Most Important Things to Know About Successful Energy Management Programs

BY THOMAS MULHOLLAND

Energy markets change quickly, making energy management critical to protecting your bottom line. Here are the most important things to know about successful energy management programs.

Hedging versus Speculation. The CFO of one of our large international clients had a habit of telling his energy management staff that hedging was speculating– taking a price position was, in effect, betting that we knew we had the best market price available to us, when in reality markets could drop later, giving us a better price at that time. He opined that this was tantamount to speculation and was forbidden by corporate policy. He was partly right–market prices are going to do one of two things in the future: 1) Go up, or 2) go down. We never know, with certainty, which.

But here is where he was wrong: His firm (a large, energy-intensive, industrial company) was naturally short, meaning that they are always going to use energy in the future. Without any hedges in place, they will take whatever price the market offers at the time they use energy. That means they are exposed to all of the volatility in the market between the point in time when they could have hedged  energy prices and when they ultimately use energy. It means without hedges, they have taken a short position. They are betting prices will go down. Simply put, they have already placed a big bet. The effect of the hedge is to counter or neutralize the bet they took.

By countering a short position with buying energy ahead of the time of its use (hedging), they are getting back to a neutral risk position. This is not speculation. It is the opposite.

Laudable Objectives Can Become Your Undoing. Here is a laudable but elusive objective we hear from one of our clients regularly: “I’m just looking to reduce my prices year-over-year.” I understand the sentiment. But it isn’t an objective.

If  futures indicate pricing for next calendar year is 20% higher than this year, the client’s objective isn’t particularly useful, even if I share their desire.

We help our clients develop energy objectives such as defining risk tolerances for cash flow-at-risk, risk capital risk limits, absolute price points for futures and options, and so forth.

The point is that we need to first control risks through a well-defined set of risk objectives, and then we can work toward cost reduction or savings objectives.

The Bidding Conundrum. Many of our clients believe deeply that bidding schema will result in lower prices. The thinking, underlying most purchasing paradigms, is that bidding business to new competitors will naturally bring about innovation in the supply chain, and with it, price compression. Or that a large volume purchase will drive a lower price.

Energy markets don’t work that way. Because energy commodities are based upon very visible, liquid, futures contracts, sellers all have basically the same comprehensive market information available to them at the push of a button, and will not offer discounts to sell to Party A when Party B will buy at the undiscounted price. Granted, some suppliers are more competitive than others, but the best sellers will be within a hair’s breadth of one another.

Choose suppliers that have 1) the geographical coverage you need for the commodities you use, 2) sharp pencil pricing, and 3) most importantly, solid financials, because who wants to business with a supplier who melts down and takes your hedge into bankruptcy with them when an adverse market happens (think Enron).

Bidding, by itself, will not drive low prices. Market timing and a strong understanding of the phenomena of contango and backwardated market curves are much more valuable (more below).

Power Laws. Most of our clients manage energy purchases as a purchasing function: Commodities are like all other consumables, right? Well no, not exactly. Because commodities are subject to mathematical power laws (a common element of all financial markets), commodity prices fluctuate much more radically, and quickly, than do other feedstocks a company might buy.

Recognizing that energy prices have characteristics unlike other products a company might buy augurs for a fundamentally different approach.

Value-at-Risk Models Can Increase Risk. VaR is used to assess the risk of markets and specific transactions. VaR uses “certainty” levels to say things like, “There is a 95% probability that the price we will encounter will fall between X value and Y value.” Energy traders, and energy users who listen to them, often get a false sense of security that if we’re within the certainty range, all is well.

The problem with VaR is that it truncates historical data. What I mean is that the analysis ignores infrequently occurring high and low market prices in order to make the statistical model work. In fact, that is exactly what makes the model not work. What we are most interested in are the infrequently occurring high values that could wreck our profitability of they do come about.

When using VaR to assess risk, add stress testing to the analytics. Calculate VaR, but then stress test the model by forcing it to consider  effects of very high prices. See what happens. If the model predicts a disastrous outcome, look into ways to control them. Don’t ignore high prices; use them as a tool to build a more robust solution.

Models are important, we can’t emphasize that enough. But to get the right answer, you’ve got to ask the right questions.

Savings Conundrum. Success of energy management is often measured with the metric of savings. But if we are starting with a short position, there is no guarantee of savings. And waiting for savings to arrive means leaving risk exposures open, hoping that markets move favorably.

