Locking In Gas Prices

I recently received an offer from my household natural gas supplier, Washington Gas, to lock in my gas purchases for the next 12 months at a price of $0.699/therm. They reminded me that I had paid as much as $0.96/therm and as little as $0.68/therm over the last 12 months, before distribution charges, so on the surface this looks like a good deal. Of course the real measure of the attractiveness of this offer is not what I've paid in the past, but what I'm likely to pay in the future if I don't take advantage of it. Unsurprisingly, Washington Gas left that for me to work out. This is no simple task, even if you follow energy trends as closely as I try to do.

The price of natural gas is notoriously volatile, particularly in years when supply is tight, the economy strong, and weather extreme. Historically, gas often spiked in the winter months, as cold weather drew down stockpiles, and traders bid up the price for prompt delivery. That pattern has shifted somewhat in recent years, as seen in the chart below, not because global warming is making winters warmer--though that seems to be the case in the most general sense--but because US gas consumption patterns have shifted.

In 1997 residential users accounted for 22% of total US gas demand, commercial and industrial users took nearly 52%, and just 18% went to power generation. Last year residential use was 21%, but commercial and industrial had fallen to 40%, while the power sector took over 30%. And since power generation, for which gas turbines are often the incremental supply, typically peaks in the summer months, the annual peak of gas prices is now as likely to occur in June or July as in January or February. That's an important consideration if you're a residential customer like me. Of the roughly 1,100 therms my household consumes each year, 84% are bought between November and March.

In this context the first place to check on whether the offer from Washington Gas is fair was the futures market. Yesterday's average closing price for the one-year "strip" from November 2010 to October 2011 was $4.26/million BTUs. That's the price at the Henry Hub, a gas distribution point in Louisiana. In order to compare it to what I've been offered, I need to account for the average differential, or "basis", between that location and the supply point for Northern Virginia. The "city gate" price for Virginia over the last year averaged $2.39/MMBTU higher than Henry Hub. Even that doesn't quite get me to the Purchased Gas Price that shows up on my utility bills. Over the last 12 months I paid an additional $0.60/MMBTU, on average, because the mix Washington Gas sells me includes gas purchased under long-term contracts, as well as incorporating the results of its hedging activities. When I add all this together, the equivalent futures-based price to compare to the deal I've been offered for the next 12 months works out to about $7.25/MMBTU, or $0.73/therm. For the November-March period that will affect me most, it's around $0.71/therm.

From that I conclude that my supplier is offering me a price that's in line with the market, and that I couldn't beat it even if I did the hedging myself. However, it's important to recall that the futures market isn't a forecast; it's just the current consensus on what buyers and sellers are willing to agree on today, based on everything they know. In order to decide whether I should lock that in and give up any upside or downside, I ought to have a point of view on gas prices, based on supply, demand and inventories. The supply side is dominated by surging shale gas output, which has taken US gas production to levels we haven't seen since the 1970s. For production to drop by enough to drive up prices significantly within the next year, the shale gas bandwagon would have to slow appreciably. That's certainly possible. In several presentations at the recent IHS Herold Pacesetters Energy Conference I saw graphs indicating that a number of producers aren't covering all their costs at current prices. Some of them must continue drilling new wells in order to satisfy the terms of their leases, but others could slow down if they chose. A slowdown in drilling would translate into reduced supplies fairly quickly, because of the rapid drop-off of output from individual wells. Even bigger supply risks are inherent in the growing environmental concerns surrounding shale gas drilling, which have seen New York's state senate vote to impose a moratorium on shale drilling. Yet while it's hard to envision a big enough drop in output from any of these factors, soon enough to affect this winter's prices, it's even harder to see so much additional shale gas coming to market in the next year that it would drive prices well below current levels.

On the demand side, the weak economy dominates, particularly in the industrial sector, which despite having rebounded from last year's lows is still running well below its consumption in the early 2000s. A sizable fraction of that lost demand isn't coming back, even if the economy started growing at rates more characteristic of past post-recession expansions, because the high gas prices of the previous decade drove some fertilizer and petrochemicals producers out of business or offshore. The biggest upside demand potential comes from the power sector, which is also suffering from low demand, at the same time we see low gas prices and environmental pressures displacing coal with gas and renewables. That's a clear medium-term trend, though as with reduced shale drilling, the situation seem unlikely to change much in the next 3-6 months.

