Coal buyers mine risk management strategies to boost profits

James Martin

Peabody Energy Solutions

“We travel greater distances in a shorter space of time and with more ease than was ever dreamed of by the forefathers. Market prices are hourly known in every commercial mart, and the investments of the people extend beyond their national boundaries into the remotest parts of the earth. Vast transactions are conducted by the tick of a button. Every event of interest is immediately cabled.”

Although this sounds like a quote from Bill Gates` testimony to Congress in 1998, it is actually an excerpt from President McKinley`s speech at the Pan-American Expo in 1901. It also serves as a reality check.

On the verge of a new millennium, the energy industry views itself as utterly sophisticated-undoubtedly, at least as sophisticated as the folks at the last turn of the century. In other ways, though, the industry is quite similar to the world in 1901. Because so many changes occurred since the introduction of the Energy Policy Act (1992) and the Public Utilities Regulatory Policies Act (1978), this is thought to be a far different era.

Indeed, it is a different era; but the industry now stands at the threshold, seeing only the tip of the iceberg in terms of change. This is especially true for the sale and purchase of coal. (See “Online lumps”) Although an over-the-counter (OTC) market has begun for several specifications of coal, electricity trading has a much more robust profile. There are several reasons for this, but the most overwhelming is the fuel-adjustment clause.

Fuel costs for most utilities in this country are still regulated by state commissions and pass through to the ratepayer. The coal buyer has no incentive to pursue “creative” transactions. If he takes risk and is successful, all benefits pass to the ratepayer. If the deal is unsuccessful, the utility shareholder bears the loss.

The function of a New York Mercantile Exchange futures contract for a coal buyer will be to hedge his position. Coal-burning utilities are naturally short (buyers requiring coal supplies). They will be able to financially hedge a portion of this position by buying a futures contract. Once again, there is no current incentive for a utility that is fuel-adjustment clause regulated to participate in this market. Why hedge when there is a built-in hedge in the form of cost pass-through to the ratepayers?

It is no coincidence two of the more prominent coal tolling deals signed were with utilities that had just been released from their fuel-adjustment clause. For example, Ohio Edison and Public Service Electric and Gas were able to take the tolling fees generated from these transactions and generate earnings for their shareholders.

Although the fuel-adjustment clause limits activity, there is a burgeoning market in swaps, options, indices, weather adjustments and other products that can be tied to coal. Companies are looking at these products for several reasons:

– to manage risk after being released from their fuel- adjustment clauses;

– to take a portion of the earnings to shareholders in spite of the fuel-adjustment clause; and/or;

– to experiment with risk management tools on a small scale prior to being “completely on their own.”

The following risk management tools offered by producers and marketers focus on structured (more complex) products. In addition, there is a developing OTC market for coal in the East and West.

Basic coal swap: Fixed price

Objective

– To protect against rising coal prices at no cost without being tied to any one supplier.

Description

– Utility pays the producer a fixed price for coal in exchange for a floating price. The swap is financially settled. Therefore, if the market price is above the fixed swap price in the appropriate period, the producer pays the utility the difference. If the market price is below

the fixed swap price, the utility pays the producer the difference.

– The standard swap contract usually has monthly pricing periods. However, the producer will customize swap settlement periods, maturities and price sources.

Risk/Reward

– Utility receives a fixed coal price while incurring no fee.

– Utility can`t take advantage of declining prices.

Example

– A utility enters a 12-month coal swap in which it fixes its purchase price of Powder River Basin (PRB) coal at $5/ton.

– At the end of each month, the utility pays the producer $5/ton. In return, the producer pays the utility the price at the agreed-upon price index.

– If the average price in a given month is $5.50/ton, the producer pays $0.50/ton to the utility.

– If the average price is $4.50/ton, the utility pays $0.50/ton to the producer.

Issue

– Both parties must be comfortable with the index to be used. There is concern that producers and/or utilities can manipulate current “survey” indices.

