TransActions - September 2001 (Vol 401)

THE CHANGING ROLE OF SOME G&T COOPERATIVES

Because of changes in the industry, some of the larger G&Ts in the country have seen their roles change in recent years.  Some of their members have decided to take on power supply responsibilities that previously the G&T would have handled.  Here are some of the industry changes that have contributed to why this has been happening.

In the last couple of years, we in the power supply planning business have observed increased activity on the part of electric distribution cooperatives in power supply planning and procurement.  These are cooperatives that are members of generation and transmission ("G&T") cooperatives, and they would have traditionally relied on the G&T to handle these matters for them.  Particularly here in the Southeast, some members of the large G&T cooperatives have sprung out on their own in recent years, running their own power supply RFPs, entering into independent power supply transactions, even building their own power plants independently of the G&T.  It seems that several changes in the industry in recent years have contributed to this activity:

1.  Growth - A lot of the distribution cooperatives that we see working independently of the G&T are large cooperatives.  Load growth in areas served by cooperatives has been strong over the last 20 to 30 years, particularly in some of the suburban metropolitan areas, to the point where some of the distribution cooperatives have system peak loads approaching 1,000 megawatts.  With this size, these cooperatives can achieve the economies that 20 or 30 years before they would have had to form a G&T to achieve.  They are attractive to potential new suppliers, and they can afford the costs of managing their own power supply.  In addition, if power supply needs among the cooperatives within the G&T have grown disproportionately, such that the power supply needs of some of the larger member cooperatives dominate the needs of the G&T, these larger cooperatives often feel they might as well do it themselves.

2.  Open Access Transmission - 30 or more years ago, when many of the G&Ts in the country were forming, cooperatives found that banding together allowed them to obtain more equitable transmission arrangements.  They needed the combined size of the group to leverage themselves with the power companies who owned the transmission systems.  Today, however, individual cooperatives can obtain comparable and equitable transmission service on their own.  Since the amendments to the Energy Policy Act were passed in 1992, access to the transmission grid to move wholesale power has steadily improved to the point where today, transmission dependent utilities are able to obtain transmission service easily and at a reasonable price (though things still have a ways to go in some areas).  Many of our cooperative clients of our are experienced in managing network service arrangements, making OASIS reservations, and working to obtain transmission crediting. 

3.  Smaller Scale Generation - A large majority of power plants being built 30 years ago were large scale coal and nuclear power plants.  Given the size of these plants, often 2,000+ megawatts, and given their baseload characteristics, the capital investment required was large, and the lead times to construct these plants were anywhere from 5 to 10 years.  Cooperatives interested in these projects needed the size of the G&T to participate.  Today, the prevailing technologies are smaller, less expensive to build, and don't require the long lead times.  Simple and combined cycle combustion turbine facilities can be built in as little as two years, and the capital costs are half what it costs to build a baseload coal-fired plant.  As a result, it is easier for smaller cooperatives to participate in these plants.

4.  More Vibrant Wholesale Markets - With the advent of open access transmission and the resulting emergence of independent power producers, we've seen an explosion in the number of wholesale market suppliers in the last 10 years.  All these power marketers are beating the bushes for sales.  In addition, the markets have become more liquid.  There's more activity and higher volumes being transacted, and market structures have evolved to where the infrastructure is there and deals are easier to do.  As a result, there are more opportunities for wholesale customers of all sizes to "do deals."

Can we expect to see more independent power supply activity among G&T members?  To some extent, probably so.  As the industry continues to see more and more activity at the wholesale level, it will tend to increase activity among cooperatives as well.  But it may not be widespread.  The needs for the G&T seem to be stronger than ever.  These days, with the ever-increasing complexities of the wholesale markets, with the sophistication that is required to manage load following power supply arrangements, and with the natural economies associated with serving aggregated load, it makes as much sense as it ever has for distribution cooperatives to consolidate the management of their power supply arrangements through the G&T.  But for those that have ventured out on their own, hopefully this explains some of why that has happened.

For more information, contact David Brian at 770.425.8100 or e-mail: info@gdsassociates.com. 

USING FINANCIAL PRODUCTS TO MANAGE NATURAL GAS PRICE RISK

Natural gas prices have had some real ups and downs.

Recently we have been asked more and more to assist clients who are looking into using financial hedging products to manage natural gas price risk.

