How to improve the energy buy
Hedging with energy futures, aggregating usage across multiple plant sites and screening potential suppliers carefully can help in an uncertain market.
By Gordon Graff -- Purchasing, 6/3/2004 2:00:00 AM
High on the wish list of just about every chemical industry manager today is finding a way to cope with the roller coaster gyrations of energy prices. Energy price volatility, particularly of natural gas and electricity generated from natural gas, can convert a profit in one quarter into a loss the next, and make budgeting a dicey proposition. Now, energy procurement managers, sometimes aided by outside consultants, are developing systematic hedging strategies to minimize their risks in today's climate.
Until about five years ago, industrial consumers in the U.S. typically paid between $2 to $3/million Btu for natural gas. "At that time there was less urgency about hedging and understanding the energy buy," says Mitch Maynard, a manager at Delta Energy LLC, a Columbus, Ohio-based energy management, consulting and gas delivery firm. Today, he adds, monthly gas prices can vary between $4 and $12/million Btu. For purchasers on the spot market, 15% changes in natural gas prices on a daily basis are not unusual, he notes. Such variations have enormous implications. "A $12 buy can completely throw a company upside down," says Maynard.
For chemical companies in particular, the escalation and fluctuation in energy rates are a double whammy. "Aside from their impact on our direct utility costs, natural gas rates also affect the prices we pay for our raw materials and feedstocks," says Rick Piotrowski, director of energy and risk management at Bayer Corp.
Chemical purchasers of energy also have to deal with confusion over regulations. This problem has intensified since the Federal Energy Regulatory Commission and individual states began deregulating natural gas and electricity markets. Among other things, this move has unbundled the selling and transmission of natural gas, so that cost-conscious purchasers often find it advantageous to buy gas from one company and contract for its delivery from another. The new regulatory environment "makes it very difficult for national companies who have to deal in many, many marketplaces" throughout the country, says Bryan Anderson, a partner in the energy practice group of the law firm Foley & Lardner LLP, Chicago, Ill. The reason for this, he explains, is that large companies must deal with energy contracts and distribution companies in different states, and each utility in each state has its own regulations.
Of course, chemical industry consumers can often buy energy the traditional way—from regulated local utilities that both supply and deliver gas. But federal deregulation has made it cheaper, in most cases, to buy from a deregulated third party supplier. The savings from doing this can range from 10%-25%, estimates Piotrowki. But he cautions that in separating the purchase of gas from its delivery "the buyer assumes responsibility for the administrative services normally provided by the local utility company." For example, he notes that pipeliners impose penalties if deliveries of gas through their system rise above or fall below agreed-upon benchmark levels by certain margins. Therefore, he says, purchasers need to balance their deliveries with consumption to minimize pipeline imbalance penalties.
There are other potential headaches for purchasers who opt for the do-it-yourself energy route, note industry sources. While regulatory uncertainty is one of them, other problems can include supply interruptions from pipeline companies, as well as unpleasant rate surprises stemming from vague contract language or new utility tariff rules.
Regardless of how they purchase energy, manufacturers are most concerned about commodity price fluctuations that can bust a budget or sink margins. The strategy that most of the large chemical companies have adopted to deal with these ups and downs is to implement hedging programs. Put simply, hedging involves locking in prices of energy when future rates are expected to go up, while retaining the flexibility to exploit the opportunities if rates should drop. "The whole concept of hedging is to stabilize the price you pay around some targeted objective price," says Piotrowski, who adds that Bayer is stepping up its natural gas hedging efforts.
First identify needs
The first step in implementing a hedging program, Piotrowski advises, "is to identify your existing energy spending and see where and how it impacts your budget." He says that his group at Bayer recently went through this exercise, which he describes as a "painstaking process." Once energy procurement managers have identified the values at risk, they are ready to exploit various hedging possibilities. Bayer's hedging approach, says Piotrowski, usually involves purchases of over-the-counter (OTC) financial products called derivatives that help keep energy outlays within the targeted range.
One way Bayer planners try to lock in an attractive price for natural gas is to purchase financial instruments called "swaps." These are contracts in which a counterparty promises to sell a specific amount of gas to the contract-holder at a specific price at some future date—say a month or a year from now. At the time of the contract settlement (when the gas purchase actually occurs), if the market value of gas exceeds that specified in the contract, the counterparty remits the difference to the contract holder. But if prices have dropped below those in the contract, the contract holder must remit the difference to the counterparty. Thus, funds are "swapped" when the contract is settled.
Swaps "are a particularly useful tool in a market where energy prices are trending upward," says Piotrowski. When prices go down, of course, buyers of swaps must pay the difference. But the Bayer executive says his company minimizes the impact of such "opportunity losses" by spreading out its purchase of swaps over time. So swap purchases are "layered in," particularly after prices have begun to fall. This will often save money for their purchasers as prices start to climb again.
Another hedging strategy that Bayer finds helpful is the purchase of options. These are contracts that give the buyer the right—but not the obligation—to buy gas at a certain price at some future date. Options are useful, says Piotrowski, "when you expect that prices may go higher, but there's also a good chance they may drop." If prices rise above the option strike price, then exercising the option can save money for the energy purchaser, even when the initial price of the option is factored in. If market prices fall below the option's strike price, the option holder is not required to buy gas at the higher strike price and is only out the money used to purchase the original option.
The standard option in which an energy consumer pays for the right to cap its energy purchases at some maximum rate is known as a "call." This can be combined with a "put" option, where an option buyer guarantees that it will pay a specified minimum amount for energy, even if market prices drop below that floor level. The advantage of this dual arrangement, says Piotrowski, is that "I limit myself at the top in return for agreeing to pay a minimum at the bottom." Deals can be structured, he adds, so that the put sale of the buyer offsets the premium of the call option. The result is a "no-cost collar," because no cash is exchanged when the deal is transacted.
