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Price Spike Roulette: Can Utilities Play By Wall Street's Rules?

Fortnightly Magazine - October 15 1999

serve] and its long-term sales contracts to a number of municipals, Cinergy had effectively burned through its reserve margin, thereby creating a short position that was to be covered by hourly purchases in the highly active, liquid and relatively cheap Midwest power market. This strategy, however, anticipated some things that just didn't happen: 1) deregulation didn't relieve Cinergy of its native load customers as fast as expected, and 2) hot weather drove price through the roof," says the Merrill Lynch stock analyst report.

Steve Brash, Cinergy's manager of external communications, says that full requirements contracts were primarily with municipal electric systems and rural electric cooperatives.

"We consider those contracts to be very similar in nature to our native load. These are human needs. These organizations are full requirements providers. We are their single source of power and they serve, in most instances, residential population," says Brash.

"Certainly if we look at today's circumstances in relation to the full requirements contracts, you don't see anybody writing full requirements fixed-price contracts," he says. "We have had a period of time while these contracts are still in force where we have to fulfill the requirement of these contracts acting to limit their impact on earnings."

Brash would not say if risk management products could have averted the company's financial losses, as the company was still conducting an internal review of the matter. Furthermore, by November Cinergy was to decide whether to retain its supply/trading/marketing business.

Nevertheless, UtiliCorp United's Payne says there are a lot of people that successfully play in regulated and non-regulated markets where there are fixed-price full requirements contracts.

"It does offer a set of risks that must be properly managed," he says.

"If you think about the characteristics of a full requirements contract, what you have is fixed-price risk with a variability of take. Essentially you have granted an option to your customer and that option is to take more and take less. What drives that variability is typically weather," he says.

For example, if it is hotter than normal and you have electricity load, people are going to turn up their air conditioning because they want to cool down - not because they are in-the-money or out-of-the-money on a contract, Payne says. (When a contract is out-of-the-money it has no intrinsic value.)

"To the extent that incremental load exposes you to fixed-price risk, you have to recognize that is price risk and need to price your product in a way that mitigates price risk," he says.

Nevertheless, Brash says he does not believe there is much that other utilities can learn from his company's experience this summer.

"It used to be in the utility industry that there was a total pack mentality. Nobody did anything until someone else did it first, and then everybody watched to see it happen. The circumstances in the market are altered now that each company's circumstance is very much individualized. It is very hard to draw conclusions on one set of occurrences and say this is the direction that a specific company ought to take," Cinergy's