What if they don’t? I’ve known many well-meaning plant managers, with their own performance incentives based on plant operating cost reductions, who left positions open because markets wouldn’t cooperate at budgeting time. Such actions are at cross-purposes with effective energy management objectives. There is a better way.

We can structure performance goals around risk reduction objectives, profits earned on energy risk capital, and incremental improvements on hedges after their initial placement, as well as other measurements. These are very real metrics, and more importantly, are supportive to a well thought out energy management program.

Market Timing. Market timing, leavened with a deep understanding of the behavior of futures curves, is crucial for capturing savings. While no one knows when a market will hit its absolute top or bottom, we can know when we have reached our objectives, or reached a risk tolerance limit.

Building an energy management program based on appropriate objectives allows us to tap into the power of market timing without opening ourselves up to unfair Monday morning quarterbacking from those who might later criticize a decision to lock in prices. Approval of energy management objectives at the outset gives us the ability to protect the company’s interests, with alignment throughout the decision-making chain of command.

BOTTOM LINE: A successful energy management program, with well-defined objectives, can create tremendous, measurable value for an organization, and allow energy users to harness insights into energy markets to its advantage.

Job Creation Effect of Illinois Electricity Aggregation

BY THOMAS MULHOLLAND

Residential electricity aggregation programs are sold to the voting public on the appeal of personal cost savings. But aggregation offers a much more important public good: An increase in community prosperity through local job creation. Electricity aggregation has a tremendous job creation effect. Here’s why.

Northwestern Mutual published research stating that business investment is a healthier driver of economic growth than either consumer or government spending, and goes on to say that because the US economy is driven by consumer spending, GDP growth accelerates when consumer spending increases [Note the key words "business investment" in this sentence; we'll talk about that later]. The Economic Policy Institute’s Josh Bivens found that $115,000 in additional economic activity results in the creation of one new full-time-equivalent job (Bivens 2011).

Take a look at the impact of electricity aggregation programs on job creation using Illinois as an example. With a population of 11 million people, the state has approximately 5.4 million residential customers.  I estimate that 4.4 million customers will shift from bundled retail electricity service formerly provided by investor-owned utilities to market-based electricity service brought about by aggregation programs. Only 9 months into implementation of aggregation in Illinois, EIA documented that 1.3 million customers already made the shift, not counting 1 million customers in the Chicago area that will switch in early 2013. That’s over 53% of the population in just a few months—a huge success.

Customers of aggregation programs save a lot of money. The Illinois Commerce Commission reports the average electricity rate as 4.5 cents per kWh. In comparison, the default rate from the Illinois Power Agency is currently 8.1 cents per kWh. It’s scheduled to drop on July 1, 2013, but is expected to remain above 6 cents per kWh.

Analyzing these data, residential electricity aggregation in Illinois pushed $433 million back into local communities in 2012. Considering voter initiatives approved in 2012 and slated for implementation in 2013, the cumulative increase in consumer spending at the local level will total approximately $900 million by year-end 2013, and is estimated to surpass $1.5 billion by year-end 2014.

Using Biven’s metrics, increased consumer spending driven by aggregation in Illinois created over 3,700 jobs in 2012, and will create over 13,000 jobs by the end of 2014. The US Bureau of Labor and Statistics published that Illinois added 41,900 jobs in 2012. Aggregation drove almost 10% of total job growth in the state.

Aggregation tackled the problem of creating energy savings for residential customers, and industrial customers have had market access for a number of years. Commercial customers are a gap in the market. They are the neglected child: Too small for direct sales initiatives and too big for aggregation, a large percentage remain with default (read: expensive) supply.

Returning to Northwestern’s comment above, cost savings for commercial customers translate directly into job creation and are more important to long-term growth sustainability than are increases in consumer spending.

Electricity aggregation is a huge success for residential electricity customers, increasing prosperity for Illinois communities. Now business customers can join the effort. To learn more, please read this article.

Dear Illinois Commercial Electricity Consumer: Join the effort to increase the prosperity of your business and community!

BY THOMAS MULHOLLAND

I’m writing you today to let you know about an opportunity that’s now available to commercial-sized electricity users to help you increase the prosperity of your business and community. This is a movement that started with aggregation of residential customers, putting truckloads of dollars back into local communities. It’s now available to commercial customers, but individual businesses have to take action.

