California crisis underscores need for hedging energy price risk

March 26, 2001
The recent crisis in California's electric power sector points to the critical importance of being able to use certain financial instruments as tools to hedge energy price risk.

The recent crisis in California's electric power sector points to the critical importance of being able to use certain financial instruments as tools to hedge energy price risk.

The prospect of power disruptions spreading to other US states underscores a real urgency in enabling other energy sectors to hedge prices freely.

This is particularly crucial at a time when oil, gas, and power supply, demand, and prices are extremely volatile. Indeed, the California energy crisis has emerged as an early energy policy flashpoint for the new administration of President George W. Bush (OGJ,, Feb. 12, 2001, p. 70).

There is, in fact, evidence to suggest that a widespread "institutionalization" of the practice of hedging energy price risk will itself act as a moderating influence on price volatility while still helping to bolster the energy supply outlook.

Meanwhile, there are early signs that the California debacle is already acting to change the dynamics of the North American natural gas market, with a move toward long-term supply contracts serving to moderate price risk as well as lock in markets for gas producers. Among those signs are the introduction of new legislation designed to lock down long-term electric power contracts, coupled with plans for the state to purchase as much as $10 billion of power on behalf of California's two largest investor-owned utilities via long-term purchased-power agreements with wholesale electricity producers. These two developments could spur a return to long-term natural gas supply contracts that have all but disappeared. This, in turn, could ameliorate some of the inherent risk in a price-hedging strategy.

Risk management strategies

The key to preventing power disruptions in regions outside of California is to allow utilities to use risk management strategies, according to Ed Krapels, director of natural gas and power markets at Energy Security Analysis Inc. (ESAI), Wakefield, Mass.

Many public utility commissions (PUCs), notably the California PUC (CPUC), have either prohibited utilities from hedging prices or have placed stiff limits on the practice.

"ESAI suggests that distributors in at-risk regions be encouraged to buy their power forward this summer," Krapels said.. "Deals should be structured so that the distributor can participate if the markets turn out to be much calmer than feared."

The summer of 2001 presents an extremely dicey situation for many utilities and their PUCs, Krapels says, noting the difficulty of offering a generic risk-management prescription that would fit all cases. However, he says that it is possible to recommend a general principle of risk management in those markets where regulatory review is a major concern.

"The summer of 2001 is likely to be a very difficult one for companies that are short of power. It should be held prudent in many regions for distribution companies to buy much, if not all, of their power forward, even though this may lock in $100 power," Krapels said.

Power generators-those at the other end of forward purchases-would be taking a sizeable risk that the spot price of power will in fact exceed the $100 committed for delivery. But they have the means to hedge that risk in the fuel and other associated markets (weather, tranmission, etc.), according to Krapels: "Thus, for these companies, 2001 represents an opportunity to show that they are serious players, committed to doing business with their customers, neither giving a subsidy nor getting one but executing deals that they have the wherewithal to execute without serious downside risks to their shareholders."

In the financial community, Krapels points out, such "downside participation" can be sold-not given to customers. "For example, if the forward price of power for the summer in a region is $100, it may cost an additional $5 (or more) to structure this downside participation. If so, that may well be a price worth paying and-upon completion of due diligence review-PUCs should not be critical ofellipsethe decision to buy it [after the fact]," he said.

Krapels concluded, "So this is the summer for independent generators and marketers to step forward and do deals with distributors. This is the autumn for PUCs to avoid bashing utilities who hedged, even if they paid more for price certainty than they would have paid to gamble with their ratepayers' pocketbooks."

Other factors

A key driver of the California crisis was high natural gas prices, along with the power price caps and "ill-conceived policy initiatives," says Krapels.

Here, too, was a situation that could have been alleviated by hedging prices.

"What is the end game?" Krapels asked. "In addition to all of the usual remedies (encourage conservation, remove or ease restrictions on power generation, negotiate with neighboring states, pray for rain, etc.), something decisive has to be done to reestablish a viable trading system."

Krapels cites three culprits in California's energy dilemma:

  • High natural gas prices. ESAI analysis shows that, for the first 9 months of 2000, gas generation accounted for 49% of power in California, vs. 19% in New England and 18% in New York. Krapels shows that the relationship between natural gas and power prices in California was a classic "chicken-and-egg" situation. "Natural gas prices increased for a variety of reasons in 2000, among them unprecedented increases in demand from California's power sector," Krapels said. "Power demand in California was driven to surprisingly high levels in the summer of 2000. Strong underlying economic growth was part of the story, as was hot weather. The number of cooling degree days in the Pacific census region increased by 13% in 2000."
  • Power price caps. Also contributing to the crisis were price caps placed on California electricity. "Price caps in California made it unprofitable for traders to export power to California. From a trader's perspective, importing power into California via the bilateral forward markets was practically impossible if California's capped forward prices were lowerellipse," Krapels said. In the absence of power imports scheduled into California via the month-ahead bilateral markets, this shortfall could be made only up in the day-ahead and real-time markets. "But that meant dependence on short-term markets for a lot of power, which in turn required that California's day-ahead and real-time market prices be higher than those of competing states. Caps in general made that requirement difficult to achieve, and $250 prices caps made it practically impossible much of the time," Krapels said.
  • Bad policy. Krapels points to California government agencies, particularly the California Public Utility Commission (CPUC) as the final culprit in the state's energy crisis. CPUC established a system that placed the utilities into "a classic trading trap, in which they had fixed a large part of their sales without fixing their costs. Given that the costs were to be incurred in two of the most volatile markets known to man-natural gas and electricity-this position can only be described as highly speculative." Krapels contends that CPUC further hamstrung the utilities by not allowing them to hedge their risks. "The gas and power spot price increases of 2000 could have had a minor effect on the state if the utilities had engaged in routine hedging, matching the maturity of their fixed-price position with a portfolio of forward contracts," Krapels said.

