The Promise and the Reality of Wisconsin Wholesale Natural Gas
In 1980, after graduating from Carnegie-Mellon University, I left a rusting Pittsburgh and moved to Houston, Texas, to seek my fortune in the energy industry. Houston at that time was in one of its boom cycles and I was promptly hired by Natural Gas Pipeline Company of America during my very first interview. As a result, except for various excursions overseas as part of the Army Guard, I have spent my entire professional life in the natural gas industry.
Last year, after retiring from the Tennessee Valley Authority and the Army Guard, my wife and I finally achieved one of our long-term goals, to move back to the North, when we moved to Madison. Like many people in my age group, I did not actually retire, but instead went to work with a local company that wanted someone with my expertise. This company
was convinced that many Wisconsin companies and institutions were in dire need of help when it came to natural gas purchasing. Little did I know how right they were in this assessment of the state of affairs.
In a little over 15 months we have performed dozens of audits looking at how Wisconsin businesses and schools purchase their natural gas. The companies range from large, well-known companies to small town operations. The schools range from large urban districts to small north woods schools. In almost all cases however, we have found significant shortcomings within their gas purchasing programs.
The first thing that struck me when we were doing audits was that very few people actually know how to read a contract. My guess is that many of us have gotten used to signing up for cell phone service or company health plans without ever bothering to read the fine print. There seems to be an assumption that someone is watching out for us even when that may not be the case. We become virtually speechless when we see client after client signing retail gas marketing contracts that basically read “you will pay me whatever I bill you”! These contracts have absolutely no protection for the consumer and expose them to greater price risk than if they had stayed with their local, regulated gas utility.
For example, one term that is common to many gas contracts is “market price”. If one goes to the definitions section of the contract this term is often defined as the price the retail gas marketer, in its sole discretion, determines to be applicable. The reality is that natural gas is traded in hundreds of locations around the country every day and those prices are published in trade papers daily. A market price should be defined as the price at a specific published location as reported in the trade papers so that it is both verifiable and auditable.
Furthermore, natural gas can be priced daily, monthly, seasonally, or annually. Daily prices are the most volatile form of pricing and can be heavily influenced in the short-term by extreme weather. Monthly prices are more stable because they average the price for a month. If a three day cold front blows through, the price is moderated by the prices traded on the warmer days of that month. If your contract simply states “market price” then it is entirely possible that you will get the highest, most volatile of these prices.
And “market price” is far from the only problem with these retail contracts. I am amazed that anyone would sign a contract that allows for “reasonable marketing fees” or for prices that “relate” to something that is in the sole discretion of the retail marketer. As six degrees of separation has shown us, almost everything is relatable. The big question comes down to whether the terms of the contract are auditable? If the pricing is not tied to industry published indexes and the supplier cannot provide data or even a calculation for the pricing, then you have a very serious problem.
The second thing that struck me when I was doing audits was that virtually no one understands the logistics of natural gas. Natural gas is like most other commodities in that it is produced in one location and consumed in another location. The old axiom “out of sight, out of mind” seems to apply to natural gas. Unlike coal which moves on the railroads, natural gas moves from production areas to consuming areas through large, underground, interstate pipelines.
As large as they are, these pipelines still have a finite limit as to how much natural gas they can move at any one time. This fact was driven home during the Polar Vortex Winter of 2013-14. During that winter the U.S. was actually producing record amounts of natural gas. The price spikes of that winter were not the result of too little gas, but rather too little space available in the natural gas pipelines. Thus, as the weather got colder prices spiked as companies bid up those last increments of available capacity with which to ship the natural gas.
But in all the audits that we have done so far, only two companies were actually familiar with this issue and had taken action to limit their exposure to this price threat. In fact this is one of the main reasons why people ask us to do audits. It is hard to say how many times we have been asked by an executive why they paid $2.70 per therm for natural gas when they thought they were hedged at $0.40 per therm.
The fact is that this is another area where unsophisticated consumers get into trouble. Unlike the gas price, which is published in numerous sources, the transportation price, known as basis within the industry, is normally only published in trade papers that most consumers cannot readily access. Therefore, the gas consumer is generally flying blind on this critical element of the delivered gas price.
