Market volatility can create buying opportunities
Mary Clair Austin -- Purchasing, 9/2/2004 2:00:00 AM
Natural gas production is expected to increase by only about 0.5% in 2004 and 2005. Despite increases in new natural gas well completions, production growth will be modest because of the high rate of decline in output from existing wells. Yet, natural gas demand is expected to increase by about 1.1% in 2004 because of increasing economic growth, the continuing rise in electricity demand, and below-average hydroelectric power levels in the Pacific Northwest. Economists expect demand growth in 2005 to be limited by prevailing, relatively high, natural gas end-use prices.
The government's Energy Information Administration (EIA) now forecasts that natural gas prices will remain high through the rest of 2004. Wellhead prices are expected to average $5.85 per million Btu from July through December, compared to $5.40 in the second quarter. Strong demand for natural gas coupled with high petroleum prices has led to higher gas prices despite nearly normal storage inventory levels. Overall in 2004, EIA predicts that spot wellhead prices at the Henry Hub—which interconnects nine interstate and four intrastate pipelines—likely will average about $6.12 per million Btu, which is 9% higher than the 2003 average. In 2005, prices are expected to decrease only slightly as production gains are expected to be relatively low.
To get a better sense of these trends, Purchasing tapped Craig Schultz, president of Energy Buying Strategies, a Bethesda, Md.-based consultancy that helps natural gas end-users make decisions that manage the costs and risks of energy purchasing. This interview considers the risks of energy purchasing and suggests what buyers need to know to find strategic ways of dealing with risk.
Q: Who buys natural gas these days: Purchasing or operations?
A: In my experience, it's roughly evenly divided between three groups: purchasing, operations (plant managers and engineers), and other (energy managers, finance officials, chief executive or chief operating officers). Over time, though, it has tended to move away from those who touch the energy physically (plant managers and engineers) to the purchasing and finance folks. This is because there is growing awareness of the financial/ risk management aspects of energy buying.
Q: How have risks changed in the last five years?
A: That's a great question because natural gas pricing over the past five years (2000-2004) looks very different than it did over the five years prior to that (1994-1999). Since 2000, the average natural gas futures price for the prompt-month (next-month delivery) on the New York Mercantile Exchange (Nymex) has been $4.49/million Btu, after averaging $2.18 between 1994-1999, so a doubling of average commodity costs. The commodity portion of an end-user's gas bill is, by far, the largest component. Other than the higher level of gas prices, gas market risks have not changed too substantially.
Surprising to some, relative volatility is not higher now. Credit risks (the risk of your supplier defaulting on its agreements) are probably lower now because the number of gas suppliers has been thinned out considerably. This thinning was due to the slowdown or reversal of progress in electric deregulation, failures by smaller players due to unhedged financial risks and the unavailability of cheap wholesale energy market credit in the aftermath of the Enron blow-up, and lastly the pull-out of unregulated affiliates of many utilities who have become more conservative for a number of reasons and the general effects of competition.
Q: What does the natural gas supply chain look like?
A: There are really two supply chains facing end-users—one physical, one financial. Physically, there are gas producers that sell to gas marketers and utilities, who pay pipeline companies for interstate transportation, and then sell gas to end-users.
On the financial side, I'd describe the supply chain as having an active commodities market in which gas marketers, utilities, banks and many other players act to hedge their underlying physical price risks. For most end-users, their suppliers are acting in the financial market on their behalf, in essence. So, for most end-users, the supply chain looks like one piece—the physical and financial sides being paired together and managed by their suppliers.
However, some large end-users separate the supply chains by buying physical gas from a gas supplier and, then, separately entering into pure financial transactions such as swaps, calls, and collars with either an energy supplier or a financial house. In that way, end-users separate physical supply from price risk management and also can do things to control price risks that are unavailable as part of a normal gas transaction. However, few end-users use energy financial derivatives, for good reason.
Q: Are there foreign players in the natural gas market?
A: Some foreign firms have ownership interests in U.S. gas marketers, but most of the direct suppliers are domestically owned.
Q: What are the supply chain risks?
A: The major supply chain risks include: price volatility, credit supplier defaults, volume deviations from contract typically involving either the purchase of full requirements 'insurance' or exposure to index prices for deviations from contract volumes, and weather-related disruptions to pipelines or utility supplies, which also affect price).
Q: Today's market for natural gas is high and volatile, but just how volatile are we talking?