That leaves gas inventory as the last major fundamental factor to assess. As of the most recent figures, gas storage was running about 5% below the same week last year, but ahead of the previous three years. A severe cold snap might test these inventories, but they don't loom as a big upside price risk today.

On balance, then, it appears I've been offered a fixed price that is not only in line with the current futures market, but at which I would also be giving up relatively little chance of paying significantly lower prices later--barring a double-dip recession--while gaining protection from weather or supply-related surprises. If the next year looked exactly like the last one did, I'd end up saving a bit less than $100. If you've followed my logic this far, you might think this was a lot of effort in order to convince myself that what looked like a good deal really was, but then I guess that's the lot of a former commodity trader who routinely had to make decisions like this, but for much larger stakes. And perhaps I've given you some food for thought, in case you're facing a similar decision.

Understanding Southwest's Hedging

I don't normally pay much attention to the quarterly earnings reports of companies outside the energy sector, so I initially missed the confusion over the impact of fuel hedging on the third quarter results of Southwest Airlines. An article in yesterday's Washington Post brought this to light again, along with the effect of falling oil prices on the fuel hedging efforts of a diverse group of companies, including Coca Cola, Royal Caribbean Cruise Lines, and local heating oil distributors. The reporting on this subject illustrates two important points: commodities hedging is no free lunch, and understanding its full consequences requires more that a superficial look at the bottom line.

This morning I pored over Southwest's quarterly earnings press release to see what had happened. I was suspicious of the headlines suggesting that hedging had pushed Southwest into the red, because the average futures price of West Texas Intermediate crude oil for the quarter was $118 per barrel--hence ExxonMobil's record-breaking earnings--still well above the level at which Southwest was generally understood to have hedged its jet fuel. After some scrutiny, and to my considerable surprise, I concluded that both the Post and the Wall Street Journal in their earlier story on Southwest's earnings appeared to have misinterpreted some key aspects of the hedging results. Discerning that wasn't easy, since Southwest saw fit to report their earnings on both a GAAP (Generally Accepted Accounting Principles) and non-GAAP basis, and the intricacy of their "Reconciliation of Impact from Fuel Contracts" table forced me to jump-start some brain cells that have been dormant since my B-school financial accounting course.

Evaluating the benefit or cost of a hedge must include the result of the physical transactions it was intended to cover. In the case of Southwest, it appears that its unhedged fuel cost for the quarter--what it actually paid its fuel suppliers--was $1.387 billion. The hedges and related derivative contracts that settled in the quarter offset that by $448 million, reducing Southwest's effective fuel bill to $939 million. The problem that the Journal and Post focused on was related to future hedges, not those that unwound between July and September. Marking the company's total hedge portfolio to market resulted in an additional pre-tax cost of $247 million, reported as a special item. Factoring this in turned the company's modest operating profit of $69 million into a $120 million net loss, after tax. But it's not correct to say that hedging hurt Southwest. Had it not hedged at all, its after tax loss for the quarter would have been approximately $189 million, assuming it could have operated in the same manner. That seems unlikely, given the behavior of competitors with less active hedging programs.

But while the confusion over Southwest's earnings seems to arise from the requirement to recognize the reduced value of the future hedges still on its books as a loss to current income, this doesn't justify calls to set aside mark-to-market accounting. That special item should prompt investors to read the explanation Southwest has provided concerning its overall hedge portfolio, because it signals the prospect of further hedge-related losses in the future:

"In addition to our fourth quarter 2008 derivative position, we have derivative contracts for over 75 percent of our estimated 2009 fuel consumption at an average crude-equivalent price of approximately $73 per barrel; approximately 50 percent of our estimated 2010 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; approximately 40 percent of our estimated 2011 fuel consumption at an average crude- equivalent price of approximately $93 per barrel; over 35 percent of our estimated 2012 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; and have begun building a modest position for 2013."

That means that if oil prices remain between $60 and $70/bbl, then the effective cost Southwest will pay for jet fuel in future quarters could end up higher than that of competitors who didn't hedge or who hedged lower percentages of their expected fuel consumption than Southwest. Of course, that's not certain, either, because the price of oil might again rise above the level of their hedges.

