The Nature of Energy as a Purchased Item - Part One
November 07, 2010 - SCMR Editorial
Of the myriad of items that are purchased by companies on a daily basis, energy is a stand out. In a few words: As a purchased item, energy requires unique attention and strategy. And it’s getting more involved all the time!
There is no “one set and forget” or “one size fits all” purchasing procedure for energy. For the end-user, the only prudent strategy is one of informed awareness. This includes all of the influences on the supply chain components, internal processes, as well as local, state and federal regulations. Because strategic sourcing practice employs a rigorous attention to the details, its methodology is a fitting tool for assuring best-value purchases. It should be kept in mind that the commodity cost of energy is only one part of the total cost of energy to the end-user, something that is addressed through a comprehensive energy management effort.
Among the key parameters that strategic sourcing can aid in addressing are:
Price and volume
Energy is expensive and its price is volatile. The ability of the end-user to make quick decisions based on its known needs is helpful when trying to buy energy at the best available market price. To do so the end-user needs to know the desired strike or budget price that works toward achieving desired cost ledger performance. In addition, volume requirements and the nature of that volume (constant or variable) must be known. This includes daily, weekly, monthly and sometimes real-time fractional hour usage. Storage capability is also of interest.
In purchasing, it is a normal assumption and expectation that larger volume will provide additional negotiating leverage for price determination, but this is not always the case with energy purchases. The energy end-user can expect lesser leverage than is typical of other purchased items. This is due to the relative and intentional “transparency” of the energy marketplace.
A fitting analogy to all of the above is that of buying a stock. To make an appropriate purchase, one has to determine a desired target price as well as how much one wishes and can afford to own and then buy it on a real-time exchange like the NYSE. Energy is generally purchased on real-time trading platforms like the NYMEX, ICE or a RTO.
For the end user, hedging is normally practiced as an effort to reduce price volatility and establish known purchasing price for future volumes. But since hedging is based on a guess of future price direction, it should not be done without an agreed to set of company hedging rules and philosophy. It requires informed decision making and observance of government accounting rules. Hedging should not be viewed as a profit center, but instead as a way of trying to achieve favorable business plan budget performance.
Because energy commodities are so expensive and generally paid for after delivery to and consumption by the end-user, the credit worthiness of both parties is a very important parameter. While the purchaser should be prepared to offer proof of credit worthiness, it should also check on that of the supplier’s as well. For unlike buying in a regulated market and typically from a utility, buying gas in a deregulated market from middle-man marketers can have more inherent risk; although uncommon, they have been known to default. It is a primary consideration during the entire contract period.
In part two of this discussion we will review other aspects that make energy unique among purchased items. Together, they emphasize the multidiscipline effort required to manage all of the aspects of energy (in all of its types) in a comprehensive energy management effort.
Theodore L. Eichenlaub
Senior Energy Advisor
Greybeard Advisors LLC