Managing your commodity spend in volatile weather
“I survived this past winter, but our budgets certainly didn’t,” is a common sentiment we’re hearing from manufacturers. During volatile weather, how can you better manage your commodity costs?
The winter resulted in significant demand on various alternative heating products, to the point of “force-majeure” being declared on propane in many areas in the Northeastern United States.
Force majeure can be summed up as an unavoidable accident that frees both parties from liability or obligation due to extraordinary events or circumstances beyond the control of the parties…such as the “Polar Vortex.”
Who would have known the Polar Vortex would increase demand for transportation on the TransCanada Pipeline and boost transport rates by more than 1,000 percent on the daily market? Natural gas prices soared and propane rates spiked by more than 130 percent when compared to the rates in October 2013.
It was doom and gloom and the only thing you can do during a time like this is wait. Reactive management of costs is the single biggest mistake businesses can make as you can’t fix a price when you hear the market has increased…it’s already too late.
We’re faced with the question: “What do I do now?”
To answer that question, let’s focus on three commodities we receive the most questions about: propane, natural gas, and electricity.
The good news is it’s April and your bulk heating rates should have come down by nearly 40 cents per litre. If they haven’t, there might be a good reason. Your supplier may not have keep up with the increases in the market and is now trying to recover some lost margin.
The fact is, you should have a good look at the pricing and information to make sure overall costs are consistent with your expectations.
While preparing for next winter, you can consider fixed rate options. This is something we’re working on with many companies as it’s a great way to prepare. We know what increased demand can do and the risk versus reward can be well balanced, depending on the vendor you choose.
Due to the differences in various markets we’ve broken this commodity into two sections: specific for Ontario and specific for other provinces.
Specific for Ontario
The media in Ontario did a great job mentioning rates were increasing by 40 per cent. The issue is many people don’t understand the Ontario utility rates and how they work.
The utilities set their rates every three months and it tends to take them six months to reflect the market during a time of extreme volatility or drastic changes in rates. Therefore, companies that were with the utilities this winter likely did well compared to the actual market prices.
However, they’re now left with either an increased rate to remain with the utility, or fixed rate options that are 50 percent higher than those they were offered back in October.
Specific for other provinces
Many businesses have felt the increase in costs as most provinces follow the true market in a manner more responsive than Ontario. The recommendation below still applies, since you can limit your exposure to the forward market. For the first time in many years, we have a number of variables that aren’t in our favor.
Our suggestion can be summed up in one word: timing.
Unless you have a process load you can wait for the market to soften. While many executives are asking purchasing teams to do something about the costs, reactive management isn’t the option. Our clients are waiting for prices to come down so they can consider one to two year options on a portion of their volumes. Remember, you don’t have to fix 100 percent of your volume.
We’re starting to see a significant increase in feet-on-the-street selling contracts. If you’re getting advice from suppliers, ask yourself how they’re paid. This summer will dictate if the next winter will bring a $9.29 per Gj ($0.35 per cubic meter) or a $5.00 per Gj ($0.188 per cubic meter) price.
Unfortunately, only Alberta and Ontario are deregulated–the only places where customers have a choice when it comes to supply, and although the generation mix for both provinces is different, the market is essentially designed the same, with both relying on natural gas to meet peak demand.
The wholesale electricity price in Alberta—called the Alberta Pool Price—saw extreme volatility in 2013 from a low of 2.8 ¢/kWh in March to a spike two months later to 13.7 ¢/kWh; even though the average daily natural price only increased $0.15Gj for that period.
In Ontario, the hourly Ontario energy price (HOEP) had averaged 3.03 ¢/kWh since 2009 and with the global adjustment (GA) ensuring Ontario generators don’t go out of business it looked like 2014 was set for another low HOEP/ high GA year.
That was of course until the winter that wouldn’t end arrived and depleted our natural gas storage and finally put pressure on Ontario’s peak demand; driving the commodity up to 6.5¢/kWh in January, 8.5¢/kWh in February, and 8.05 ¢/kWh in March.
So how do you manage the volatility? With volatility comes opportunity. The pool price and the HOEP change every hour, 8,760 times per year. The good news is both markets have many suppliers with trade floors who offer fixed rates that also change 8,760 times per year. This gives you 8,760 different opportunities to compare pool/HOEP to the futures market.
Take into account the marginal cost to produce power in your province, during times of mild weather and good capacity, then look at the worst times of extreme hot/cold weather and tight capacity. From there, evaluate the current one-year year fixed rate offered by various suppliers and determine the risk in how far the pool/HOEP will swing above and below your fixed rate.
Ultimately, the only thing we know for a fact is that these prices will swing, and proactively managing the volatility is the only way to control your costs.
This article is part of the Financial Management Success Centre, which showcases leading strategies for cost control and preservation of working capital in manufacturing.
The views and opinions expressed in this article are those of the author and do not necessarily reflect or represent the views and opinions held by CanadianManufacturing.com