A: First off, you're right that gas prices are exceedingly high by historic standards. The Nymex 12-month natural gas strip is now trading at about $6.30 per million Btu, compared to an average of $3.70 for the past seven years. Natural gas prices are also quite volatile. For example, the closing prices of prompt-month futures contracts move by an average of 2% to 3% each day. That can lead to 10% movements in a single week. But contrary to what many believe, the relative volatility of natural gas prices has declined. The average daily change in prompt-month closing prices is 2.1% so far in 2004, compared to 3% last year and 2.8% between 1994 and 1999. So, what is distinguishing today's natural gas market is more its high price than its volatility.
There is another kind of myth out there that volatility in energy prices is bad. I think that's only half the story. While volatility does create uncertainty in budgeting and can cause unpredictable financial results which are bad, it also creates opportunity which is the other half of the story. One of the few great truths about the gas market is this: it will go up, and it will go down. And the longer we can wait, the more it will go up and the more it will go down. Any analysis of gas prices bears this out. Gas prices follow a gaping saw-tooth type of pattern, not smooth progressions up and up.
This lesson is simple, but it is powerful. It means that, if you can wait a bit in your purchasing and set price targets below current market prices, and there are several techniques like trigger contracts for doing so, you can expect declines in prices. This is the good side of volatility. If the market weren't volatile, we would expect current prices to prevail for a long time with only incremental change. That has not historically been the pattern in gas prices.
Q: What information should purchasing people assemble?
A: First, they should look internally. Obtain several years' worth of their energy volumes and costs, at least in monthly detail. Several years' worth are needed to sort out idiosyncratic events like weather and plant maintenance. Next, they should forecast any changes in their expected future demand—due to plant or building expansions, changes in machinery, etc.
After gathering internal data, end-users should get external data on what energy products are available in their regions from credible suppliers and prices that apply to those products.
The third step is to make an honest assessment of the end-user's energy budget, risk preferences, and administrative resources that can be dedicated to energy buying. At this point, the end-user can start to match its internal needs to externally available products.
Q: Do you think it's necessary for all end users to devote a high level of attention to their energy buys?
A: It depends on how important energy is to the end user's overall cost structure and profitability. Remember: The greater the impact, the higher the level of attention that is merited. However, at a minimum, all end-users should have a basic energy buying strategy and year-over-year measurements to evaluate that strategy.
Q: How can buyers acquire the info they need?
A: The usage data and costs are resident with end-users, and can also be obtained from their suppliers. Data on supplier offerings and their solidity rest with suppliers, other end-users in the market, buyer associations, and consultants who have developed some proprietary databases. There are historical Nymex energy commodity data sets, and current data from the exchange are available at www.nymex.com. Other great, free sources of market price data are, www.enerfax.com, and www.eia.doe.gov, the Energy Information Administration of the U.S. Department of Energy. Often, existing suppliers or those competing for the business can be great sources of market data. If more detailed data sets are necessary, end-users can buy them from a number of publications and other data sellers, or can take the added step of having a qualified consultant analyze and provide them. In some ways, the most important information for energy buying involves the end-user's energy budget, risk preferences, and personnel available for energy buying—this can only come from the end-user itself.
Q: How does purchasing natural gas more efficiently help manage risk?
A: Efficient and effective buying strategies will mean that an end-user: (1) will not unwittingly expose itself to short-term price risks, (2) will have tactics in place to take advantage of future price declines, (3) will not take on unnecessary risks (e.g., credit and legal/contract risk), and (4) will employ techniques like diversification that provide the same expected costs at lower volatility.
Q: Are utilities opting out of retail selling altogether?
A: There has been a pull-back over the past several years, as utility holding companies have become more conservative. Expected large profits from retail marketing without major capital expenditures haven't panned out; Wall Street has penalized undisciplined strategies in the wake of Enron, even after applauding deregulation and technology plays in the late 1990s. Some utilities remain, but they have tended to focus on regional markets they know well. This will probably remain the case until the expected wave of mergers occurs.
Q: If there is another price spike on the horizon, will buyers see it coming?
A: In addition to the difficulties inherent in forecasting any financial market, natural gas markets have the added difficulties of being heavily exposed to extremely unpredictable events like weather and political stability. If the end-user has a sound risk management strategy in place, it need not worry too much about short-term price natural gas price spikes, and may actually be able to benefit from them by switching to another fuel if it can. Sound buying methods will also protect end-users from long-term price increases, as best they can be protected.
Natural gas prices to drop 55% this year
05/15/2009Natural Gas Prices Down
06/18/2009Further slippage ahead in natural gas prices
08/20/2009
Now Playing: 