Published to LuthINformed issue 2 (April 29, 2016)
In our last issue, we discussed fundamentals of natural gas supply, pricing and markets. In this issue we look at competitive supply options. You may ask “what makes a good supply agreement?” Simply put, a good agreement is one that allows a buyer to meet budget expectations without paying too high a premium for price insurance.
Hedging and Risk
Many institutions look to reduce, or eliminate, the risk that energy cost volatility will negatively impact their operating budget. The most common way to do this is to conduct a competitive purchase RFP, and enter into a supply agreement with the lowest priced supplier. The premise of this process, of course, is that competition drives down prices. Remember that the price being offered is the Citygate price (below) – not the burnertip price.
The vast majority of buyers hedge volatility risk by means of a fixed price supply contract. But many fixed price contracts still contain risk because they contain usage bandwidths. A fixed price, full requirements contract eliminates this additional risk. Full requirements means the supplier will charge the agreed price, no matter how much gas your facility uses. Such a supply structure meets the needs of a client with a low risk tolerance profile. In order for your supplier to offer you a price, they must first know how much, and when, you use gas. Typically, data from the past 12 months is used. Either your supplier or consultant may use a technique known as weather normalization to adjust your usage data to reflect “normal”, rather than actual weather conditions.
Full requirements, fixed price contracts provide budgetary certainty, however, they may also include a hefty “risk premium” because the supplier cannot know, for example, exactly how much, or how little, gas your facility will actually use. An ESCO charges this premium to protect themselves against potential penalties and to cover the cost of unknown variables such as fixing cost components which may change in the future. So generally speaking, fixed price, full requirements contracts are among the most expensive contract options.
Understanding this, it’s not surprising that a supplier will offer a lower price if the buyer accepts usage “bandwidths”. This means that any usage above, or below, a certain threshold will be “marked to market”. Under certain circumstances you may be charged current market prices for any usage outside those pre-defined limits. For example, if your facility burns too little gas to satisfy the contract, perhaps because of unusual weather or an operational issue, the excess gas will be sold into the market. And chances are, under those circumstances, the unused gas will be sold at a loss – a loss that can be passed on to you. The opposite scenario also holds true. In January 2014, the polar vortex created unprecedented demand and delivery constraints – and NYC natgas spot prices reached $120/Dth. There were numerous anecdotes regarding dramatic pass-through’s as a result. With respect to futures pricing, the rules of supply and demand always apply.
Next time we will continue our discussion of supply contracts and active management strategies…
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