Manage Your Institution's Energy Costs

Are rising energy costs squeezing your budget? Come down from the “Energy Grandstand” and manage your institution’s energy costs. Smart institutions are transferring the risk of rising energy prices via a “Dynamic Cap”—such a risk transfer buys tomorrow’s expected energy consumption today and saves significant money.

The author of this article is James L. Mahnke, founder of Shield Plus LLC. Shield Plus LLC is an investment firm focused on institutional energy hedging and protected asset management for endowments, foundations, eleemosynary organizations, corporations and other accredited investors. Contact Mr. Mahnke by e-mail or by calling 651.270.1254, for more information about Shield Plus' family of alternative investment funds.

The Energy Grandstand

Many institutions have watched natural gas, heating oil/diesel fuel, crude oil, electricity, and other energy prices skyrocket over the past years. Such increases in costs are painfully forcing many institutions to shift resources away from mission and growth pursuits to pay their utility bills. For those institutions that contractually pass the rise of energy costs on in a surcharge, they may be insulated only in the short term as their customers and consumers ultimately get squeezed by higher inflation. Such inflation, at some point, will likely slow the overall economy and come back to lower the sales and profits of those who passed on energy surcharges. Potential solution: use a “Dynamic Cap” to save money and to lower surcharges when energy prices rise.

Volatility and prices have notably increased since 2000.

Energy prices and market volatility have risen dramatically over the past seven years—for example, note the adjacent natural gas chart. Such price appreciation and volatility are due to a variety of factors, but is primarily driven by increasing global demand, particularly in China, India and other highly populated countries with rapidly expanding economies. The International Energy Agency says oil demand has seen the biggest increase in 25 years. Demand for oil may drop if the global economy slows, but long-term demand is likely to trend higher simply because global population growth, at roughly 75 million per year, does not appear to be slowing down.

On top of the potentially higher demand, the supply of fossil fuels is limited to what is in the ground. OPEC argues that its members are almost pumping flat-out and that OPEC is powerless in a situation where factors other than mere short-term supply and demand are at work. Only Saudi Arabia has significant spare capacity among suppliers and their cushion is susceptible to geopolitical unrest and constrained by insufficient global refining capacity. Getting the necessary expansion of global refining operations is estimated to take years to complete.

Additionally, the production cost of electricity, which is primarily generated by nuclear, coal and natural gas powered turbines, is obviously dependent on price changes of uranium, coal and natural gas. In particular, uranium, natural gas and renewable energy demand are expected to jump given the proposed 2007-2008 U.S. Climate Legislation, introduced by Senators John McCain and Joseph Lieberman, to reduce greenhouse gas emissions. However, additional supply is questionable. Natural gas from the Alaska natural-gas pipeline and other sources are another 9 to 12 years out. Paul Cicio, President of the Industrial Energy Consumers of America, reinforced this demand/supply issue by stating, the upcoming legislation and associated government forecast “overestimates the availability of natural gas; underestimates electric power consumption of natural gas; underestimates the price of natural gas; and overestimates nuclear capacity additions by 2030” (Bloomberg 10/3/07). Even with renewable energy sources coming on-line, the net result is that demand for uranium and natural gas will likely be higher than available supply over the next 8 plus years.

All of these intertwined energy and legislative issues have some analysts projecting that we have a mere decade to solve the long-term energy puzzle before demand permanently exceeds supply.

This energy puzzle is not just a future problem—it’s a difficult situation now. For a college burning 300,000 MCF of natural gas per year in 2001, their budget and expenses (with an average price of $3.00/MCF) were roughly the same at $900,000 because of low price volatility. Today, with significantly higher market volatility and price levels, a budget can be easily busted. That college, consuming the same 300,000 MCF today as in 2001, with an annual average price equal to current prices of approximately $8/MCF, now spends $2.4 million. Add the increased costs for electricity, heating oil/diesel fuel and gasoline, and it is apparent, that this college and many other institutional energy budgets, whether for large or small institutions, have climbed to where some monies for staff, new equipment, curriculum enhancements, new business opportunities and other necessary capital improvements have been shifted to pay utility bills. If energy prices continue to rise over the long-term, how should institutions respond?

Most institutions send monthly payments to their energy suppliers—paying their utility bills routinely—without realizing that they can manage their rising energy costs. These institutions, the “Energy Grandstand” spectators, simply verify their meter readings and watch their energy prices (liability costs) go up and go down. Unfortunately, when managing a market-driven energy liability that has to be purchased and consumed, passively watching from the seats of the “Energy Grandstand” is not an effective management strategy to control energy costs. In essence, this behavior of the “Energy Grandstand” spectator is acting as a speculator, betting energy prices will only remain stable or fall. But, if energy prices rise, these institutions are forced to divert cash from mission and growth purposes to paying higher utility bills.

Once the institution’s finance committee and board realize that acting as a passive spectator is not in the best interest of the institution—especially if the long-term trend for energy prices is potentially up—the institution has taken its first step towards coming down from the “Energy Grandstand” and entering the playing field of energy risk management. The object of the risk management game is to successfully transfer the institution’s energy risk to another speculator. How do you play the game of transferring risk? What are the rules? What is the best solution or strategy for your institution?