This section could easily be labeled: “Who’s watching the store / schoolhouse?” We have literally been flabbergasted by an abject failure on the part of companies and institutions in Wisconsin to apply any metrics to their gas purchasing activity. The natural gas industry is one of the most transparent and quantifiable industries out there. Gas prices and the cost of gas transportation are published daily (most local newspapers publish the gas price in their business section). The last piece of pricing, the cost to deliver gas to any facility by the local gas utility, is regulated by the Public Service Commission and is available on both the utility and PSC website.
If these prices are available, then why is no one doing metrics?
In one audit, we reviewed the records of a school district that had been contracting natural gas from a retail gas marketer for 13 years. They paid more money to their retail gas marketer, than they would have paid to their gas utility, in every month during those 13 years except for the two months the U.S. was impacted by Hurricane Katerina back in 2005. Virtually all of the audits that we have done have revealed that the clients were worse off with a retail gas marketer during the Polar Vortex, than if they had simply stayed with the local gas utility. In some cases, the expenses of that winter literally wiped out years of supposed savings they had garnered from the retail gas marketer.
The big question is why have these clients failed to apply any metrics to their gas purchasing.The most obvious question should be “am I actually saving money by buying from a retail gas marketer”? With the publicly available data, that is a really easy question to answer.
The second question that should be asked is “what is my relationship with my retail gas marketer costing me”? While this question is a little more complex, the answer is relatively straightforward. Since we already know what the utility would have charged, we simply need to pull the published data for the gas trading region to find the wholesale price. Once you know the difference between the retail prices and the wholesale price, one can then determine the split of any savings.
We have done this calculation a number of times and the one constant is that the numbers always favor the retail gas marketer. (See chart at top right.) In the case of Company C, a Milwaukee company, the difference between the wholesale prices and the retail prices represented 24% of their total gas spending with 20% going to the retail gas marketer and just 4% going to the company.
As a practical matter, if you have a sound gas contract, your purchases from the wholesale market should beat the utility cost by ~10% to 15% on an annual basis. Those should be the assumed savings during periods of low prices such as the one we are in now. However, if you have a good contract, those savings should be greater during higher priced periods such as the recent Polar Vortex winter.
I have a sign that hangs in my office that says, “If you think it’s expensive to hire a professional, wait until you hire an amateur”. If there is one area of expertise that this applies to in
Wisconsin, it is natural gas purchasing.
The bottom line is that saving money on your natural gas purchases is entirely possible. However, it requires an expertise in contracting and industry knowledge that is missing in many institutional situations. Many companies seek outside experts to help them with their health plans and other complex decisions. After what we have seen over the last 4 years, they would be well served to also seek out independent expertise to help with their natural gas purchasing.
23 Sep 2016
Natural Gas Contracts 101
Avoiding common mistakes in the contracting process
In the August issue of Wisconsin School News, we discussed the natural gas supply chain and the differences between the regulated gas utilities and retail gas marketers. Building on that foundation, we will focus on the key features of natural gas contracts and how to avoid some of the common mistakes that occur in the contracting process.
Know Your Price
Let’s get this on the table first and foremost: the most glaring mistake we find in many retail gas contracts is the lack of a definitive price. Can you look at your contract and deter- mine what you will actually pay for your natural gas?
There are two fundamental ways to price natural gas: (1) fixed price or (2) index priced.
If you have a fixed price, then the contract should specify a price in million British thermal units (MMBtu) also referred to as Dekath- erms (DTH) or Therms. As a point of reference, gas is currently trading nationally at $2.75/MMBtu, which is $0.275/Therm.
Fixed pricing is commonly used by those who want cost certainty, however, just remember that cost certainty can cost you dearly.
Natural gas prices go both up and down and a fixed price can be either a significant loss or gain.
Indexed pricing is often used in lieu of a fixed price. Indexed pricing is the linking of your gas price to a publicly traded price that is reported by independent news organizations. For example, your contract could state that you will pay the New York Mercantile Exchange (NYMEX) “last day settlement price” for January 2017. NYMEX pricing is reported across numerous news organizations every day and reflects the results of thousands of transac- tions per day.
One advantage of using NYMEX pricing is that most retail marketers or utilities will allow you to convert it to a fixed price at little to no cost. This can be important if there are changes in market conditions that make you reconsider your pricing strategy.