Basic off-peak power swap: Fixed price

Objective

– To increase off-peak generation.

Description

– Producer pays the utility a fixed price for off-peak power in exchange for being paid a floating price. The swap is financially settled. Therefore, if the market price is below the fixed swap price in the appropriate period, the producer pays the utility the difference. If the market price is above the fixed swap price, the utility pays the producer the difference.

– The standard swap contract usually has monthly pricing periods. However, the producer will customize swap settlement periods, maturities and price sources.

Risk/Reward

– Utility can lower its cost of dispatch when off-peak prices are lower than the fixed price while incurring no fee.

– However, utility`s cost of off-peak generation rises if off-peak prices are above the fixed price.

Example

– A utility enters a 12-month electric power swap in which it is paid a fixed price for off-peak power of $16/MWh.

– At the end of each month, the producer pays the utility $16/ton. In return, the utility pays the producer the price at the agreed-upon price index.

– If the average price in a given month is $15.50/MWh, the producer pays $0.50/ MWh to the utility.

– If the average price is $16.50/MWh, the utility pays $0.50/MWh to the producer.

Issue

– Both parties must be comfortable with the index to be used. There is concern that producers and/or utilities can manipulate current “survey” indices.

Call option: Ceiling price

Objective

– To protect against rise in coal prices at low cost.

Description

– Establishes ceiling price for coal.

– Utility purchases the option to buy coal for a specified price.

– Can be settled financially or physically.

Risk/Reward

– A utility retains ability for unlimited gain from price increases while limiting the maximum loss to the initial premium or fee.

Example

– Utility buys a 12-month call option on PRB coal with monthly settlements based on the following stipulations: Strike price-$5/ton; Premium-$0.15/ton.

– If the market price rises above the strike price to $5.50/ton, the utility exercises the call and buys coal for $5, thus gaining a net profit of $0.35 ($0.50-$0.15 premium).

– If the market price dips below the strike to $4.75/ton, the utility allows the option to expire and effectively purchases coal at the market price. The total cost to the utility is the premium, or $0.15/ton.

Put option: Floor price

Objective

– To reduce coal costs in a static or rising coal market.

Description

– Utility sells the producer the right to sell coal to the utility at an agreed-upon below-market price to gain revenue from the premium.

– Settled financially or physically.

Risk/Reward

– Utility assures itself revenue from premium to offset coal costs but forgoes gain from a price decline.

Example

– Utility sells the producer a 12-month put option on Pittsburgh #8 coal with monthly settlements based on the following stipulations: Strike price-$24/ton; Premium-$0.75/ton.

– If the market rises above $24/ton, the producer allows the option to expire, and the utility keeps the $0.75/ ton premium.

– If the market price declines below the strike price to $22/ton, the producer exercises the put and sells coal to the utility for $24/ton. Since the utility gets the premium regardless, the net cost for the utility is $23.25/ton ($24-0.75 premium).

Straddle option: Plus/minus

Objective

– To derive revenue from the volume option, or plus/minus provision, contained in some older coal contracts in a time of static prices or when the utility has a plus/ minus provision in other contracts.

Description

– Monetizes the plus/minus provision.

– Utility receives from the producer a fee for the right to exercise the plus/ minus provision.

– Applied to a coal contract the util- ity has with the producer or with another supplier.

– Settled financially or physically.

Risk/Reward

– Utility receives revenue from the premiums but forgoes some flexibility.

Example

– The producer pays $0.30/ton to a utility for a 12-month straddle contract with monthly settlements on PRB coal, in which the producer buys a call and put on plus/minus 20 percent of a 1 million-ton contract-or 200,000 tons-at a strike price of $5/ton. Quantity is prorated on a monthly basis.

– If the market price reaches above the strike to $5.50, the producer can exercise the call and pay the utility for the additional coal at the $5 call price.

– The producer probably will not exercise

the call if the market price stays around $5.