Don’t worry, we’ll help.

For over two decades, we have connected customers with great solutions to help them meet their business objectives. This is a particularly great opportunity that does not come around often.

Our goal is simple: We want to help businesses in Illinois tackle what to them seems like a daunting task–contracting for market-based power–by leveraging our expertise. We believe we can create hundreds of job in Illinois.

If you’re a commercial-sized energy user (or know someone who is) that wants to help make an impact in your community and on your own bottom line, we’re asking you to contact us by emailing me at thomas@energy-risk.com. I’ll help you get underway.

For more details, click the link below.

Your community thanks you. Your bottom line thanks you. We thank you!

Thomas Mulholland

Prepare Procure Prosper

Disruptive Innovation Vs. The Utility Regulatory Paradigm

BY THOMAS MULHOLLAND

Lately, the energy press has been full of stories about utilities seeking regulatory approvals for a number of new projects they’d like to build. While I’m sure utilities have great justifications for why their proposals make sense, at least to them, it’s clear the existing regulatory paradigm allows utilities to shift untenable business risks to customers, while privatizing profits. It is time to change the regulatory paradigm and to expose utilities to disruptive innovation. Here’s why.

Southern Company is proposing a coal gasification plant in Mississippi. Ameren is proposing a new small-scale nuclear plant in Missouri. Ameren and Excelon received approvals in Illinois for grid modernization under which they will invest $4 billion. What do these proposals have in common?

All of these projects  1) are huge and risky investments, 2) take decades to pay off, 3) use questionable business logic and offer dubious customer benefits, and 4) rely on captive customers with no ability to change suppliers in the following decades. And, without this last feature, brought about by the utility regulatory paradigm, it’s doubtful any of these projects would go forward.

Southern Company’s investment in coal gasification at its Ratcliffe plant will total $2.4 billion. Southern’s CEO Tom Fanning says  “I can’t bet [natural gas] is going to be cheaper forever.” But in fact he is betting—and betting big—that natural gas will cost more in the future than coal converted to gaseous fuel. He’s betting coal prices will be consistently lower than natural gas prices for 40 years. But wait: Utilities are closing coal-fired plants now because they can’t compete against natural gas. Hmm…funny bet. Guess he intends to make it up on volume. This is a risky, risky commodity price speculation, the kind that violates fundamental risk management principles. He is willing to make (and probably lose) that bet because he knows customers must backstop potential losses.

Consider Ameren’s proposal to build a new nuclear plant. They’d like to build a new $1 billion, 225 MW nuclear plant at the same time they’re shuttering 5,000 MW in coal-fired capacity. The plants are closing because they aren’t profitable. The Midwest market is awash with overcapacity. One study estimated 12,000 MW of capacity will close in Illinois, Michigan and Ohio as a result of EPA air emissions rules, ill-fated by low market prices that make compliance with EPA rules uneconomical. Yet, at the same time, Ameren is proposing a new plant at $5,000,000/MW. Oh, the new plant won’t be on-line for ten years. Can Ameren assume markets won’t change during that period? Perhaps they should talk to Progress Energy about the nuclear plant it’s building. It’s now 8 years late and 5X the original cost, clocking in at an astounding $24 billion, or more than $10,000,000/MW.

The only explanation is this: If a utility has a captive customer base, it can afford to write-off fully amortized plants that don’t contribute much to earnings, and replace them with shiny new gold-plated ones that do. Customers can thank a faulty utility regulatory paradigm for the opportunity to pay for expensive, unneeded assets for the next several decades.

A utility customer is to the energy industry what taxpayers were to the financial bailout: the financial backstop of last resort. The post-2008 financial bailout brought forth a firestorm of criticism that the financial services industry privatized profits but socialized risks. The utility industry is doing the same thing, but without a whimper of protest from customers or the press. Notice also, that regulators aren’t looking to change things up either (see the comment by Missouri Public Counsel Lewis Mills Jr. here).

Let’s look at competitive markets for a minute. Clayton Christensen, in his great book The Innovator’s Dilemma, discussed how to gain and maintain market leadership. Christensen defined the rules of “disruptive innovation.” Regulation, however, shields utilities from most disruptive forces within industry verticals.