The key to a successful hedging strategy is that companies shouldn't view it as a magician's hat out of which to pull larger profits, quarter after quarter. The benefit comes from reducing the volatility of earnings and enabling firms to continue operating more normally, when others have had to cut back drastically. Although this strategy could rebound on Southwest, if oil prices remain low for an extended period, falling prices may not hurt them as much as rising prices have hurt their less-hedged competitors, some of whom are now in a very poor position to capitalize on lower fuel costs.

Note: Energy Outlook will be on vacation next week, with postings resuming the week of November 10.

Offsets and Behavior

It took a while for US petroleum product demand to respond to high oil prices, but once gasoline neared $4 per gallon in a slowing economy that no longer afforded consumers the opportunity to translate home equity appreciation into purchasing power, it set up the first absolute decline in gasoline use since 1991. But would this response have been so dramatic, if the majority of consumers had already locked in their fuel costs, or hedged them financially? That question has interesting parallels with regard to climate change, for which emissions offsets can provide individuals with a cost-effective temporary alternative to more difficult or expensive changes.

Having just received a renewal notice from my emissions-offset provider, it seemed like a good time to recap my family's fuel consumption for the past year, in order to calculate how much CO2 our two cars emitted. I won't pretend the Styles household is typical in its gasoline consumption. Since neither adult commutes to work, we drive less than the national average. That's just as well, since our cars' fuel economy is nothing special: the station wagon and the sports sedan both get around the national average fuel economy of roughly 22 mpg. Together they consumed 705 gallons of gasoline in the last 12 months.

Tallying our fuel use also provided an opportunity to assess the actual impact of higher fuel prices on our family budget. At an average price increase since last July of 63 cents per gallon, we spent $450 more on gasoline than in the previous year. Although that result fell short of my perceptions, it still represents money we could have spent on other goods and services, or saved. Yet I also knew I couldn't view it isolation, without considering the impact of the natural hedge provided by the oil company stock I retain as a result of my previous employment. Although its performance has been disappointing since oil began its retreat from $145 per barrel, over the last four years it has more than offset the approximately $2 per gallon increase in fuel prices we've experienced. But that isn't just a benefit of being an ex-oil company executive; anyone could have created such a hedge, if they had a spare few thousand dollars to invest.

Four years ago the average US price for regular gasoline stood at $1.90 per gallon. This week it's $3.95. Although its rise has hardly been smooth, that works out to roughly an extra 50 cents per gallon each year, compounded. For a typical car consuming 500 gallons per year, that equates to a cumulative fuel-expense increase of $2,500 over the entire period. As it turns out, $2,900 invested in a fund tracking the Amex Oil Index (XOI), a basket of oil equities, on August 1, 2004 would have grown to $5,750 by now, enough to cover the entire increase in gasoline prices and still pay a 3% return on the principal, though not without significant risk and volatility. Since oil equities are hardly a perfect proxy for fuel prices, a bolder investor might have achieved the same hedge by investing directly in a commodity fund. Alternatively, anyone lacking the capital or the inclination to tie it up this way could have locked in his or her gas purchases using a service such as MyGallons.com. (I haven't tried it and can't vouch for it in any way; caveat emptor.) And never forget that hedges can lose money; if you hedge but the price falls, you will be worse off than if you had done nothing.

Even without our natural hedge, I doubt that we'd seriously be considering trading in our pair of 4-year-old cars on new, more efficient models, in order to save that $450 per year. We don't drive enough to justify taking the resulting hit on depreciation, even if we doubled our fuel economy. Nor does our desire to reduce our greenhouse emissions alter that calculation by much. The gasoline we've burned since last July produced 7 tons of CO2. Based on the rates charged by TerraPass, we can offset that for $83.30, getting us effectively to zero emissions, rather than the reduction of 1/3 to 1/2 we might expect from newer, thriftier cars--and at a much lower cost.

Now, I've heard all the arguments about "buying indulgences" instead of making real changes in our lifestyles. Although my family has effectively negated the personal impact of higher oil prices and our vehicles' CO2 emissions, the world as a whole might be better off if we had bought a pair of hybrids, instead. However, that argument contains two fallacies, one arising from the inappropriate application of a pollution mindset to greenhouse gases, and the other reflecting the limited supply of highly fuel-efficient cars and the benefit of allocating them first to the highest-intensity users. As long as my offset provider is really investing in projects that truly reduce emissions--emissions that are equivalent in impact regardless of where on the planet they occur, and that wouldn't be cut otherwise--then for less than $100 per year we have the climate equivalent of two EVs running on wind power, minus their cachet. And we aren't competing for a hybrid with someone who drives 20,000 miles per year.

