By the end of last year, much was being made of the failed attempts at multibillion-dollar mergers by FPL with Constellation, Exelon with PSEG, and Southern Co. with Progress Energy. In spite of...
Temperature, Price and Profit: Managing Weather Risk
THE SUMMER OF 1996 OPENED COOLER THAN normal in June and July, cutting electric sales. When prices for natural gas did not fall as expected, as a counterbalance Consolidated Edison Co. of New York entered a combined gas-conversion and weather-heading transaction with power marketer Aquila Energy, giving Con Ed some measure of protection against further revenue shortfalls in August.
The deal was designed to run four days a week throughout the month (Tuesday through Friday) and to provide a guarantee of total cooling degree-days in New York City, with no apparent direct cash outlay from Aquila. If the variance between actual cooling degree-days and the forecast fell 10 percent below specified parameters, Con Ed would win a discount from Aquila, presumably on power the utility purchased from the marketer. Any returns due the utility from the marketer would come in increments of 50 cents per megawatt-hour; Aquila capped the utility's entitlement at $1.50 per megawatt-hour.
"It was a no-lose situation from my perspective," says Ken Bekman, Con Edison's wholesale power director. "It was an opportunity to generate some savings. The product ... was a good deal. It worked and we were happy with the results."
In the case in point, the parties took counter positions in weather. The utility sought protection against weather risk - the uncertainty in earnings and cash flow due to weather volatility - by entering into a weather-based hedge. The energy company took a weather position plus offered a client a desired weather risk management product.
Yet some question the strength of the link between temperature and prices. Weather hedging may prove useful, they acknowledge, but not as vital as some would have the industry believe. Earnings depend on many factors, including price and quantity, yet the effect of weather is felt largely on volume only, without integrating coverage against price risk.
Joe Petrowski, president of Consolidated Natural Gas Energy Services (an affiliate of the Pennsylvania utility, Consolidated Natural Gas), says the link between weather and underlying energy prices is growing more tenuous.
Although the weather remains the single largest variable in energy, Petrowski says, a "disconnect" in prices and weather now exists due to three distinct factors: 1) increasing speculative interest in crude oil, natural gas and power, which allows factors like the gross national product, currency spreads and production volumes to affect the market more; 2) more hedges (forward contracts sold), which means the spot market is no longer the market's sole calibrator, and 3) greater market efficiency, allowing for a closer match-up in timing between consumption and prices.
Bottom Line Impact:
According to Carl McCutcheon, Koch Industrial and Utility Services senior vice president, the weather-to-earnings correlation is very strong for utilities that have volumetric rate structures for a large share of their load, such as natural local distribution companies and some electric utilities. A study conducted by Koch Energy Services shows that from 1966-1995, the correlation of the price of New York natural gas as a function of heating degree-days (HDD) was 31 percent, yet the correlation of the use of New York