2010-08 Gas Price Forecasting

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Natural gas prices are critical to a range of regulatory decisions covering both electric and
gas utilities. Natural gas prices are also often a crucial variable in electric generation capacity
planning and in analyzing the benefit-cost relationship for demand-side and energy-efficiency
programs. High natural gas prices, for example, can make coal generation the most economical
new source, while low prices can make natural gas generation the most economical. For gas
utilities, future natural gas prices affect the benefits of energy efficiency, the level and nature of
hedging, and the need for new utility infrastructure. Natural gas prices can also affect decisions
about how to control carbon dioxide emissions. Finally, in organized wholesale electricity
markets, natural gas prices frequently drive market prices and thus the value of all generating
facilities (and their cost to ratepayers).
While natural gas prices constitute only one factor affecting the economics of a utility’s
decision, an erroneous forecast can cause errors costing hundreds of millions of dollars. The
pervasive effects of gas prices mean that state commission decisionmakers frequently must
assess, and choose among, parties’ competing natural gas price forecasts. Forecasts vary in
quality and credibility. With billions in ratepayer and shareholder dollars at stake, regulators
need to know what forecasts to trust. Even where forecasts are trustworthy, their wide range
requires regulators to understand the uncertainties and risks associated with their decisions.
Gas price forecasters face multiple uncertainties, including (1) uncertainties over the time
frame of the current economic recovery and long-term economic growth, (2) the effects of recent
shale gas discoveries, (3) liquefied natural gas (LNG) market developments, (4) carbon dioxide
regulation, (5) demand for new electric generation, and (6) the effectiveness of energy-efficiency
initiatives. The totality of these uncertainties speaks to the unreliability of any natural gas price
forecast, especially for longer-term periods (e.g., beyond five years).
Two major questions relate to natural gas price forecasts. First, how can regulators
distinguish between reliable and unreliable forecasts? Reliable forecasts require a sound
analytical framework that quantitatively relates price to different predictors. This relationship
must take into account historical patterns and economic theory. This paper illustrates the
questions and issues associated with forecasting natural gas prices from an econometric model.
Second, how can regulators best use these forecasts when making decisions? Should
regulators identify a single “best guess” forecast, and then base their decisions on that
information? (The “best guess” forecast is based on a single scenario chosen by the regulator as
the most likely.) Or should they determine a range of forecasts, with the midpoint defined as the
“best guess” forecast and the boundary prices representing the high and low prices associated
with alternative scenarios?
This paper first explains the major elements composing a natural gas price forecast and
the critiques and defenses commonly associated with forecasts. Then the paper makes four

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