Energy buying for the risk-averse

A guide to pooling and hedging the energy buy

By Gordon Graff -- Purchasing, 8/11/2005

The chemical industry, a voracious consumer of oil, gas and electricity, has been hard hit by the energy price volatility for the past few years. As a result, many chemical companies have adopted energy procurement strategies to shelter themselves from the wild fluctuations of energy rates. For example, some producers are joining regional buying pools to lower their utility bills. Others are resorting to hedging - the purchase of contracts or financial instruments that allow them to lock in their energy expenditures around a fixed amount or a narrow range for a given period.

While larger companies usually can hire their own energy procurement experts, small and medium-size businesses are increasingly relying on outside firms to help them navigate the uncertain waters of the energy market. These energy management firms design energy purchasing strategies for their clients that minimize their risk; they may also negotiate with potential energy providers to get the best deals for their customers or organize buying pools composed of companies in the same industry to get volume discounts on energy purchases.

Not surprisingly, the hotbeds of energy pooling activity in the chemical industry are in two U.S. hubs of chemical manufacturing—New Jersey and Texas. Because of the high electric power rates in New Jersey, that state has been at the forefront of the pooling movement. Two years ago, about 40 manufacturing members of the Chemistry Council of New Jersey (CCNJ), a Trenton-based chemical industry trade group, created an electric power buying pool. The pool, set up with help from energy procurement consultants Epex of Exton, Pa., chose electric power supplier Reliant Energy Solutions to provide up to 300 megawatts of power to more than 60 processing locations in New Jersey. Members of the pool—whose businesses included pharmaceuticals, flavors and fragrances, precious metals, oil refining, cosmetics and food processing—were each presented with a customized contract with terms ranging from 10 to 26 months.

Elvin Montero, a spokesman for CCNJ, says participants in the program, whom he declines to name, have cut their electric power bills on average by 15-20% in the past two years, representing a combined $20 million in savings. Montero says that a second round of bidding to supply CCNJ members with power is now underway.

Inspired by the success of the New Jersey effort, two chemical trade groups in Texas are joining forces to organize their own electric power buying pool. In February, the Texas Chemical Council (TCC) and the Association of Chemical Industry of Texas (ACIT) disclosed that they would partner with Priority Power Management, a Midland, Texas energy management firm, to help their members leverage their collective buying power to obtain the lowest possible electricity rates.

According to Jeff Gray, executive vice president of TCC, which represents the large chemical manufacturers in Texas, the effort is at a fairly early stage. "Right now we're just advising our members that Priority Power has some electrical power aggregation [pooling] opportunities that they might want to explore," Gray says.

The other party in the agreement, ACIT, which represents suppliers to the Texas chemical industry, is also alerting its members to the energy saving opportunities offered by the partnership, he adds. Gray emphasizes that interested member companies in the two groups are expected to deal with Priority Power Management on their own. Because many member companies' power contracts are still in force, says Gray, organizing any new buying pool will probably be a one or two-year process.

Perry Ruthven, director of Priority Power Management's Houston region, says the company has already received letters of intent from some TCC and ACIT members regarding possible participation in a power buying pool, often as the expiration dates of their present power contracts draw near. Many power customers in the chemical industry prefer to renew their electric supply contracts - usually for one or two-year periods - at the end of summer, when power prices tend to weaken, Ruthven notes. So he expects interest in a pooling arrangement among the TCC and ACIT members to pick up in the next few months. He says his company will probably announce its first chemical pool "very early this fall."

Ruthven says the average savings members can expect depends on the size of the company and its energy buying patterns. But based on Priority Power's other industrial power pools, which have focused largely on the oil and gas industry, Ruthven estimates that chemical purchasers of power in Texas might lower their electric bills by 2-6% if they joined a pool.

Priority Power Management also offers market research to its customers. Outsourcing every aspect of the energy buy is vital for firms that don't have the time to keep their fingers on the pulse of the energy market or the wherewithal to hire internal consultants, says John Bick, owner and managing principal of Priority Power Management. Typically, Priority Power studies the energy needs and consumption patterns of a customer and recommends an energy procurement plan based on some combination of market-rate buying or hedging. The relative proportions of each, he adds, depends on how much risk a company is willing to tolerate.

Hedging, in fact, remains the cornerstone of most energy risk-management programs in the chemical industry. Koch Supply & Trading offers hedging and other energy risk management services for energy producing and consuming industrial customers. A subsidiary of Wichita, Kan.-based Koch Industries, Koch Supply & Trading trades individual hedging contracts for its customers and typically structures a portfolio of financial products tailored to its clients' needs.

One of the simplest and most widely used hedges that Koch Supply & Trading offers is a "swap," or financial contracts that allow an industrial energy consumer to lock in a particular purchase or sale price for a fixed period of time. Nick Dazzo, director of derivatives marketing in the New York office of Koch Supply & Trading, explains how swaps work: "Often a company may be buying crude oil at $50/barrel this quarter and wants to lock in the same $50 for the next quarter," he says. "And suppose at the end of the next quarter, oil prices turn out to be $60. Compared to what the company budgeted for, they'd be losing $10 for each physical barrel of oil bought for that quarter. But if you had bought a swap, it would pay you, dollar for dollar, for every increase in oil beyond $50. So you'd be losing on the physical side but making it up on the financial or paper side." On the other hand, Dazzo continues, "if prices fell to $40 in the next quarter, then you would owe $10 for each barrel of oil you purchased, even though the physical barrels would be $10/barrel cheaper." So swaps involve an exchange of funds at the end of the agreed-upon period, which is usually one month rather than every quarter.

While swaps ensure that energy expenditures will be constant for a given period, other financial contracts, called collars, allow them to swing between established ceilings and floors. Collars "give you some comfort by keeping you a little bit hedged, but they also give you flexibility," says Dazzo. For example, he cites the case of the company that wants to keep oil expenditures around $50 in the next quarter. If it has a collar that gives it the right to buy oil at prices between $45 and $55, then if prices fall from $50 this quarter to $48 in the next quarter, the company would not owe anything and would reap the $2 per barrel benefits of cheaper oil.

Swaps, collars and other energy risk-management products (see table) are traded on financial markets just like stocks, bonds and commodities. Generally, the more volatile energy prices are at any one time, the more expensive are the asking prices for hedging contracts.

One caveat regarding hedging contracts, particularly those sold over the counter, says Patrick Melia, a derivatives marketer at Koch, is that participants should evaluate the financial stability of the institutions that back those contracts.

Meanwhile, Priority Power Management's Bick advises that risk management should encompass all forms of energy purchased by a company. Too often, he notes, industrial buyers pursue hedging for either gas or electricity, but not both. In fact, he says, "gas and electricity rates are closely tied together," so when it comes to hedging, "it makes sense to have a comprehensive strategy" that looks at the total energy buy.