But competitive pressures affecting long-term investments are between verticals. Innovation in the natural gas industry radically altered supply and demand, and is keel-hauling the coal industry. Forces of change are there, but they aren’t incremental. They are fundamental sea-changes to which the industry has difficulty responding except through massive dislocations and write-downs. It is ironic that their response to write-downs is to re-invest in the same fundamental technologies, and to tee up another day of reckoning four decades down the road.

There is another way. Customers are expressing desires for new products—notably energy efficiency and renewable products—that threaten utilities’ entrenched interests. Rather than digging in and resisting change, utilities must seek ways to embrace emerging customer needs, develop creative solutions, and propose them to regulators. In this way, we stand a chance of avoiding the buildup of new stranded costs through big bets gone wrong that depend on a captive customer for a bailout. Let’s treat customers like what they are: customers, and give them real, meaningful choices.

Electricity Aggregation in Illinois: Preliminary Results Are In!

Source: U.S. Energy Information Administration, Monthly Electric Utility Sales and Revenue Report with State Distributions (Form EIA-826).

BY THOMAS MULHOLLAND

The EIA posted this great graphic on its website yesterday showing the share of the Illinois residential market captured by various suppliers since aggregation began in 2012. It shows that aggregation is a hit in Illinois. Here are some other insights.Each residential “Customer” on the chart is about 2.5 people…there are about 4.5 million residential customers overall; about 1/3 have moved to market-based supply via aggregation. Most of those moved after ballot initiatives in the first half of 2012. A second ballot held in the fall will likely move another 1.5 million customers to aggregation by mid-2013, meaning market-based suppliers will then serve about 2/3 of Illinois’ residents.

Six suppliers carved up roughly 85% of the market. Four of the suppliers are relatively large national companies, showing that there are some significant barriers to new market entrants. In our experience with these four, we have found them competitive and relatively credit worthy.

Ameren Energy Marketing (now Homefield Energy) has about 200,000 customers; if trends continue, they should end up with around 400,000 customers, or roughly 10% market share. Reading the tea leaves, it’s not a stretch to say that Homefield’s inability to hold on to a significant share of the competitive Illinois marketplace contributed to their decision to write-down the majority of their merchant generation assets.

So far so good—customers are seeing lower prices—and everyone is still in the “wild enthusiasm” stage of the market. Some risks remain:

• The cities executed contracts with block structures, leaving risk in imbalance energy settlement. They would be wise to consider more innovative approaches.
• Contracts are relatively short-term. Cities representing aggregation customers must stay abreast of market prices to extend contract terms so that customers don’t get unexpected price hikes. Price volatility is currently pretty tame, but there’s no guarantee it will remain so.
• A number of the cities bundled “renewable energy” into the electricity supply deals. It’s arguable if residential customers understand that RECs are not exactly the same thing as renewable electricity supplied directly from the source. Cities have a number of alternative approaches they can use to meet the needs of a green-minded constituency while mitigating potentially troublesome risks.
• Roughly 15% of the market is held by small suppliers. Aggregation could suffer a significant black eye if these suppliers default, throwing them back to the supplier of last resort.

The thing that jumped out at us the most was the lack of integration between aggregation transactions and other needs customers express that we identified in our research. Examples include efficiency, renewables, low-income assistance, and integration into community-based energy-related project development. We hope that city leaders will begin to look for opportunities to meet more customers needs than just price discounts.

One-Dimensional Thinking

BY THOMAS MULHOLLAND

The WSJ printed an article today titled, “Rush to Natural Gas Has Coal-Fired Utilities Seeing Red.” In the article, utility executives express their concern about relying too heavily on one source of fuel when considering what kind of generating plant to build in the future. Their thinking shows that they are making decisions involving huge leaps of faith, highly speculative leaps that we customers are legally bound to backstop financially, regardless our agreement with those decisions.

It seems to me that the discussion about what is cheaper misses the point. Fanning at Southern Company says “I can’t bet it is going to be cheaper forever” but he is willing to bet (other people’s money, both that of investors and customers) that coal gasification will stay cheap. What special insight does he have into the future of markets that leads him to bet that he should bet billions on gasification to displace the source of fuel (gas) that is cheaper now and for the foreseeable future?

To the point, these guys all let their personal biases, or the bias toward a particular approach borne out of the regulatory paradigm, lead them to make investments that are risky to us the customers because they are so outsized and one-dimensional. There is no built-in exit strategy, no fall-back position, no opportunity for trading and arbitrage.

