Saturday, March 17, 2012

It's a Gas

I've written a great deal about the 90% of our spending which has to with compensation and benefits. This article is going to be about something in the other 10% - our cost for natural gas.

Natural gas is one of those commodities for which "futures contracts" can be written to lock in prices for points in time out in the future. Commodities futures trading and its first cousin, options trading, are a favorite investment vehicle for speculators, and are often viewed negatively because of it, but they have legitimate purposes beyond speculation.

For example, farmers like to know, before they plant in the Spring, what they'll be able to sell their crop for in the Fall. They can do that by signing a contract to sell a certain amount of corn, for example, at some point in the future for a certain price. This week, the price of corn to be delivered in December 2012 is about $550 for 5,000 bushels. A farmer who signs such a contract would be obligated to deliver 5,000 bushels of corn this December, and accept $550 in payment.

So what's the harm in that?

What if a big October windstorm flattens his corn before he gets it harvested?  The contract still obligates him to deliver 5,000 bushels of corn in December, and be paid $550 for it.  In order to fulfill his contract obligations, he'll have to buy 5,000 bushels of corn from someone else.

Remember that this $550 price was set in March. Now it's December and a lot of things might have changed. It could be that a lot of the corn crop nationwide was lost, and the price of corn has therefore skyrocketed due to the reduced supply. Maybe he'll have to pay $800 for 5,000 bushels of corn, just so he can turn around and sell it for $550. And he's already out all the money he had invested in the crop that was wiped out by the storm.

A farmer can further "hedge his bet" by buying futures options, but that's another topic for another time.

By the way, anyone who uses the phrase "dumb farmer" has no grasp of the complexity of the fiscal decisions these folks have to make in order to have any hope of surviving over the long haul. They have to be prepared to make a nice profit when the opportunity presents itself, and to survive times when it seems like Mother Nature and the commodities market are conspiring to put them out of business. Both situations require knowing when to buy supplies and heavy equipment and how to use the futures market and crop insurance to mitigate risk. They don't just throw seeds in the ground in the Spring and rake in the money in the Fall.

Our school district is a commodities player as well. We have to buy significant quantities of electricity, natural gas, and diesel fuel to operate our buildings and buses. As every American is painfully aware, the prices for these commodities have never been more volatile.

So it is reasonable for the school district to make purchases of these commodities via futures contracts that give us some predictability as to our future costs. There is risk if we do, and there is is risk if we don't. If we don't buy futures contracts, the prices could shoot up rapidly, creating havoc in our budget.

This was the concern back in early 2008, when natural gas prices were going through the roof. In the first six months of 2008, natural gas prices increased from around $8 per MMBtu* at the beginning of the year to over $13 by early summer. That's over 60% in just six months. At that rate it could be $20 by the end of the year.


Our school district is a member of a buying consortium called the Metropolitan Education Council (MEC), through which nearly 200 Ohio school districts have joined to buy everything from school buses to IT services. When this run up of natural gas prices was happening, the MEC joined a larger buying group to purchase millions of dollars of natural gas futures. While I was not part of that decision process, I imagine that the intention was to  create some predictability for our budget, and also to lock in the current price should the price continue to go up at that astronomical rate.

This consortium started buying futures contracts in June of 2008. They were at a price of $11.45, with monthly delivery dates stretching through May 2014. In July, they bought a bunch more at a price of $10.19.

Those had to look like pretty smart decisions after seeing the price hit $13 in early July. If prices had indeed doubled by the end of 2008, as it looked like they might, we would have saved a ton of money.

But they didn't. This is the pricing chart for 2008:

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As you can see, by year end the prices settled back to about where they had been at the beginning of the year. Now we're holding contracts to buy natural gas for 50% over the market price. So what did they do?

In September 2012, after the prices had dropped back to the pre-spike levels, they bought another batch of natural gas futures for around $9. By the way, you can identify pricing spikes only in retrospect. While the prices are rapidly increasing, it's impossible to tell whether it is a spike, or a permanent lift in prices. In 2008, the folks making this natural gas decision thought it was the latter. A decision to buy more contracts at $9 is reasonable if you're relatively sure the prices are still generally headed up.

But they weren't. This is the pricing chart for 2012. Instead of going up, natural gas prices have continued to plummet. Right now, the price for natural gas to be delivered in December 2012 is lower than for gas to be delivered this month. Now it doesn't look so smart to be paying $9-11 for natural gas when we could just buy it from anyone today for a third the price.

click to enlarge
So we want to get out of our old deal. What does that entail?

Well, we need to get someone to buy all these high-priced contracts. But frankly, there's no reason for anyone to pay any money at all for a contract set to a price that is higher than the market price. It would be like me standing next to a pump at a gas station, trying to sell a can full of gas for $10/gal when the price on the pump is $4.00.

If I really want to get rid of that can of gas, I'll have to give to you the gas AND $6.00/gal to make up the difference in price.

That's what your School Board voted to do at the March 12, 2012, when we passed item F1 on the agenda. This authorizes the Administration to pay the cash necessary to get us out of the old contracts. Given current futures prices, this is estimated to be about $300,000.