If your institution realizes energy risk is not desirable, you can transfer the risk via a purchased contract that buys tomorrow’s expected fuel consumption today. By buying today for tomorrow’s needs, you have transferred the price risk of future rising prices and expenses to the contract seller, (i.e. to your supplier, a dealer or a global market participant speculating that energy prices will fall). This bought contract can be structured as a “Passive Hedge” or “Dynamic Cap.” Either of these energy price management strategies can act as just a financial overlay; that is, either strategy does not change the on-demand purchase and consumption orchestrated by your institution’s facility management group.

The “Passive Hedge” locks up your institution’s budget and upcoming expenses at a certain dollar amount by buying a forward or futures contract; lock-up means the dollars you earn on the contract offset the extra dollars needed to pay the rising expenses when energy prices rise (and vice versa, where the dollars saved on lower spot price purchases are offset by losses on the contract when energy prices fall). Hence, the budget and expenses are locked at a dollar amount whether energy prices rise or fall tomorrow (e.g., the previously discussed college could lock its expenses at $2.55 million—which equals a price lock of $8.50/MCF multiplied by the future delivery of 300 thousand MCF of natural gas; note that price includes an approximate $0.50 supplier/dealer profit margin or futures basis cost).

Alternately, the “Dynamic Cap” also does not change your facility management procurement and acts as a financial overlay by buying a call or another option-based contract. A call option gives you the right but not the obligation to buy natural gas at an agreed strike price (for instance, at $8/MCF, the current price for the discussed college and, similarly, the unchanged price in the corresponding table). In this table, the call (or “Dynamic Cap” investment) costs $1 and appreciates in value when energy prices rise. This call appreciation offsets the rising energy expenses experienced by your facilities management—in essence “capping” your budget and expenses at $9/MCF. Equivalently, that is $2.7 million for a consumed 300,000 MCF per year. Yet, when energy prices fall, the loss on the call is limited to its cost. And if the cost of gas (procurement expense) falls more than the call’s cost, net savings are realized in total expenses creating a budget gift. For instance, if natural gas prices fall to $5/MCF, you pay $6/MCF with the “Dynamic Cap” or equivalently $1.8 million for a consumed 300,000 MCF. Whereas, the “Passive Hedge” has locked expenses of $2.55 million or $8.50/MCF. By the way, if you remain as an “Energy Grandstand” spectator and the cost of gas jumps to $14/MCF, you will pay $4.2 million.

Keep in mind, the previously discussed schematic only depicts an example of an annual budget and expenses. As time passes, a “Passive Hedge” or “Dynamic Cap” needs to be rolled forward in time—that is, as the current contract is being closed, the next period’s contract is being purchased. If your institution does not roll, next year’s budget becomes exposed to potential rising expenses if energy prices increase.

Now the word “Dynamic” in “Dynamic Cap” means the call option(s) are automatically rolled forward on the institution’s behalf. Further, “Dynamic” also means active option management for the purpose of adding value versus any “Passive” (buy-and-hold) strategy. For institutional clients of Shield Plus LLC, the realized value-added amount is significantly higher than the corresponding rise in energy expenses over the past 4 years ending 12/31/07. This value-added is a result of a fully-covered market-neutral investment process used in the Shield Plus Dynamic Cap. Examples of rolling, as well as a more comprehensive explanation of a market-neutral investment process, are available upon request.

Choosing the most efficient hedging strategy requires financial expertise; continual valuation and modeling of the various hedging strategies; and identification of the cheapest/richest hedge positions. This process also requires the capability to efficiently act on this research by transacting and rolling positions forward over a desirable time horizon—all in order to capture value and maximize market-related savings for the energy budget. Many institutions do not have the financial tools and expertise to constantly monitor and decipher richness/cheapness between the risk transfer vehicles—let alone take the time to continually execute and adjust hedge positions. Most institutions decide it is unadvisable (or not feasible) to have their facilities staff be glued to energy market monitors and models on a daily basis. Rather, they decide to have the facility staff stay focused on and do what they do best—identifying the cheapest BTU (British Thermal Unit) to buy and consume for today’s heating, cooling, lighting and transportation demands. And correspondingly, they realize the need to hire an experienced energy investment manager (similar to engaging an equity or bond manager for the endowment and retirement plans) to focus on energy market volatility, risk management models and execution. This energy investment manager, in concert with the facilities staff, adds value by identifying and executing the cheapest energy risk transfer for tomorrow’s expected energy consumption for the institution.

In sum, coming down from the “Energy Grandstand” is realizing that betting (or speculating) that energy liability costs (prices) will only remain stable or fall is not in the best interest of your institution. Instead smart institutions are transferring the risk of rising energy prices via a “Dynamic Cap” on their energy budget—such a risk transfer buys tomorrow’s expected consumption today. In so doing, the Dynamic Cap creates the potential for a “monthly to annual capture” in which the strategy’s investment gains are locked and paired off against an institution’s rising energy costs (in essence “capping” the institution’s energy budget and expenses for natural gas, heating oil, electricity, etc.). If energy prices fall, losses from the Dynamic Cap are limited to a certain dollar amount which has a high probability of being significantly less than the savings from lower spot purchases of energy used to operate the institution. By design, the Dynamic Cap’s capability to capture gains and limit losses adds up to energy savings for institutions, and, hopefully, lower surcharges passed onto customers and consumers. Talk with Shield Plus LLC, we seek to protect and add value.