Krapels maintains that the combined impact of these three forces combined to create a disastrous situation by the end of 2000.

"The plight of the California utilities became common knowledge, the political atmosphere deteriorated, and traders became increasingly selective about whom to trade with, making an already illiquid market even more so," he said.

Need for hedging, trading

Trading and hedging expertise will increasingly be a requirement for success in gas and power markets, Krapels contends.

In an article for ESAI's website, Krapels wrote, "Price and earnings volatility is not good for a company's share price, unless investors believe the company has organized effective trading groups to deal with the volatilityellipseVolatility in energy prices offers risks and rewards, and that's why one engages in the business, after all."

Krapels also contends that the quantum leaps in information technology have provided the instruments needed for ever-improving analysis of risks. This has certainly been borne out in the financial sector, which has excelled at harnessing huge data flows into coherent risk-measurement and management strategies. He contends that, among energy markets, electric power more closely resembles the financial sector than it does the oil sector.

"The minute-by-minute nature of power risk and the magnitude of power price moves-both inherent in electricity's status as an unstorable commodity-make it essential that market participants develop sophisticated market analysis and risk-management tools," Krapels wrote.

It follows, then, that a risk-management strategy is needed for any energy commodity price that has become increasingly volatile-especially for natural gas, because its price is so sensitive to fluctuations in weather, directly in the winter and indirectly in the summer.

"A reasonable argument can be made that the increased demand from the power sector constitutes a step-function change in the long-run gas price," Krapels wrote. "Before 2000, most assumed the long-run equilibrium price of gas to be around $2.50/MMbtu or lower.

"After 2000, in light of the failure of gas supply to respond materially to the doubling of prices, many would raise the long-run equilibrium price to $4/MMbtu or higher. The forward gas market has been providing opportunities to sell long-term gas at prices even above that level."

Nevertheless, gas prices will once again soften as the resource base expands in reaction to higher prices. Gauging the timing of when prices will slide again is a timing call determined by weather, notes Krapels: "By becoming tethered to the inevitably volatile power market as well as to the winter weather market, gas prices will have the potential to have a huge impact on gas inventories, inducing energy traders to 'buy the rumor' of severe weather and to 'sell the fact' if that weather doesn't materialize."

Long-term contracts

The potentially devastating financial effects of such wide swings in gas and power prices beg for a more-reliable supply approach than the currently dominant bid-week monthly gas sales.

Raymond James & Associates Inc., a St. Petersburg, Fla., analyst, contends that it "seems obvious" that signing long-term electric power contracts (regardless of price) is also going to spur the signing of long-term natural gas contracts.

Noting the growing convergence of the gas and power markets, RJA last month predicted that long-term natural gas contracts emanating from the California crisis will be signed at levels well above the then-current price forecasts (OGJ, Newsletter, Feb. 23, 2001, Newsletter, p. 5).

"For investors, this should signal a change in valuation. Natural gas assets and [exploration and production company] stock valuations should improve significantly as uncertainty is mitigated by greater visibility in future natural gas prices."

As investors recognize the "new paradigm" for natural gas and confidence in the long-term earnings and cash flow capabilities of E&P companies improves, RJA noted, "We expect the sector to achieve valuations more in line with stable streams of cash flow, necessitating an expansion in the current low valuation multiples. As a result, investors will likely reward these companies with higher earnings and cash flow multiples. Historically, North American producers have traded at 4-8 times forward 12-month cash flow. However, as these long-term contracts remove some of the cyclicality of natural gas prices, we expect cash flow multiples to expand and remain at the higher end of that range."

Accordingly, if E&P companies can also take further steps to reduce their own exposure to that cyclicality via accelerated price risk hedging, it will have an effect on their future balance sheets comparable to the surety of long-term supply contracts.

ESAI's Ed Krapels
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Trading and hedging expertise will increasingly be a requirement for success in gas and power marketsellipseThe gas and power spot price increases of 2000 could have had a minor effect on California if the utilities had engaged in routine hedging, matching the maturity of their fixed-price position with a portfolio of forward contracts.