Another example of indexed pricing would be for your contract to state that you will pay the “first of month midpoint price” for Chicago Citygate prices as reported by Platt’s Gas Daily publication. This is a news organization that has been reporting on gas prices for decades and is depended upon by buyers and sellers across the country. Each day they report on gas trading activity at dozens of locations from Maine to California. The advantage of this type of pricing is that it should be based on a price that is traded close to your physical location and thereby includes the majority of your transportation/ basis cost.
While fixed pricing and index pricing are two popular options, these are not the only ways to price a gas contract. So how can a school official really determine if they have a con- tract with real gas pricing? My answer to this dilemma is to ask one simple question: “Can my district audit its gas price?” If there is any hesitation or obscuration in answering, then you may have a problem.
Additionally, make sure that the price being quoted is for delivery to your location. If your price does not include the cost of delivering the gas (a/k/a basis), then you may be in for a rather rude surprise come the next cold front.
Another key to natural gas contracts is to understand how the contract handles your gas usage. Just as you cannot forecast how many cell phone minutes you will use next month, very few people can forecast how much natural gas they will burn. And yet, in order to secure a definitive price for gas, you will need to supply the Retail Marketer with a forecasted gas volume.
Strategies to deal with these issues will vary, but they generally fall into two categories. The majority of consumers tend to aim low and purchase 50 to 80 percent
of their expected usage. The other group tends to aim high and pur- chase 110 to 120 percent of their usage. Which of these strategies is the best?
The answer to that question is in your contract.
Since virtually no one can forecast their gas consumption, every contract provides a remedy for gas ordered, but not consumed, or for when the quantity ordered is less than what you consume. For large national contracts, the remedy can be that the quantity difference is carried over to the next month. But for retail gas contracts, the retail marketer is going to charge you a price for any extra gas and it should pay you for any gas you ordered, but did not consume.
How these prices are determined is the key to determining which strategy you should adopt.
It is at this point that we re-visit our earlier conversation on gas pricing. The prices paid for any variance in gas volumes should be clearly stated and should be audit- able. If they are not clearly stated, then you may find in cold weather that the price you pay the retail marketer is greater than you would have paid the local gas utility. At the same time, if you do not have a distinct price for volumes that you fail to consume, you may be selling them back to the retail marketer at prices substantially below market.
The key, as you might guess, is to make sure that the prices for any variance in gas consumption are clearly stated. When these price are clearly stated, you can then perform the mathematical simulations neces- sary to determine which is the best strategy for your situation — aim high or aim low.
If you want some fun reading for a long winter weekend may I suggest a copy of the Federal Acquisition Regulation or the shorter State of Wisconsin Acquisition Regulation? They are not exactly cliff hangers, but both agree on one central tenet — competition is the best way to secure value for the public. Consequently, both documents urge con tracting officers to avoid perpetual agreements and provide for a number of procedural hurdles that must be met before such a contract can be signed on behalf of the government.
The central point is that when a contract has a definitive end date in a competitive marketplace, the buyer has contracting leverage. Having an end date forces the buying official to take action and hopefully evaluate the recent performance of the con- tract prior to entering into a new or extended contract.
One way that the national gas industry dealt with this issue was to develop the North American Energy Standards Board (NAESB) Base Contract for the Sale and Purchase of Natural Gas. The NAESB contract is what is referred to as an enabling contract. The base NAESB contract does not contain any commercial terms and does not obligate either party to a transaction. What the base NAESB contract does is to establish a commercial relationship between a potential buyer and a potential seller that explains how transactions will be handled if the parties opt to execute a transaction. Only if and when both parties execute a transac- tion confirmation, as described by the NAESB contract, is there a binding commercial transaction.
This template was developed to facilitate the broader national market for gas. Large gas trading companies may have hundreds of NAESB contracts in place to facili- tate high volume trading. The key is that each transaction must have a distinct gas volume, price, location, start date and end date.
Most retail marketers will encourage buyers to sign their in-house contract, but as one saying goes, there be dragons. Retail mar- keters, like cell phone companies and others, draft their contracts to favor themselves. However, if pushed, most retail marketers will agree to a NAESB contract. At that point one just needs to adhere to the KISS principal and make sure that the transaction confirmation has a distinct gas volume, price, location, start date and end date. Remember, you should avoid any language that seeks to automatically extend or perpetuate the transaction.
