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.
Why do Gas Prices Fluctuate?
Contrary to what the cost plus, plus, contracts seemingly imply, the natural gas industry is actually one of the most transparent industries in the world. This is a result of both the importance of energy to our economy and the efforts of the Federal Energy Regulatory Commission (FERC) to promote e-commerce.
As with most products, there is a cost to make or produce the product and there is a cost to move the product to where it is needed. The natural gas model is similar to that of the coal industry. In that case coal is extracted from the ground by a mining company and then loaded onto trains or barges to move it around the country. Natural gas by comparison is extracted from underground rock formations by gas production companies and then shipped around the country through large diameter underground pipelines. On an average day over 60 billion cubic feet of natural gas is moving through these pipelines.
From a commercial standpoint, natural gas is traded around the clock as both a financial and a physical product. Everyone from investment banks to power plants to speculators trade natural gas. This broad participation with competing objectives in part explains the extreme volatility (price movement) that natural gas can exhibit from time to time.
Another reason for such price spikes, especially in winter, is due to the cost of moving the natural gas. Natural gas has become increasingly plentiful as a result of shale gas drilling, however, the ability to move natural gas is dependent upon the previously mentioned underground pipelines. A new gas well can be drilled in days, but building more gas pipelines can take years. Thus in a state like Wisconsin, where demand for pipeline capacity can increase dramatically during events such as the Polar Vortex, prices can become exaggerated as demand for natural gas and pipeline capacity peaks.
However, just as natural gas trades as a commodity, so does the cost of moving the natural gas. On any given day, this cost is traded on both financial and physical trading platforms for over one hundred locations across the U.S. Moreover, these prices are published daily in multiple industry sources. This means that you can set this price in advance and not leave yourself open to wild fluctuations.
Thus an educated buyer can choose to set the price of natural gas and the cost of moving that gas to avoid budget busting price spikes.