A Fresh Look at Natural Gas Contracting

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.

Natural Gas Contracting Best Practices

Since the natural gas industry is transparent, the truth is that the best practices for buying natural gas are actually the same as with any other product or commodity. Thus any Wisconsin school district purchasing or looking to purchase should follow these best practices:

Rule #1 – Know Your Natural Gas Price.

Every natural gas contract should have a clearly stated price for the gas. This allows the price to be known before the gas is consumed and also allows the price to be verified and audited. Typical pricing methods for Wisconsin can range from fixed price to those based on the New York Mercantile Exchange (NYMEX) financial contract to the Platt’s index for physical Chicago city gate deliveries. Since these types of prices are published, using any of them dramatically increases contractual transparency. As with any contract, the mantra should be trust, but verify.

Rule #2 – Know Your Delivery Cost.

Your natural gas contract should also clearly state the price or indices being used to determine the cost to deliver the gas. We have seen cases where the business managers thought they bought gas for $4.00 /Dth, but were then charged $27.00 /Dth. The difference occurred because the gas supplier failed to adequately explain and protect the customer from the risk associated with moving the natural gas. This could have been easily prevented by fixing the delivery cost at the same time the gas price was set.

Rule #3 – Know the Fee You are Paying.

According to the Federal Acquisition Regulations, the fee that one pays should be reflective of the degree of risk involved in the contract. In other words, if the school is taking all the risks by entering into a cost plus, plus, contract, the school should be paying a very low fee to the gas supplier. The answer should be as easy as looking at your bills from last winter. If you paid high prices, then it is fair to ask what exactly did your gas supplier do for you and what risk did they actually take?

The bottom line is that any natural gas contract should clearly specify (1) the price paid for natural gas, (2) the price paid for moving and delivering the gas and (3) the fee you are paying the supplier for this service. Once

you embrace these three rules you will be in a better position to manage your natural gas contract, lower your risk exposure, and set more concise budgets.

Parting Comments

So why is this important to your school? Clearly unexpected natural gas costs can have an adverse impact on any institution. No one wants to cut back on programs or services because of unanticipated increases in your natural gas bill. It was, after all, the price spikes that occurred post Hurricane Katrina and the commodity bubble of 2008 that prompted a number of schools to seek relief by pursuing wholesale purchasing and gas transportation.

Unfortunately, while the natural gas industry is extremely transparent, the market dynamics, terminology and rules can be as challenging as trying to purchase a health insurance policy. In fact, in a number of cases that we have reviewed, the school would have been better off to have stayed with their local utility rather than expose themselves to the market place where “caveat emptor” (buyer beware) often applies.

Nevertheless, this does not have to be the situation for your school. The first step is to apply the best practices contracting rules described above and/or seek out a natural gas broker who you can trust to help you through this process. Above all, energy purchasing can and should be easy to understand and provide consistent benefits for your district. Remember the utility bill is not a necessary evil that you simply pay; you have choices that allow you to manage and lower your energy costs. v

For more information or questions about this article, contact Blake Baxter at 608.819.4011or via email at bbaxter@mepsolutions.org.

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