– If the market price declines below the strike price to $4.50, the producer may sell the additional coal at $5/ton to the utility for that period.

Tolling fee

Objective

– To monetize unused plant capacity and enhance shareholder profits in a regulated environment. Utility is also able to monetize favorable rail contracts and achieve

the volume minimum in rail contracts.

Description

– Utility receives fee for the renting of its capacity by the producer.

Risk/Reward

– Utility receives a fee, does not have to inventory the coal and increases the capacity of its plants. In many states, the fee is accredited to the shareholders instead of the ratepayers.

– Utility, however, forgoes the opportunity to use this capacity. Stripping out the summer months is almost essential now that prices in the summer are so volatile.

Example

– The producer pays a utility $13/MWh to toll on-peak hours in October. Producer

delivers coal at the end of the month in a quantity equal to MWh delivered at an agreed-upon heat rate.

Tolling option

Objective

– To monetize unused plant capacity and enhance revenue.

Description

– The producer pays a utility a premium for the right to toll. If the producer exercises that right, it will pay-in addition to the premium-a tolling fee and will provide the coal and take the power.

– A utility is assured revenue because even if the producer does not exercise the option, the utility pockets the premium.

Risk/Reward

– Presents a win-win situation for the utility, which gains a premium in either case and may even increase its capacity use.

– Utility, however, forgoes opportunity resulting from rising demand for electricity and the concurrent rise in the asking price for tolling.

Example

– Producer buys a premium for the right to toll based on the following stipulations:

Heat rate: 10,000 Btu/kWh

Premium: $2/MWh

Tolling fee strike price: $7/MWh

– If the producer elects to deliver coal to the utility`s plant and take back electricity, it will pay the utility the $2/MWh premium plus the $7/MWh tolling fee for a total of $9/MWh.

– If the producer does not exercise the option, it still pays the $2/MWh premium.

Coal or power delivery

Objective

– To lock in low prices on coal and power through the ability to accept either commodity.

Description

– Utility specifies price level at which it takes power in lieu of coal.

– Utility pays a lower price for coal and for power in exchange for allowing the producer to deliver either commodity at an agreed upon price or energy ratio.

– Utility can determine when it is more economic to take electricity over generating internally.

Risk/Reward

– Utility achieves lower prices for both coal and power. However, it forgoes some flexibility in the quantity of coal or power it purchased.

Example

– A utility enters a 12-month contract to purchase coal or power.

– A utility enters a 12-month contract to purchase coal or power with the following stipulations: Delivery period- monthly; PRB coal at $4.40/ton ($.60/ton discount) for 100,000 tons; 100MW at $19.50 MWh ($1.05/MWh discount) for on-peak delivery for specified days during the month.

– At the end of each delivery period, the producer delivers either PRB coal at $4.40/ton or 100MW on-peak for specified days during the period.

There are other products not described here, such as coal tied to a power index, coal tied to weather, and coal/SO2 allowance deals. As the demand for coal risk management tools increases, these types of products will become more interesting for coal buyers.

There is some skepticism about the need for risk management tools for coal, even after all utilities are released from their fuel-adjustment clauses. Although it is true that coal has a much lower volatility profile than electricity, keep in mind that the dollars involved in the purchase of coal are staggering.

One trainload of coal (10,000 tons) in the East can cost $250,000, absent the transportation cost. This would fuel only about 75MW on-peak for one month. Some customers spend as much as $ 1 billion each year just on coal. At that rate, even at coal`s lower volatility of 15 percent (compared to the astronomical volatility related to electricity trading this past summer), the swing in cost could be $150 million.

As the industry prepares to step across the threshold to an era of increased competition, the risk management tools discussed represent a new and important way of viewing coal and power within a deregulated marketplace.

James Martin is senior vice president with Peabody Energy Solutions.

Click here to enlarge image

The dollars involved in the purchase of coal are staggering. Some customers spend as much as $1 billion each year just on coal. Photo courtesy of the National Mining Association.

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