I do not see in vision or industry leadership in their public pronouncements. I do see that they are ignoring key shifts happening in the markets now under their noses. None of them are developing strategies that look to the future. Instead, they are making 40-year bets on trends extrapolated from the history of the past three years, and in cases like Fanning’s they are ignoring even that reality as well.

These decisions, the other side of the coin of wide-scale closures of coal-fired power plants with accompanying write-downs, expose unsound risk management. They expose the flaws that exist in the current regulatory regime that reward risk-taking of this sort with what amounts to a built-in bailout.

In any other market, looking to the public to backstop poor decision-making on this level would lead to a revolt.

Is Innovation in the Utility Industry Dead?

BY THOMAS MULHOLLAND

Is innovation in the utility industry dead or isn’t it? We think there are tremendous things happening in energy and its utility sector, but you have to pay attention.

Forbes magazine published an interesting article this week titled “Innovation Almost Dead, Perhaps Not So In Electricity” saying that the opportunity for innovation exists, and in some corners is moving ahead full steam. But the article goes on to say that there are many obstacles to innovation, especially its culture about which Forbes offers a trenchant assessment, a very worthwhile read.

Here’s an example of where the culture rubber hits the innovation road. In a seemingly unrelated article, the Chicago Tribune wrote in December that Ameren (AEE) is looking to divest its merchant generation portfolio. Ameren announced it would write-down as much as $2 billion of its investment in that business unit.

When the Illinois electricity market opened for competition, Missouri-based Ameren (formerly the Union Electric Company) bought generation in Illinois. This amounted to a very limited foray into innovation: Using the same plants and the same distribution network, it attempted to market electricity to essentially the same customers, but using a different, market-based pricing mechanism. It was a profitable move during the period when electricity prices (along with oil and natural gas prices) skyrocketed due to a perceived shortages. But, no longer guaranteed a return on its investment, Ameren was forced to rationalize essentially the entirety of the business when power prices dropped and they could no longer compete.

Sadly for investors, Ameren, and many other merchant generation companies, were not innovative with the companies they bought and especially with regard to the customers (not ratepayers) they serve. And now, a market that demands excellence and exerts its will through forces of creative destruction is compelling their withdrawal. They simply did not have what it takes to meet competition to stay in the game for the long haul.

Since that debacle, Ameren has been making the rounds in Springfield and Jefferson City selling ideas that it should make huge capital investments in 1) upgrades to its grid that probably won’t create benefits for its customers and 2) an extremely expensive and unneeded new nuclear plant to replace the unneeded coal plants it, and many others, are shuttering by the dozens in the Midwest. It sole innovation is audacity: It created new justifications, and methods to go over the heads of state regulators, for gold-plated boondoggles that it will force its customers to pay off over the next forty years.

This makes no sense. Innovation everywhere abounds. I just finished a book about the history of cancer (The Emperor of Maladies; a great read) that talks about how gene manipulation is emerging as the way, not to eradicate cancer, but to turn off its fecund reproductive pathways so that the patient can simply live with it in perpetual remission. The book says that therapies are catching up to advanced research in cellular biology conducted over the past couple of decades. Here is another example. The WSJ reported today that scientists have stored audio and text on fragments of DNA and then retrieved them with near-perfect fidelity. This is a somewhat esoteric example of the advance of technology, but let us not forget that the nature of DNA was barely even understood just a couple of decades ago.

The synthesis of basic research that is happening now will open up profound new insights into how things work, giving birth to not-as-yet-conceived new technologies.

And in the energy industry, even though the utility paradigm will not change quickly, there is tremendous opportunity for innovation. These are exciting times.

Contrast that sentiment to what you can imagine it feels like to have a meeting in the office of a utility chief executive these days. I’ve been there. The whole place feels dead. And no wonder. Faced with layoffs from bad investments and uncertainty about the future direction of the company, employees keep their heads down, speak in hushed tones, and hunt for the three of clubs—not exactly the environment in which one will find driven entrepreneurs, bristling with excitement about ideas for new growth businesses they are carrying around in their heads.

Entrepreneurs are having a heyday in today’s energy economy.

The EIA says that renewable resources now produce over 13% of US electricity supply. Hydro power is the largest renewable resource, but nearly all built before the mid-1970s, much of it at dams owned by federal agencies. Non-hydro renewables increased by more than 400% over the last decade—the vast majority built by entrepreneurs, not utilities—with enough capacity to meet the demand of Los Angeles. Wind generation, once considered a pesky annoyance to utilities, emerged as a real-time resource in some markets, and often drives marginal pricing to the point it competes with super-low pricing of nuclear plants.

