Managing Oil and Gas Companies-I Marketing BTUs: Gas, Electricity Lead Oil In Innovation

Edward N. Krapels
Energy Security Analysis Inc.
Washington, D.C.

• What Energy Buyers Want [26986 bytes]

Implications of that question affect all companies of all sizes because they relate to fundamental changes in the business environment. It is as important for the smallest independent producer to examine these core issues as it is for behemoths such as Enron and Exxon.

The transformation in relations between energy providers and users-powered by reform of electric utilities and by continuation of natural gas deregulation-is challenging several fundamental precepts of how oil companies managed their deregulation. In the wake of the price decontrol completed by the Reagan administration in 1981, oil companies (1) retreated from national business structures, (2) focused on limited range "core" businesses, and (3) provided minimal oil price risk management services for their customers.

By contrast, the electric and natural gas industry is consolidating for the purpose of playing a role in ever-larger markets, diversifying its products and services, and providing innovative hedging instruments to itself as well as its customers. From Enron, one can purchase physical and paper energy, delivered in whatever form desired, nationwide and internationally, with or without mechanisms to manage price risk.

Here is our vision of the future of energy markets: distinctions among liquid and gaseous and wired energy will appear less and less consequential when viewed from the perspective of U.S. BTU markets. The issue appears to be not what customers to serve, but with what mix of energy services. Already detectable is the nearly heretical idea that a multinational oil company will have more difficulty meeting the oil product requirements of a national U.S. business than will a progressive utility serving the same customer for power and natural gas.

What, therefore, will impede the newly integrated energy companies-which are composite electric plus natural gas firms-from also delivering products and services now rendered by the oil companies?

Is it outrageous to think that this virus might even intrude upon the heart of the U.S. oil business-the gasoline market? Could utilities organize gasoline consumers better than oil companies? If the Price Club can sell gasoline at 10¢ below market, why can't the new energy companies do so?

What consumers want

In considering whether oil companies need to become BTU companies, it is necessary to examine what energy consumers, especially large industrials and commercials, want. As the U.S. power market becomes commoditized, energy consumers are confronted with a bewildering array of procurement choices from power marketers and brokers. The power marketers in turn are prodding the established utilities to match their offers lest they lose their large commercial accounts.

This energy deal-making in the U.S. power/gas market is growing geometrically. According to the latest Federal Energy Regulatory Commission Quarterly Power Marketers Report, the volume of business done by this group has increased from a low range of $35 million in the first quarter of 1995, to $57 million in the second quarter, to $127 million in the third quarter, to $204 million in the fourth quarter, to $399 million in the first quarter of 1996, to $536 million in the second quarter. These are low ranges: We estimate that the nonutility power market is now a $5 billion/year business.

At the cutting edge of this process are BTU marketers, like Enron, offering large energy consumers a choice of energy service as well as a choice of financial instruments. The best of these BTU marketers are willing to extend service all over the country, although it remains to be proven that they are promising what they can deliver. They are, however, also capable of providing a full array of energy hedging services, including BTU swaps.

Can the oil part of the energy market remain isolated from all this activity? We don't think so. As was the case with gas and electricity, the cutting edge of change in the relationship between oil providers and oil consumers will be the large industrial and commercial accounts.

Energy Security Analysis Inc.'s experience with its large energy consumer clients has taught us that what they want-in addition to supply reliability-is price stability, procurement simplicity, and cost minimization. That, of course, is no revelation in itself.

What is a revelation is that this is the order of their energy acquisition priorities. The typical large energy consumer is often less concerned with energy cost minimization than with stabilizing energy costs.

Part of this is, of course, corporate faddism. A management theory espoused by some consultants is that large energy consumers should not dedicate resources to understanding energy markets. Instead, they should out-source as much of their fuel problem as possible. The amount of attention top management can devote to core businesses is deemed so precious that it should not be diverted by worries over energy prices.

We suspect that this idea will have its own "product cycle." One day it will be displaced by the theory that companies should master the parts of the business that account for, say, 20% of variable costs.

Procurement and costs

Be that as it may, the current mood of many chief executive officers of energy consuming companies appears to be swinging towards valuing procurement simplicity and cost stabilization rather than cost minimization (Fig. 1).

The typical corporate energy consumer sets an energy budget each year and does not like to be surprised. Whatever the outcome, management is pleased if the energy procurers meet that budget, even if the budget price turns out to be higher than the actual market price. The goal of predictable budgets will have been met.

They will not be pleased, of course, if the market price utterly collapses and their fuel "risk management" program has locked them in at much higher prices. But with modern derivatives instruments like participation swaps and finite risk management programs such outcomes are easier than before to avoid.

It is even better if the energy procurement program is simple. Some large energy consumers are looking for strategic energy partners (another of today's management buzzwords), suppliers to whom they can outsource all of the details of the energy delivery program. This meets the goal of energy procurement simplicity.

A large energy consumer's emphasis on stability and simplicity represents a marvelous opportunity for energy marketers. When consumers give up cost minimization for the sake of stability and simplicity, the creative and aggressive energy marketer has an opportunity to obtain the "rents" or profit margins that commoditized energy markets often provide to those who become experts in them.

Innovations and lessons

The message from ESAI in all this: The nascent, even immature, markets for power and natural gas are providing innovations-and lessons-that the oil industry would be wise to heed.

One such lesson is that localized fuel markets will give way to national energy markets. A second lesson is likely to be that consumers can and will be organized to exercise market power. And the final one: The buying and selling of all energy will eventually be organized to provide risk management options for consumers and producers alike.

Thus, the deregulation of power will help revitalize the energy derivatives markets, helping them grow from their current level of, say, $100 billion, to more than $1 trillion in notional outstanding contracts in 5 years.

The Author