here are sufficiently

simple that they rarely require capital resources beyond that which is

already budgeted. For example:

The installation of programmable thermostats. When temperature settings are adjusted

appropriately for just 8 hours a day, a business facility can save as much as 10% on its annual

heating and cooling bills. Remotely programmable thermostats, which have dropped considerably

in price, add operational efficiency gains to the ROI equation. With a network connection and a

password, a single energy manager can program and control hundreds—even thousands—of

thermostats across a distributed enterprise, maximizing energy savings while minimizing facilities-

level human intervention.

The replacement of standard fluorescent and incandescent light bulbs with next-generation CFL

(compact fluorescent), LED (light emitting diode) and improved halogen bulbs. Depending on the

size and scope of the business, according to energystar.gov, more than 35% of commercial

electricity expenses go toward lighting; CFL bulbs are up to 75% more energy efficient than

traditional incandescent lighting, and lighting incentives are among the most lucrative

opportunities. Upgrades to facility lighting systems often deliver 25% to 35% reductions in lighting

energy, with a simple payback of two-three years.

Some steps to

reducing energy

consumption are

sufficiently

simple that they

rarely require

capital resources

beyond that

which is already

budgeted.


As is common in retail, a great percentage of energy is being consumed on lighting and HVAC. With this

in mind, some no cost/low cost lighting initiatives might include:

Use of occupancy sensors in areas of low activity

Verification of optimum start and stop settings

Perform a dark store lighting check

Some no cost/low cost HVAC system initiatives might include:

Maintaining temperature set points

Verification of optimum Start and Stop Programming

Other steps, such as outlier investigation, energy intelligence and benchmarking solutions, metering and

utilities-based rebate programs are slightly more complex. However, taken as part of a holistic energy and

sustainability management program, they will yield compelling results. Fortunately, for many of these

energy efficiency measures, there are energy rebate programs available through utilities, which

companies may take advantage of to help subsidize the cost of capital improvements. Read more about

the keystones of TESM (total energy and sustainability management) here.

While the end value of taking these initial steps is industry specific and market dependent, most

businesses can expect total utility savings of 20% to 30% from intelligent TESM investments. When

applied to areas with rising and volatile prices, those savings go a long way to reducing energy cost risk.

ELECTRIC CONSUMPTION (kWh)

Sample: Small Retail

Sample breakdown for a small box retailer’s energy consumption mix

http://www.ecova.com/ecova-blueprint.aspx


Best Practices to Achieving Expected ROI

with an Energy Management System

Monitor and Manage Human Interaction

Standardize on Proper Alarm Management

Minimize Access to Systems

Document Standard Configurations and Sequences of Operation

Pinpoint Sensor Location for Powerful Tracking Results

Implement Variance/Change Management Program

Back-up Configuration and Program Files

Re-Commission Energy Management Systems

Apply a System Monitoring Program

Read Ecova’s Best Practices for Maximizing ROI of Energy Management Systems

White paper that details methods to counter the challenges above.

http://www.ecova.com/ecova/2013/april/maximize-the-roi-of-your-energy-management-systems.aspx


CONCLUSION: NEW PERSPECTIVE ON ENERGY

PRICES REQUIRES CONSCIOUS MANAGEMENT

The long-term lull in energy prices we’ve enjoyed in recent years will cause many business energy

stakeholders to be caught off guard as the influences we’ve discussed above cause prices and volatility

to increase.

Specifically, as natural gas increasingly becomes the primary driver of electricity generation costs, energy

price risk will shift into a higher gear. Deregulated markets and regulated regions that allow fuel cost

pass-throughs will see the cost impacts first, while more heavily regulated markets, will tend to lag but

ultimately will see similar rate increases smoothed over a longer period.

Responsible businesses will take heed of the changing influences and risks impacting their energy costs

and take action on multiple fronts: Procuring, budgeting, and reducing usage more proactively.

Learn more about minimizing your organization’s energy costs and energy consumption:

The Ecova Blueprint, your guide to developing a proactive, strategic and actionable Total Energy &

Sustainability Management (TESM) plan.

Big Data Look at Energy Trends: 2008–2012, leverage Ecova’s big data insights to help your organization

see more savings.

How to Capitalize on Billions in Available Energy Incentives: Four Types of Qualifying Energy Efficiency

Investments. (Whitepaper)

Best Practices for Maximizing ROI of Energy Management Systems, (Whitepaper)

Inside Energy webinar series — Stay informed on energy trends with Ecova Webinars, subscribe to

receive invitations to upcoming webinars.

http://www.ecova.com/ecova-blueprint.aspx

http://www.ecova.com/solutions/ecova-technology/ecova-big-data-warehouse.aspx

http://www.ecova.com/news-media/whitepapers/billions-in-available-incentives-whitepaper.aspx

http://www.ecova.com/news-media/whitepapers/billions-in-available-incentives-whitepaper.aspx

http://www.ecova.com/ecova/2013/april/maximize-the-roi-of-your-energy-management-systems.aspx

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ABOUT ECOVA

Ecova is the total energy and sustainability management company whose sole purpose is to see more,

save more and sustain more for our clients. Using insights based on consumption, cost and carbon

footprint data spanning thousands of utilities, hundreds of thousands of business sites and millions of

households, we provide fully managed, technology-optimized solutions for saving resources, which in turn

increase returns, lower risks, and enhance reputations. Ecova is the largest non-regulated subsidiary of

Avista Corp (NYSE: AVA and avistacorp.com). For more information, visit the company’s website at

ecova.com, on LinkedIn at linkd.in/ecovainc, or follow Ecova on Twitter at @ecovainc.

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