Consider natural gas. Just a few short years ago conventional wisdom held that we were running out of natural gas, and priced accordingly. In 2008, natural gas prices peak at $13/MMBtu. Now gas hovers below $4/MMBtu. The seismic shift in prices led to a seismic shift in thinking. Utilities are using natural gas to fuel coal-fired plants. Electricity produced from natural gas, once considered uncompetitive, is forcing coal-fired generation plants to close. Natural gas is transforming vehicle fuels. The chemicals and plastics industries are making enormous investments in new plants (and new technologies).

And under the radar screen, we are continuing to develop a number of renewable fuels technologies and projects that will transform our small corner of the world—serving customers on their terms with innovations that unlock tremendous value. We believe further innovation will come to the utility sector. Change might be incremental. But under the right conditions it could come as an earthquake.

Chesapeake and JP Morgan: Poster Children for Failed Risk Management

BY THOMAS MULHOLLAND

The Walls Street Journal  published an interesting article chronicling more of Chesapeake Energy’s financial woes. JP Morgan has also been in the news, having lost $2 billion on so-called hedges. Their actions make them poster children for failed risk management.

We’ve written about Chesapeake’s asset sales previously. They’re selling production and reserves to get cash to fund more drilling. While asset sales bring money in the door now, they also create a long-term liability–the cost to produce gas down the road. Why is Chesapeake doing these deals? Because they’re not generating enough revenue from sales of natural gas to cover the cost of exploration and production–the market price is simply too low, and their business is upside down. One way out is to front-load future cash flows so they can live to fight another day. 

But there’s a problem: Asset sales don’t yield enough to pay all the bills. And, if they sell too much now, they’ll create obligations for the future that lay the seeds of another, looming disaster, absent a big jump in natural gas prices.

The WSJ explained that Chesapeake is borrowing heavily–$3 billion in a new, unsecured line of credit. That will help them partially repay a $4 billion secured line of credit. There’s a catch: the interest rate on the new line is 8.5% now and jumps to 11.5% if not repaid by the end of this year; the old line had a rate of 2.75%. The company will pay a higher rate to avoid drawing down all of its existing line and to avoid breaking its terms. Chesapeake’s financing costs will jump by $173 million. The cost of staying solvent just got a lot more expensive; the treadmill is turning faster and faster.

Why is this a risk management issue? Chesapeake is a commodity producer, in an industry rife with risk management techniques and expertise. But even with that backdrop, the company violated a simple but key risk management principle: It didn’t match its book. It buys at a fixed price (leases and field services) and sells at a floating price (natural gas to market). The market is now crushing them for betting the entire company on unhedged speculation. Chesapeake is an example of enterprise-wide risk management failure. [Ironically, investors who agreed to loan Chesapeake $3 billion are also speculating on energy commodities--that gas prices will rise, helping Chesapeake regain financial strength to repay debts.] Bottom line: They could have hedged to maintain adequate cash flows and solvency, but didn’t.

Here’s another example. According to the WSJ, JP Morgan took huge positions in 2011 in derivatives related to corporate bonds to try to protect itself against a possible recession in Europe, which could hurt Morgan by increasing defaults in its nearly $1 trillion loan portfolio. When the economies of Europe strengthened in 2012, Morgan tried to shorten its position, but rather than unwind a part of its bond derivative portfolio, it traded new derivatives–it sold credit default swaps related to bonds maturing in 2017, bought CDS swaps with maturities in 2014, and took a position on the spread between CDS swaps with maturities in 2014 versus 2017. Because JP Morgan didn’t unwind its position in a straightforward way, it took on new, huge, unpredictable, and entirely avoidable risks that the swaps would not move together and deliver expected results.

The market decked Morgan with a one-two punch:

Uppercut: If this was Morgan’s attempt to put on a hedge, it was a poor attempt. If they used financial modeling techniques, and if their analysis predicted the trades would perform well, it reinforces our belief that such approaches are fatally flawed. My own belief is that Morgan’s traders disregarded data showing the trades didn’t correlate well, and put the positions on anyway. That is probably why Morgan showed several executives the door after the trades blew up. Rule No. 1: Thou shalt not violate thine own risk management policy.