In other words, since 2008, we have been paying a substantial premium over market prices for natural gas, and are now having to pay another $300,000 to get out of that deal.

So were the Administrators who recommended this deal, and the School Board members who approved this in 2008 all bozos?  It's easy to make that assessment with 20/20 hindsight isn't it?

But what did the situation feel like then? I can tell you - it looked pretty scary on all economic fronts. I was so scared about the state of our financial system that I pulled all of my retirement savings that I had in money market accounts - instruments that had always been considered extremely safe ways to hold short-term cash - and shifted them to FDIC-protected Certificates-of-Deposit at commercial banks.

It was a reasonable bet, and I think that - had I been sitting on the School Board then - I might well have voted in favor of that resolution as well.

Decisions can't be remade in the past. All we can do is make decisions for the future. That's what this resolution at the last meeting was all about - to get out of what has become a bad deal, and make the best decision we can for the future. By being able to return our natural gas prices to current market levels, the payback on this buyout cost will be less than two years, and I think that's reasonable.

Should the decision have been made sooner?  Probably, but that's hindsight too. Our natural gas costs have apparently been way above market for at least three years. But remember, that as soon as the spot prices dropped, the cost to get out of the futures contracts we already owned went up simultaneously. Wouldn't it have been stupid to buy out of these contracts in 2009, then have prices go back up in 2010?

Like I said, there's a risk associated with such decisions. There's also a consequence to not making decisions. It could have gone either way.

This new resolution authorizes the Administration to enter into a new buying agreement via the MEC, through which a new set of natural gas futures contracts will be purchased. It seems like a good move to buy futures when prices seem pretty low. But who knows what the opening of the vast gas fields in eastern Ohio will mean to us. Can/will natural gas prices go any lower?

When these futures will be purchased, for what delivery dates, and at what prices will be determined by a "Hedging Committee" appointed by the members of the consortium. I hope our own Treasurer Brian Wilson gets to sit on this committee, but if not him, then our Operations Team is gunning to have Jeff McCuen, the Treasurer of Worthington City Schools be our voice.

* Natural gas is sold in a unit of measure called the "MMBtu," or millions of British Thermal Units, which is a unit of energy, not volume. This is because natural gas can be transported and consumed at various pressures, allowing it to be in the form anything from a dense frozen liquid (very high BTUs/gal) to the gas that comes out of your kitchen stove. By pricing the commodity in units of energy, it doesn't matter what physical form it is in when the transaction takes place.


  1. Paul, What percentage of the estimated gas obligation was hedged this way? One should never hedge 100% of a future period at once, but should layer it in over time. That is, by 25% per year for four years, as an example. This reduces the risk of locking in at the wrong time. You still have some price risk, but at least not on the whole obligation. How does the program you approved work?

    Second, do you realize that you bet on gas prices going down further by buying out the hedges? If we have a cold winter next year that $300k will be less.

    Third, if this consortium is run by the same bunch, have you done the district any favors? You might do better working with a gas retailer to hedge 80% and buy the remaining from Columbia at spot.

    What is the annual natural gas budget for the district and for what future period did these hedges cover?

  2. I don't know the answer as to how much of of the collective natgas usage by the consortium was hedged, but I'm assuming a pretty good piece of it. Because the winter has been pretty warm, our total natgas usage in the current year has been lower, which likely means that a higher percentage of our requirements are filled by the hedged positions.

    I'm familiar with the process of laddering investments. Laddering is itself a form of betting on future prices - it just time-shifts the swings. For example, I had the fixed income portion of my portfolio laddered with 2-3 year maturities 10 years ago when those could easily yield 5-6%. But they matured into a 0% rate interest climate (for retired folks, interest is income, not an expense!). I would have been much better off putting everything in 10-15% year maturities in 2006 - I'd still be making 5-6% today. It would certainly be stupid to buy long maturities in today's fixed income market.

    This agreement places the decision process in the hands of a "Hedging Committee" which is made up of representatives selected by the member organizations, who will operate under a protocol also determined by the consortium members.

    Our cost to liquidate the hedges will be determined by the spread between current futures prices and the delivery prices set in the contracts we hold. If futures prices go down further prior to the liquidation - which will happen very soon - then our cost to liquidate will be higher than this estimate, but the payback period will be shorter. The current spot price of natgas is not important in determining the liquidation cost, except to the extent that the spot price informs the futures prices.

    Under the current contract, our annual natgas spending is about $500,000. We should be able to drop that to about half, according to the estimates of our Treasurer, Brian Wilson.

  3. I think many of us were pretty concerned in 2008, especially with oil heading to $150/barrel. I don't fault anyone for making these decisions then, and if natgas does continue to fall at least the difference between $3 and what, 10 cents? :) isn't that traumatic.

  4. Oh jeez. Our Board is speculating on energy commodities? You can play that game all you want, but over the long run, the house always win.

    I dont know who the counter parties in these arrangements are, but I guarantee they know more than our Board and this consortium about the natural gas market.