Dr. Ken Rietz

This is the monthly issue dealing with commodity spreads. This month, we return to a product spread, but a rather different one, called the spark spread. Pretty much all product spreads (and most others) focus on how profitable some company can be. The spark spread looks at how profitable a natural gas powered electricity generation system can be, by subtracting the cost of the natural gas from the wholesale price of the electricity. The crack spread is easier to understand, in that the crude oil input is converted directly to gasoline and heating oil (or diesel fuel). The conversion of natural gas to electricity is less clear, so I will explain the process in more detail. But first, here is the graph of the price of natural gas, front month futures. |

Figure 1: NYMEX price of natural gas front month futures, from 2021 to present, in USD per million BTU The main feature of the futures prices of natural gas is that they follow fairly closely with last year’s prices and are generally lower than in previous years. There are a number of features of the spark spread that restrict its usefulness. One is that that one of the inputs to it is the wholesale price of electricity, so the spread’s value does not automatically apply to the domestic price. Another is that the wholesale price of electricity varies quite a bit depending on location. (There is a graph of this at the end of the article.) The spark spread, therefore, really must be customized for a specific generating station, or a collection of stations in one area. Following the pattern of product spreads, we calculate the value of the spark spread by (value of product) minus (value of input needed for the product). The value of the product is the wholesale price of electricity, which is typically measured in USD per megawatt-hours (MWh). (You may be familiar with the term kilowatt-hours from your home electric bill, which is a measure of how much energy you have used. One thousand kilowatt-hours equal one megawatt-hour.) This is a value you must find for the station(s) you are investigating. The units for natural gas don’t convert quite so easily into megawatt-hours. The typical unit for natural gas is cubic feet, but that doesn’t help. Another unit for natural gas is BTUs (British Thermal Units), and this, at least, is a unit of energy, like MWh, so a conversion between them is possible. That value can be looked up, but that is not going to work, because converting energy from one form (chemical) to another (electricity) always involves a loss. (Unusually interested readers can find more information by looking up the second law of thermodynamics.) So, how do we get electricity from natural gas? The answer, of course, is with a natural gas generator. So, now we are back to a question that at least we have a chance of answering. How much natural gas do we need to produce 1 MWh of electricity? It depends on how efficient the natural gas generator is, of course, which is another reason you can’t generalize the results to other places. The usual spark spread equation is: spark spread = wholesale cost of electricity − price of natural gas × heat rate. However, the subtracted term needs a bit more explanation. What we want is the total cost of the natural gas needed to produce 1 MWH in the wholesale cost of electricity. The wholesale cost of natural gas is measured in USD per million BTU, and the conversion to electricity is what the heat rate is all about. The heat rate is the term used to describe how efficient the generator is; the lower the heat rate the better. (This makes some sense, because heat is energy that is lost. Once energy is turned to heat, it is nearly impossible to recover, so you want it small.) A typical heat rate for a good, industrial natural gas generator is about 6,500 to 8,000. If those numbers look large, it is because of the units used. The cost of natural gas is in USD per million BTU, and the cost of electricity is in dollars per megawatt-hour. Here is a table from the EIA giving the cost of electricity in various regions of the US. |

Figure 2: Cost of industrial electricty This again reinforces that no single spark spread holds for the entire country. What can be said, though? It is obvious that as the cost of natural gas drops, the spark spread increases. But the interesting fact is that you can estimate how much the spark spread changes, knowing how much the price of gas drops. Since the cost of electricity is regulated and therefore is essentially known, you get this: (Change in spark spread) = (Change in electricity rate) − (Change in natural gas price) × (Heat rate). This directly relates to how changes in the price of natural gas affect the electrical plant’s profitability. |