(Tip of the Month for April 2004)
Heating fuel budgets took a beating last winter when
natural gas prices went briefly into the stratosphere (topping, in a few
locations, $50 a dekatherm). One way to perform damage control on next year's
budget right now is through financial options, such as weather insurance and
physical hedge contracts.
A Simplified Scenario
Imagine a one-million-square-foot office park
in a northern climate of 4000 degree-days (DD), plus or minus 500 DD. Such a
facility annually consumes (at $4.50/MMBTU) $400,000 of firm gas (yielding an
average cost of $100/DD). If fuel is bought from a utility under a tariff
containing a fuel adjustment charge, the price floats with the weather: a mild
winter sees an average price below $4.50, and a very cold winter blows the
budget. (Note: all pricing is representative only and all scenarios are greatly
simplified to ease description.) To control its costs, this facility signed a
fixed price fuel contract with a marketer covering a winter up to 4500 DD, with
a floating price for fuel needed during colder weather. In Figure 1, the
horizontal blue line is the fixed price and the red line is the utility price
for the same volume of fuel. At 4000 DD, the fixed and utility prices are the
same. At 3500 DD, buying from the utility would save a dollar amount (relative
to the fixed price) represented by triangle A. At 4500 DD, the fixed price would
save an amount represented by triangle B. Since the fixed price contract has a
limited volume, however, the price for fuel used in a winter exceeding 4500 DD
is (in this scenario) the same for either option.
Getting Started With Weather Risk Management
Two alternatives are offered to control the risk
above 4500 DD: weather insurance, and a physical hedge contract. Both are tied
to usage in a specific month (e.g., January) in which extra DD (in this case up
to 500) are not uncommon. The weather insurance option may be pursued through a
broker active at the Chicago Mercantile Exchange, where weather-based contracts
are routinely traded (a variety of weather traders may be found by Googling
"weather risk management"). Such contracts ensure that, should the number of DD
exceed a defined level, payments are made at a rate of $XX per extra DD incurred
(based on current market pricing and maybe a bit of negotiating). Since the
payment is directly proportional to temperature difference, this process is
primarily designed to deal with extra fuel consumption (i.e., "volume risk"). As
seen in Figure 1, the higher pricing seen between 4500 and 5000 DD creates
additional cost risk. If the winter is normal or warm, the facility's risk is
limited to the value of the contract's premium (10-20% of its maximum value in a
cold winter). Suppose the facility instead bought a commodity contract for extra
fuel needed to cover an additional 500 DD. It would not need to take possession
of the fuel but simply maintain the right to take or sell it. The facility would
incur risk if the weather became warm and the fuel was not needed. In such a
case, it would need to sell the contract, possibly at a value lower than when
bought, thus incurring a net loss. If you look at Figure 2, on the other hand,
where the type of commodity contract is referred to as a “swap contract,” you
will see that if the weather turned cold (thus increasing the value of the
fuel), it could sell the contract at a price above that at which it was bought.
That extra cash would then be used to cover the extra cost of the more expensive
fuel it would physically take from its utility or marketer. Once again, the
transaction is purely financial, though (in this case) a physical commodity
served as the basis for valuation.
Trading A Big Risk For A Smaller One
In essence, these two choices offer ways to take
moderate risks to cover potentially much larger risks. Instead of simply hoping
for the best when it comes to controlling winter fuel pricing, the facility
could (through these and other financial methods) invest a sum in advance that
would be less than the extra cost that could result from doing nothing. While
the worst-case scenario through such advance investment is a warm winter (when
less fuel will be needed in any case, thus helping the budget), the worst-case
scenario from doing nothing was seen by facilities unprepared for last winter,
many of whom had trouble paying their fuel bills. To learn more about such
weather-related options, go to http://www.cme.com
(Chicago Mercantile Exchange) and
http://www.wrma.org (Weather Risk Management Association). For commodity
contracts, speak to an energy broker active in your area that provides such
services (e.g., Constellation, Colonial, Chevron, Duke, Tractabel, Sempra, Hess,
etc.). To find books and training on using energy risk management tools, see
also our tip, Learning To Apply Financial Options To Energy
Purchasing. While the usual due
diligence (and a chat with your accounting people on tax issues) is necessary
before signing anything, now is a good time to get up to speed - before it gets
cold again.
Energywiz, Inc.
Adding New Dimensions to Energy Services
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