December 21, 2010 • Electricity, Energy's Lighter Side, Perspectives

Energy and Economics

by Dominic Barbato

Frequently, I am asked why I chose to pursue a career as an energy consultant and what it is I enjoy about the industry.  I suppose I could come up with any number of reasons to explain why I like my job, but at the end of the day, energy and I click because I am a nerd.  There, I said it.  I am a nerd.  A very cool nerd, mind you, but a nerd nonetheless. 

You see, I studied economics in college, so from my perspective, the energy industry is like one giant, totally awesome economics experiment.  Everywhere you look, you will witness economic principles in action: from deregulation and competitive choice, to monopolistic utilities, oil cartels, elasticities, incentives and price controls.  I bet this industry would have given even Adam Smith, the widely cited father of modern day economics, a run for his money. 

Yet, the energy industry is not as difficult to understand as many people think.  Energy is a product, and that product is subject to the same basic economic principles of supply and demand that govern other goods or services we purchase regularly. What makes energy unique is that, unlike the relatively lethargic relationship between supply and demand observed for many products such as bread, milk, light bulbs or automobiles, the supply-and-demand relationship of energy changes very rapidly. To help balance the frequent changes in supply and demand, buyers and sellers of energy trade it on commodities markets just as brokers trade stocks on Wall Street.

As a result of continual price negotiation between buyers and sellers, the underlying value of energy commodities changes frequently. The frequency and magnitude with which these price changes occur determine a commodity’s volatility, and as you may suspect, energy commodities such as oil, gasoline, natural gas and electricity are very volatile.

In fact, a 2002 report issued by the U.S. Department of Energy (DOE) indicated price volatility for energy commodities, and specifically electricity, was the highest in the world! To illustrate this point, consider for a moment the chart below, which depicts the price of regular unleaded gasoline as documented by the U.S. Energy Information Administration (EIA). In the summer of 2008, U.S. drivers paid on average slightly more than $4 per gallon at the pump, while six months later, less than $2 per gallon. When was the last time you went to purchase a loaf of bread or gallon of milk and discovered the price had decreased by 50 percent?!

U.S. Average Price - Regular Unleaded Gasoline ($/gal)

This chart illustrates the evolution in average price since 2008 for a gallon of regular unleaded gasoline.

Most of us are in constant need of energy in our daily routine, as we are perpetually “short” the commodity. Typically speaking, most of us are able to delay a need to purchase bread, milk, light bulbs or a new automobile for a couple days, weeks or even months, but imagine how difficult life would be if you ran out of electricity for your home or gasoline for your car. And unfortunately, most consumers are unable to store large quantities of energy cost effectively, so we often find ourselves as price takers with limited ability to influence the broader market as a whole.

On an aggregate basis, Summit clients purchase more than $20 billion of energy annually. Needless to say, not only does each company we represent have a vested interest in reducing the price paid for energy, but we also have a greater ability to influence the market.

At Summit we work to ensure our clients get the most bang for their energy buck, or as an economist might say, coordinate the use of scarce resources so they flow to their most valued uses. Some days, this might mean managing risk by purchasing energy in the open market for a future delivery date, while on others it might mean evaluating a demand response program offered by a local utility company or even calculating the greenhouse gas emissions generated by the consumption of energy at a corporation.

The energy industry, my friends, is economics in action.  I suppose no matter which way I slice it, I am still a nerd, but you have to admit, this stuff is pretty darn cool!

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