Right Cross: They lost $2 billion, and counting, by trying to turn a hedge into a profit engine, which is why it’s not a hedge. Rule No. 2: Thou shalt know the difference between a hedge and a speculation, and handle each accordingly.

JP Morgan learned that risk management can’t serve two masters. Put on a hedge, or take speculative risk, but don’t fool yourself into thinking one set of trades can do both.

Worse yet, Chesapeake didn’t use risk management to protect its most important asset: its existence. It had various transaction-level hedges in place but it did not hedge its giant, overarching, gonna-take-you-to-the-poorhouse risk of buying services at a fixed price and selling gas at a floating price. If it had, it wouldn’t be borrowing billion of dollars just to survive.

Now consider your business. It’s one thing to take risks that are manageable or relatively small in scope, it’s another to take risks that could sink the ship, like Chesapeake and JP Morgan. What trading risks have you identified in your business, and how to you intend to manage them?

Careful Evaluation of a Customer’s Needs is The Only Way to Create Good Energy Solutions

BY THOMAS MULHOLLAND

How do you know if your energy consultant is really looking out for your best interests instead of simply selling what they have to offer? The only way to create a truly good solution is through careful evaluation of a customer’s needs, wants and long-term goals. Without this type of approach, any proposed solutions validate H.L. Mencken’s maxim that for every problem there is a solution that is simple, neat, and wrong.

As energy market volatility continues to unfold, energy costs depicted by supply and demand curves are not constrained to follow the curve. Due to many factors, including increased use of energy fuels worldwide, the price curve  will shift radically to balance supply and demand.

How does your risk management approach, and the model of your expected results, perform when market dynamics shift the curve? Read here for our comments about the impossibility of forecasting risk using VaR, and the desirability of testing fragility instead.

Customized solutions succeed by putting the customer first. We can help you realize all of the value you expect by aligning our goals with yours, and those of your business’ operation.

Delta to Buy ConocoPhillips Refinery to Hedge Fuel Costs; Return to Vertical Integration

BY THOMAS MULHOLLAND

Delta Airlines announced today that it is buying ConocoPhillips’ Trainer, PA refinery in an effort to control fuel costs through vertical integration. The move adds a new dimension to its fuel hedging program. It is a bold risk management move. Now that Delta has taken this step, did it go far enough?

Delta expects the acquisition to add to earnings, allowing Delta to recoup its investment within a year. But operating losses have doomed several refineries in that region to closure. ConocoPhillips idled Trainer months ago and planned to close it by the end of May. In an unrelated announcement, Energy Transfer Partners agreed to buy Sunoco in a $3.5 billion transaction including Sunoco’s Philadelphia refinery. ETP disclosed the refinery will remain open only if it can successfully negotiate a joint venture with the private equity firm Carlyle Group to operate it. Delta and ETP will have to turn the refineries around. Delta must manage Trainer’s operational and crack spread risks better than ConocoPhillips, ranked No. 5 of the world’s top six “super-major” vertically integrated oil companies.

It is not clear the strategy will reduce Delta’s costs or hedge its risks. For vertical integration to work as part of its risk management program, Delta must: 1) reposition Trainer to process domestic crude and 2) develop or control domestic crude supplies. In 1997, American Refining Group (ARG) did just that when it purchased the Bradford, PA refinery from Kendall for $1 plus commitments to invest in upgrades. ARG’s domestic oil wells became the source of crude for Bradford. That was the key to Bradford’s success. To be successful, Delta must use a similarly comprehensive risk management approach.

Poor performance at the start of a vertically integrated supply chain is an insidious problem. Through the acquisition, Delta guaranteed purchases of jet fuel from Trainer. It now must guard against subsidizing its early stage supply chain operations (if they produce poor quality or costly products) by those in later stages. This problem is especially acute because of  Trainer’s poor economic condition.

Delta faces another problem. Energy markets in the U.S. are going through major changes. Oversupply of natural gas is forcing drillers to shift to more crude- and liquids-rich plays. Producers and shippers are working to ease crude transportation bottlenecks (see ETP’s announcement regarding possibly converting Trunkline from natural gas to crude). Changes like these could significantly alter spreads that existed at the time of the acquisition in ways that could be costly to Delta.

Risk managers must remain nimble to adapt to changing circumstances. Because it broadened its exposures and committed to invest $350 million over five years, Delta’s acquisition could make that task much more difficult.