Playing a waiting game

With energy – and particularly natural gas – costs on the rise, are end-users finally coming to terms with the importance of hedging or are they still waiting to get burned before they enter the hedging market? Kevin Foster reports

Now is not a good time to be a large purchaser of energy. US natural gas prices hit $6 per million British thermal units (mmBtu) in February, and crude oil continues to rise with fears of an attack on Iraq. Unhedged companies face the risk of huge losses.

End-users are increasingly recognising the need for energy price risk management, says Mike Gettings, executive vice-president at energy management firm Pace Global in Fairfax, Virginia. In the industrial and commercial sector, Pace works with big, energy-intensive companies, such as metals, pulp and paper and chemicals firms.

Gettings says such companies are very familiar with the concept of risk management. “All of our clients are very sophisticated in their own businesses and have good analytical capabilities. Their treasury groups are used to focusing on risk management, for example in interest rates,” he says. “But in some cases, energy tends to be in the hands of people who are procurement-minded rather than risk management experts. So sometimes their experience in this area is not that deep.

“There is a struggle between the tendency to follow raw instincts of fear and greed, versus the more rigorous approaches that we recommend,” he adds. “That struggle is slowly being won.”

Soaring energy costs have a way of focusing buyers’ minds on the need for risk management. In the US, natural gas has tripled in price in the past year, to more than $6/mmBtu in February 2003 from $2/mmBtu in February 2002. Meanwhile, many of the energy merchant companies that provided outsourced risk management services to end-users have left the market to concentrate on their core businesses (see box).

So what do end-users themselves say are the main challenges facing the implementation of a hedging programme at current prices? The majority of large US industrial firms contacted by EPRM declined to comment on their risk management, and many would not even confirm whether they have an active hedging programme in place.

One big company that does hedge its energy risk is Dow Hydrocarbons and Resources, part of the Dow Chemical Group. Dow’s exposure to rising energy prices was cited as a factor in its poor 2002 results by company chairman William Stavropolous. “Dow’s costs for feedstocks and energy will be roughly $400 million higher in the first quarter [of 2003] than they were in the fourth quarter [2002], and compared to the first quarter of 2002, the increase may be more than $1 billion,” he said in a conference call to announce the company’s quarterly results on January 30.

Seth Roberts, commercial risk manager for energy at Dow Hydrocarbons and Resources in Houston, says the company has had an active hedging programme in place to manage its natural gas costs for about 10 years. “We employ a wide range of tools for risk management, including options, swaps and futures, as part of a portfolio to hedge against natural gas costs,” he says. He declined to comment on any specific strategies the company uses or to reveal what percentage of its energy needs are hedged.

Pace Global’s Gettings says that in his experience companies tend to hedge 25–80% of their energy needs. “But it depends on a company’s appetite for risk,” he says. “Some of our clients are more concerned about not making bad hedges than their exposure to price rises, while for others it’s vice versa.”

Dow’s Roberts says the current level of natural gas prices poses particular challenges for end-user hedging. The New York Mercantile Exchange benchmark Henry Hub natural gas contract closed at $6.61/mmBtu on February 21 – an awkward level for hedging, he says.

“In general, it’s a lot more difficult to fix prices going forward when natural gas is at $5–6 than when it’s at $3,” he says. “Statistics show that natural gas prices tend to mean-revert, so with prices at the current level you’re looking at a 50-50 chance of getting things wrong. Natural gas doesn’t usually spend a lot of time at $6 – it either rises to $10 or falls back to below $4.”

But he doesn’t question the validity of having a hedging programme in place, despite such uncertainty. “Given the volatility in the markets, and our company’s exposure to both natural gas and crude prices, it’s worthwhile at the very least to understand the markets,” he says. “There’s value for us in developing our own sense of where prices are likely to go through our hedges, whether we take a position or not.”

Cycles
Pace Global’s Gettings says he has seen a tendency for some companies that are active in the market to extend the time horizon of their hedges. “In my experience, [market] cycles have recently become more dramatic in terms of volatility and they also tend to be longer,” he says. “In natural gas, the last market bottom that represented a serious buying opportunity was in July 2002 [when natural gas traded at below $3]. So that means the market has been running upwards for about nine months. Four or five years ago, the typical cycle was closer to three months.”

But still some companies tend not to focus on the need for risk management until it’s too late, he says. “We speak to companies who look to enter the market and develop hedges only when, for example, gas is at $6, as it is right now – and then you’re caught between a rock and a hard place,” he says.

But there are market strategies that companies can use to mitigate their risk even if they’ve seen high prices eat away at their earnings, says Gettings. “If clients came in late and are uncomfortable with current high prices, one strategy we’ve been suggesting for the past month or two is to use collars [contracts that cap on both the maximum and minimum price levels],” he says.

“The risk associated with the ‘war premium’ [the perception that prices are higher than fundamentals dictate due to fears over an impending attack on Iraq] is immense,” Gettings adds. “So we’re recommending that companies cap the upside, but put money into premiums to mitigate against downside risk, as prices may fall quite sharply when that war premium is removed.

Is in-house risk management the way of the future?

Several leading energy trading companies cut back their risk management operations in 2002 in favour of the more traditional utility model. While the drop in market liquidity caused by these departures is well known, less examined is the impact on end-users – many of whom relied on such traders to manage their risk through long-term deals or outsourced risk management programmes. Dunham Cobb, a senior manager in the trading and risk management group at consultants Cap Gemini Ernst & Young in Houston, says the changes in energy markets over the past 12 months have affected end-users in two ways. First, the drop in trading volumes and liquidity has widened bid-offer spreads, which – in combination with rising natural gas prices – has made the business more expensive for end-users. Second, he says, the few players left in the trading market have begun to re-assess how profitable the end-user market was all along. “The industry is waking up to the fact that a lot of [end-user] business was not very economic, given the model suppliers were following,” he says. “Given the size of some of the suppliers, and the eagerness of them to grab market share, the focus on actually making money on a risk-adjusted basis got lost in the fog of war.” Cobb says the typical end-user’s energy risk management requirement is not very complex. “A smallish commercial customer looking to outsource its entire energy requirements is typically buying energy on pretty much the same basis as a household would – it’s paying a constant unit price, whatever the usage, sometimes with some optionality embedded in volume requirements,” he says. “A lot of suppliers dashed into the market to sell on this basis, without calculating risk variables, such as weather or load considerations,” he adds. “There was such a rush to provide these services that asking prices plummeted and the profit motive got lost in the focus on revenues and volumes.” Yet not all energy companies have stopped providing these services. Baltimore-based Constellation Energy and Sempra Energy in San Diego are two that affirm their commitment to the end-user sector. But the drop in the number of suppliers has led to many end-users taking their energy management needs in-house, says Paul Corby, senior vice-president at Wayne, Pennsylvania-based technology company Planalytics. “End-users are looking for more sophisticated tools and advice, as they seek to manage these risks themselves,” he says. “We’ve seen end-users become more involved in the futures and swaps markets, and I’ve been very pleasantly surprised by the sophistication they’ve shown.” Corby argues that while smaller consulting companies will continue to advise on energy procurement needs, the era of the one-stop shop – in which companies took on both advisory and trading roles – is over.