4 THINGS YOU NEED TO KNOW About Natural Gas Contracts
There are a myriad of ways to price a com- modity like natural gas. The most prevalent methods are fixed price or indexed price. However, because gas pricing can take many forms it may be difficult to know which prices are derived from independent public sources and which are proprietary to a single energy company. Gas pricing derived from the New York Mercantile Exchange (“NYMEX”) is available from many sources, but does not include the cost of delivering the gas to your facility. The one question that should always be asked of any retail gas marketer is whether the price stated in the contract can be audited by your accountants.
It is virtually impossible to forecast the gas consumption of any facility with preci- sion. Therefore, it is critical to understand how any extra gas or any unused gas will be priced in your contract. Just like in item 1 above, the gas pricing methodology should be clearly stated and auditable. If the gas pricing is appropriately stated, then the amount of gas that you should order can be derived from mathematical modeling.
In a competitive market- place the best value for any institution is realized through competition. Having a specific end date in a contract provides the buyer with significant contracting leverage. Any attempt to limit your ability to end a contract should be met with skepticism. Watch out for attempts to amend your contract through language inserted into routine transaction documents.
Natural gas purchasing is all about the numbers and the calculations are relatively simple. Never take savings for granted. Someone in your organization should be reporting on the performance of your natural gas transactions. Even if you are purchasing gas for budgetary reasons, in which case some losses may be acceptable, you should understand the metrics as part of any due diligence prior to doing more transactions.
In our previous article, we discussed natural gas metrics in some detail. The bottom line is that if you have entered into a good contract with a retail marketer, you should have all the information needed for you, your accountant or a consultant to evaluate the performance metrics of that natural gas transaction. The calculations are simple enough that they could be done quickly every month, but they should be done on an annual basis at a minimum.
Unfortunately, we find too many instances of officials simply assuming that natural gas pur- chasing is saving them money. In some cases, this is because people compared this year’s bills with the bills from last year not realizing that gas prices have been falling in recent years (they fell to a 17-year low this past winter). In other cases, officials have opted to fix the price for bud- getary reasons (in some cases for years) without a full grasp of the dollars at risk or the alternatives to managing gas price risk.
The only way to properly evaluate your gas purchasing program is to run the performance metrics. As we have previously mentioned this can be done in house or at no cost through a consultant that is well versed in the natural gas marketplace.
22 Sep 2016
A Fresh Look at Natural Gas Contracting
While serving as a US Army contracting officer in Afghanistan in 2012, we received a directive from the Department of Defense to stop using cost plus contracts. Cost plus contracts are typically contracts entered into in emergency situations when the cost of providing things to the troops like food, fuel and bullets is unknown. In these situations the military is literally willing to pay any cost, plus a profit, to deliver the needed material. Nevertheless, these types of emergency contracts still contain provisions that allow the Government to (1) audit the incurred costs and (2) stipulate the profit percentage the company is allowed to collect for its services.
I mention this experience with Cost Plus contracts because it serves to define one end of the contracting spectrum. At the other end of the spectrum is the firm fixed price contract that most of us use every day when we buy common products such as pencils, paper and paperclips. What this tells us is that the method we use to contract for products and services is heavily dependent upon the levels of competition, market transparency and the perceived risks.
Based on a number of natural gas contracts we have reviewed for Wisconsin schools, it appears that they entered into contracts that are best described as cost plus, plus. I describe them as cost plus, plus, because they lack specific pricing and do not provide for either auditing or specify the fee for the natural gas supplier. Lacking any specifics, this means that these schools have no idea what they are paying for their gas supplies until well after the month has closed. Unfortunately, after this winter’s Polar Vortex, a number of schools found out how expensive buying natural gas could be under such contracts.
For example, one school we reviewed paid their wholesale supplier $95,000 for natural gas during the period November through March of this past winter. If they had followed even a very conservative strategy utilizing the basic principles we will discuss, their cost should not have exceeded $65,000. They thus paid a 46% premium for natural gas this past winter.
The good news is that it is possible for schools to contract for natural gas and related services without paying such outrageous premiums.