Collecting and analyzing economic data on energy is important for a successful hedging program, Piotrowski notes. At Bayer, he says, an in-house staff tracks such parameters as natural gas storage reserves, price trends, oil markets and long-term weather forecasts, and uses this information, often with the help of software and internet-based tools, to identify future scenarios for prices and supply. Energy traders from marketing firms and banks, he says, also provide input about the forces driving the energy market. "We also talk to actual energy producers to get their thoughts" about future market trends, adds the Bayer manager.
Finding expertise
Not every chemical company has the wherewithal to retain in-house experts in energy analysis and hedging strategies. In fact, even large chemical suppliers have begun to contract out these functions. Ashland Chemical, for instance, says it recently spun off its energy management division as a separate company, Delta Energy. Delta now services Ashland and other manufacturing clients.
One of these Delta clients is Amcor PET Packaging USA, Inc., of Manchester, Mich. According to Sheridan Attig, Amcor PET's director of purchasing, Delta provides "the sort of expertise we don't have in-house" by "helping us to keep a pulse on the fundamentals of the energy marketplace." He says Delta typically provides data such as well-counts, storage volumes, market sentiment and historical weather patterns, and correlates these variables with past and present pricing. They also model the company's past and predicted energy consumption and demand, send out RFPs [requests for proposals], and summarize the strengths and weaknesses of suppliers bidding for Amcor's business. Ultimately, notes Attig, Delta presents recommendations for Amcor PET's energy procurement strategy in the form of a summary sheet that helps the company zero in on one of the bidding energy suppliers.
To make meaningful recommendations it is necessary to know a client's business thoroughly, Delta officials stress. "We've become intimately acquainted with Amcor's plants, how they operate and what kind of equipment they use," says Maynard. Such knowledge, he adds, "enables us to deliver an energy plan and strategy that dovetails with their corporate plan." The information, he notes, has become valuable in other services Delta provides, such as assistance with budgeting, and recommendations for trimming energy costs on the consumption side as well as the procurement side.
A third party in the Amcor-Delta relationship is lawyer Bryan Anderson. In his role as legal counsel to Amcor, says Anderson, "I help Amcor to be sure it understands the significance of key terms and conditions" in contracts it signs. Another function, he adds, is "to spot key legal and business risks which are embedded in complex and variant" contract provisions.
Advice from legal counsel should be part of any contract interaction between a manufacturer and outside energy supplier, Anderson advises. He describes how misleading contract language can have adverse consequences. "I saw a contract that purported to limit [energy] sales to deliveries from a single power plant" with attractively low rates, Anderson recalls. Upon investigation, he discovered that the contract actually stipulated that deliveries from that plant would only take place as long as it remained in operation. The original contract language, he notes, "threatened to force a customer to purchase energy on the spot or 'energy imbalance' market at a moment's notice."
What should a chemical manufacturer contemplating an energy hedging program take into account? "I think one key piece of information every purchasing person has to know is precisely what it is that you need to buy and when you need it," says Ron Sekinger, Vice President at Delta Energy. "Spend some time to understand the profile of your energy load," he advises. "Find out what the summer-to-winter ratio looks like?" In short, "dissect your energy needs to the smallest detail."
For an energy procurement manager "a key requirement is to know the growth plans of your operation," says Attig. This permits forward planning to meet the energy needs of any expanded production facilities, he notes.
Sam Wolfe, energy manager at Delta Energy, advises the energy procurement person to "shop many suppliers in each region where you have plants, and let these suppliers know they have competition." Also, "evaluate their marketing strategies and performance." It is not a good idea, he says, to go with one supplier on a national basis, or stay with the same group of suppliers year after year. "Markets change," says Wolfe, "and the company with the best offer one year may have the worst offer the next year."
As important as price is, it should not be the sole factor in choosing an energy provider, Sekinger points out. "You also need to know your provider's balance sheet, their ability to honor the deal that's been agreed to, and how they'll service the account," he says. "If their invoices are incorrect on a monthly basis, is there going to be someone you can contact about this problem?"
Read any contract carefully, in consultation with legal counsel, suggests Maynard. "Decide which terms you can live with and which you cannot live with," he says, "and don't be afraid to ask for changes in the contract." Also, "get the things that are important to you in the contract," Maynard advises, "and make sure you know what's included in the offered price." Drafters of contracts should be aware of the regulatory environment in their region, Maynard stresses.
On the horizon
Meanwhile, some new trends are emerging on the energy procurement front. One, identified by Anderson, is the drive toward standardization of terms and conditions in contract language. Anderson is a member of the North American Energy Standards Board (www.naesb.org), an industry forum that is developing standardized contract terms.
Another trend, particularly in the absence of large national energy traders such as Enron, has been the growth of regional energy providers. This has made energy procurement more complex, notes Sekinger, because energy consumers now need to focus on all the issues, including regulatory ones, in each region where they operate.
One of the newest trends in energy contracts for customers with more than one facility in an electric or gas distribution region, says Anderson, are provisions that the customer's energy usage variance—how much its usage is above or below the contract benchmark—will be computed with reference to the customer's total load in the distribution area. So even if a consumer with two equal-size facilities has used more energy than contracted for at one plant and less than agreed to at another plant, the aggregate energy usage in the region might be close to the benchmark. Therefore, the customer would not be forced to pay premium prices or penalties to the distributor for over—or under—usage of energy. Persuading an energy supplier to go along with the aggregate usage provision isn't always possible, Anderson says, "but when we can get it into a contract it is a key risk reducer for our clients."
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