Doubtless this is the result of the extraordinary events in the natural gas markets of late.  In the last 18 months we've seen volatility in the wholesale price of natural gas, the likes of which have never been experienced before.  Wholesale prices for natural gas have gone from about $2 per million BTUs 18 months ago to about $10 in January, and back down to $3.25 this summer.  Even for the most efficient natural gas fired power plants, this represents a swing of over 5 cents per kilowatt-hour in the cost of production!

New Financial Approaches Are One Solution
In one recent case a client was not in the driver's seat for its natural gas purchases.  That is, someone else controlled the purchase and delivery of natural gas to a power plant in which our client was a joint participant.  You may find yourself in a similar situation, or it may not be a power plant ownership situation.  Your company may purchase unit power, the cost of which is dependent on actual fuel costs.  Or you may buy power under contract that includes a variable fuel component.  Of course you're still at risk in these situations, same as you would be if you owned the plants that supply the power.

In this case, the client was faced with price risk because the operator of the plant was not hedging the gas price risk.  This is not uncommon in situations where there are multiple purchasers out of a particular facility, or where the majority owner/operator is regulated and is concerned about its ability to recover prudent hedging costs.

We looked at two financial products offered by energy companies whose business it is to assist others with risk management.  Companies including Williams, Enron, and Morgan Stanley offered two common products to help us: swaps and collars.

Swaps and Collars
In a swap transaction, the two parties to the deal agree to a fixed price and then, during the term of the deal, each pays the other for differences around that price depending on the position of the spot price.  One pays for differences when the spot price is above the agreed-to fixed price, and the other pays for differences when the spot price is below the agreed-to fixed price.  On any given day during the term of the transaction, there is a payment from one party to the other for the difference between the spot price and the agreed-to price.  Say, for example, a utility was interested in hedging its gas price risk.  The utility and an energy company agreed to a fixed price of $4.00 per million BTUs for a quantity of natural gas.  If the price one day rose to $5.00, then the energy company would pay the utility a sum equal to $1.00 times the quantity of gas involved, called the notional amount.  If on the other hand the price fell to $3.00, the utility would pay the energy company $1.00 times the notional amount.

The idea is that a purchaser of natural gas in the physical (i.e. real) world can offset his risk by becoming a seller in the secondary financial markets.  To the extent the quantities transacted in the two worlds offset each other, then the risk is washed out.  In the above example, assume that the utility had physically burned the exact same quantity at its power plant as was traded financially, and assume the utility paid a spot price of $5.00 for the gas burned.  The $1.00 made on the financial trade reduced his effective cost to $4.00, exactly the same as the fixed agreed-to price.

A collar works in a similar fashion, except it involves a bandwidth instead of a fixed price.  The bandwidth is comprised of a ceiling that, in our case, the utility would be purchasing, and a floor that the energy company would be purchasing.  Nothing happens if the spot price is between the floor and the ceiling.  However, if the spot price rises above the ceiling, the energy company would pay the utility the difference, reducing the utility's all-in effective cost for that day or month (including its physical purchases) to the ceiling price.  If the spot price fell below the floor price, the utility would be obligated to pay the energy company the difference, raising the utility's all-in effective price to the floor price.  The utility has purchased a cap on its fuel costs, but at the same time, it will not be able to enjoy the benefits if spot prices fall below the floor price.

At first glance, it may be hard to see how the energy company makes money with these products.  In a swap transaction, the agreed-to fixed price they are willing to sell is slightly higher than their expectation of where prices are going.  So the utility would expect to pay a slight premium.  Under a collar, the floor and the ceiling are skewed slightly such that the midpoint between the two is slightly above the energy company's expectation of where prices are going.  In other words, the utility is slightly more likely to pay the energy company than the energy company is to pay the utility.  But it's been our experience that these premiums are fairly small.

Are you speculating if you use these products?  No, as long as the quantities committed to do not exceed your expected physical burn.  Speculation occurs when someone guesses about what may happen to prices without any offsetting risk in the physical world.  As a result, there's a difference between speculation and risk management.  You will, though, want to check with your accountant to learn about any additional reporting requirements you may face.

Keep these products in mind as you plan for your utility's natural gas needs.  They are one more tool utility managers can use to deal with this new world in which natural gas prices can vary tremendously.

For more information, contact David Brian at 770.425.8100 or e-mail: info@gdsassociates.com. 

HEY!  Mark Zweig says we’re HOT!

The Zweigletter Hot Firm 2001 List was announced on June 25, and GDS Associates made it... smack in the middle of the 100 fastest growing Architectural, Engineering, Planning, and Environmental firms in the U.S.  We really appreciate the recognition.  We accept the challenge to keep on succeeding... for both our clients and the 80 people who are GDS.