When examining electricity plans from different electricity suppliers, clients will often ask about how to choose the best term length for a new energy contract. There are several factors that must be considered but the fundamental concept to remember when making this decision is that both electricity and natural gas are commodities, which are traded in the same ways that other commodities and securities are bought and sold. Additionally, according to the US Energy Information Agency, natural gas and electricity are among the most volatile commodities in the market. This means that there are significant variations in price over time, which are influenced by market forces of supply and demand.
Often, clients want to know how much they are saving when entering into an electricity contract with an electricity supplier. The reality is that any savings are only a function of whether market prices have increased or decreased since the last purchase. The other principle to remember is that all electricity and natural gas buyers, fundamentally, have short positions in the market. This means that all businesses are like car owners who must make regular purchases to operate their vehicles. Savings at the gas pump are purely a function of how crude oil is trading. It’s the same thing for natural gas and electricity. This is why business owners should always be shopping for natural gas and electricity plans. With these paradigms in mind, let’s examine some factors to consider in choosing the best term length for an energy plan.
when evaluating energy rates, clients will likely see offers for contract lengths as short as six months to as long as five years. Look at how those prices change with time. Are energy rates increasing or decreasing with term length? The price of electricity variations is NOT a gimmick or incentive used by electricity providers to entice buyers into one term length or another. Those pricing variations reflect how forward/futures markets for electricity or natural gas are trading on a given day. When rates are increasing with term length, the market believes that in the future, there will be less supply than demand. If prices are decreasing with term length, then the market believes there will be excess supplies in the future. There are few things that get less expensive with time and when buyers see lower rates with longer term lengths, it is usually a good purchasing signal. And in those instances, longer contract terms should be considered.
many businesses have a budget for gas and electricity costs. Use the energy rates and the various term lengths that are offered and multiply those rates by your business’s annual usage. Is that dollar amount close to what is budgeted for the energy plan? If the value associated with a given term length is significantly below what is budgeted, choosing that term length is likely the best option. If the value for a given term length is significantly more than what is budgeted, a shorter-term length may be the best decision as long as one is willing to take the risk that prices may continue to increase in the future.
a pricing matrix with many different prices, terms, and options can be overwhelming when evaluating a new electricity contract. The essential question to ask is whether one expects prices for that term to rise or fall in the future. If there is a higher probability, based on economic forces, that energy prices are likely to rise in the future, then a longer-term contract is likely the best choice. Conversely, if one believes that economics suggest prices will fall for a given term, then a shorter-term contract may be best. While this may seem impossible to determine, consumers do the same thing when taking out a loan or a mortgage. One always needs to evaluate the economic factors driving financial markets and evaluating interest rates when making borrowing decisions.
Be sure to consider significant changes in electricity or gas usage (+/- 25% or more) when choosing a term length. Is new equipment coming online? Is another shift being added? Are operations and usage expected to contract? Are energy efficiency measures, renewable energy sources, or other projects to reduce usage expected in the future? If material changes in electricity or natural gas usage are expected, be sure there is contract language that allows for these usage variations in your electricity service. If that contract language is not present, choose a term length that ends before those changes in operations and usage are implemented.
Both types of contracts have their advantages and drawbacks depending on a consumer’s or business’s needs, market conditions, and risk appetites. Let’s explore the benefits and disadvantages of short-term versus long-term electricity contracts.
Benefits:
- Flexibility: Short-term contracts offer consumers the flexibility to switch providers or renegotiate terms in a dynamic market. This is particularly beneficial when there are expectations of lower rates in the future.
- Market Responsiveness: Consumers can take advantage of spot market prices, often allowing them to capitalize on short-lived price dips.
- Lower Commitment: There’s reduced risk in terms of long-term commitment, especially useful if a consumer is unsure about future consumption needs.
Disadvantages:
- Price Volatility: Short-term contracts are more susceptible to market price volatility. If prices surge due to supply constraints or increased demand, consumers might find themselves paying higher rates in electricity bills.
- Administrative Burden: More frequent contract negotiations can increase administrative tasks and associated costs from electric companies and local utilities. You could overlook your contract renewal date and fall into a not favorable month-to-month contract or variable rate plan with expensive rates.
- Less Predictability: Budgeting can be challenging due to the uncertain nature of future electricity prices.
Benefits:
- Price Stability: One of the primary advantages of a long-term contract is the predictability it offers. Consumers can lock in a fixed rate, making it easier to budget and plan for the future.
- Reduced Administrative Tasks: Less frequent negotiations and extended expiration dates mean fewer administrative burdens over the contract term.
- Long-term Planning: With a consistent understanding of energy costs, businesses can plan strategic initiatives more effectively.
- Relationship Building: Longer contracts allow for stronger relationships between consumers and electricity providers, which can lead to better terms and mutual trust.
Disadvantages:
- Reduced Flexibility: Long-term contracts can bind consumers to a fixed rate, even if market prices fall. This means potentially missing out on lower electricity rates or incurring early termination fees for cancellation.
- Potential for Overpayment: If electricity prices drop significantly during the contract duration, consumers might end up paying more than the prevailing market rate.
- Long-term Commitment Risks: If a consumer’s electricity consumption needs dramatically change, they might be locked into a contract that no longer suits their requirements and a new contract might be needed.
There is no one-size-fits-all when it comes to choosing the best electricity or natural gas term length. However, understanding that both electricity and natural gas are volatile commodities, where prices change every day, is an important first step in choosing a contract term. This awareness, coupled with knowing your business’ energy budget and how current offers fit into that budget in light of potential changes in operations and market dynamics are some of the best practices in choosing the right contract length.
While short-term contracts provide flexibility and the chance to capitalize on market trends, they come with price volatility and administrative challenges. On the other hand, long-term contracts offer price stability and reduced administrative tasks but may bind consumers to unfavorable rates if electricity market conditions change.
Ultimately, the best choice depends on individual or business priorities, risk tolerance, and predictions about future energy market conditions. It’s essential to consider both the immediate and long-term implications of any contract and possibly consult with energy experts to make an informed decision.
You can also connect with our energy experts to discuss what is happening in the energy market for additional transparency into bullish and bearish trends in market prices and energy providers.