That isn't an excuse for perpetual indulgence, of course. When we do buy new cars, they will be much more efficient: diesels or hybrids, at least. And if the US hasn't enacted economy-wide cap & trade or carbon taxation by then, we'd pay to offset the remaining emissions. Similar calculations by millions of Americans may help to explain the fuel economy inertia of the US vehicle fleet, and why it will only improve incrementally within the next five years, no matter how efficient the new-car fleet becomes.

Bubble or No Bubble

The controversy over the influence of speculation on oil prices is gaining momentum, spurring congressional hearings and a steady patter of op-eds, including Paul Krugman's column in today's New York Times. The idea that oil prices have been artificially elevated beyond a realistic, market-clearing level is of interest to more than just consumers. Biofuel producers have so far failed to reap the bonanza from high oil prices that they must have expected, because of steady increases in the price of grain, oilseeds and other inputs. A sudden oil-price collapse back to $60 or less could do many of them in, particularly with large increments of new capacity coming on later this year. Gauging the future price of their principal competition has become more challenging than ever, when the futures market has proved such an unreliable source of predictions.

Professor Krugman makes a solid argument that today's high oil prices exhibit few of the signs of past speculative bubbles, especially in regard to the level of oil inventories around the world. They don't reflect the degree of hoarding that would be expected, as speculators stored oil in anticipation of selling it at a higher price later. But while I agree with Dr. Krugman that assertions of an oil bubble going back several years owed a lot to wishful thinking, I wonder if he underestimates the influence of an oil futures market that didn't even exist during the energy crisis of the 1970s. This goes beyond the simple notion that a large, liquid market in oil futures allows investors to speculate on the future price of oil without having to take possession of it, and at a much lower carrying cost than if they had to pay for it all and lease a tank in which to store it. The connections between the physical market and futures market have become pervasive, and they tend to reinforce the upward pressure on prices from rising global demand and restrictions on access to resources.

Last December the noted oil expert Philip Verleger testified on oil prices before a joint hearing of two Senate committees. As part of his compelling argument concerning the disproportionate impact of the government's policy of putting additional sweet crude oil into the Strategic Petroleum Reserve, he described how a relatively obscure technique called "delta hedging" could reinforce an upward trend in the futures market. He used the example of Southwest Airlines buying call options on crude oil at a strike price of $51/bbl. through 2009. As the price of oil increased, the financial firms that sold these options to Southwest would have had to purchase increasing quantities of oil futures contracts, in order to manage their exposure, as the options got ever deeper "in the money." The higher the price of oil goes, the more oil futures the call option seller must buy to stay neutral, in a classic positive reinforcing loop pushing up the demand for oil futures, and thus their price. I wish I had noticed his testimony at the time, because Dr. Verleger accurately foresaw the market move past $100 to $120.

This example offers an important insight for those who are focusing on the role of speculation in oil prices. Rather than viewing speculation as the driver of a bubble along the lines of the Dot Com or recent housing bubbles, it makes more sense to view it as an amplifier inserted into the circuit that runs between the energy futures, options and derivatives markets and the markets for physical oil. As long as demand growth continues in spite of high prices--with modest reductions in US demand offset by growth in countries that insulate their consumers from high market prices--speculation will continue to amplify negative supply news and push the market to new heights. However, if new production or conservation suddenly began to overwhelm demand growth, producing a short-term surplus, that signal would be amplified just as effectively, unraveling speculation at a record pace. The "delta hedging" mechanism described above works in reverse, too.

That doesn't mean that alternative energy firms should be overly concerned that oil prices will drop below $60 per barrel and remain there indefinitely. While oil above $100 per barrel has failed to crush global demand, at least so far, oil below $60 would surely stimulate it. The long-term fundamentals remain strong, as oil heads for an effective ultimate limit on global output--whether that limit is 85 million barrels per day, 100 MBD, or even 120 MBD. It does, however, suggest the need for financial flexibility: balance sheets healthy enough to withstand a few quarters of low or negative margins and weak sales. More importantly the possibility of a temporary oil-price dip should not blind the management of these firms to a much larger emerging threat, the prospect that a perceived global food crisis will unravel support for the government subsidies and mandates that have been the principal engines of the industry's growth for the last two decades.