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Supply Management Outsourcing Gets Mixed Reviews

Supply Management Outsourcing Gets Mixed Reviews

Can you trust a marketer with all of your regulated assets? It's a question many LDCs are asking themselves these days as derergulation and competition are stranding more and more supply contracts, upstream transportation and storage. But there's no easy answer, according to several panelists speaking at GasMart/Power '99 in Dallas yesterday.

Asset optimization clearly is not a one-size-fits-all solution, and outsourcing may not be the right strategy for every unbundling distributor. "Why do it? One reason would be to increase earnings, make more money," Consolidated Edison's Paul Olmsted noted. But that is by no means a sure thing.

"If you fully outsource you could get rid of many of the people that performed that function and cut your costs a little bit. Smaller companies may not have the staff resources on hand or really the scope of assets to really be able to effectively sell into the marketplace and get the best return."

That was part of the reason Providence Gas signed a total asset management contract with Duke Energy in September 1997. "The key issue that we were faced with was the issue of price volatility," said Tim Lyons, vice president of marketing and regulatory affairs for ProvGas. "We had over the prior three years experienced tremendous volatility. We had a [gas cost adjustment] mechanism where basically the price we were charging customers was the Nymex price. So as the Nymex went shooting up so did our prices, and as the Nymex went crashing down so did our prices. And it was this volatility that created a lot of problems for our customers and our regulators. We tried a couple of things. We tried a pilot hedging program to mitigate some of that, but we weren't that successful."

Providence Gas has a net income of about $80 million but its gas costs are about $100 million "so even a 10% slip up in any of these risks could wipe out our earnings for an entire year so it's very critical for us to manage those risks."

There were other reasons as well. ProvGas needed some extra revenue for old gas main replacement and an expansion into new economically attractive areas. Meanwhile, regulators and legislators dealing with electric restructuring were calling for a rate cut for both electric and gas customers.

What the LDC came up with was a condensed formula for all of its supply delivery needs that would provide a reduced and fixed rate for its customers in addition to the revenues required for its system upgrade. Lyons described it as Nymex plus X, with X representing costs of delivery in addition to the pure commodity. ProvGas then held an auction and granted the winning bidder, Duke Energy, an unprecedented deal that allowed total control over ProvGas' assets in return for a promised savings of $75 million over three years. It has saved customers 4% off their bills and, according to Lyons, has encouraged competition because marketers like having a fixed regulated rate to underbid in the retail markets. ProvGas has 14 marketers participating in its unbundling program, and customer savings have averaged 5-20%.

Other LDCs have jumped on the outsourcing bandwagon recently, including Brooklyn Union, which signed a $500 million, one-year gas management contract with Enron, who promised savings of more than $10 million, 80% of which would go to ratepayers. And Sempra Energy Trading agreed in January to manage the supply and delivery of gas to serve Southern Connecticut Gas Co.'s 158,000 customers, including 37 Bcf of supply, 4 Bcf of storage capacity and 162 MMcf/d transportation capacity.

But Olmstead issued a warning to LDCs who are thinking about signing on with a marketer. "You're entrusting the delivery of gas to another company who does not have the same interest in maintaining that reliable supply that we do... We're the guys with the matches. If the gas doesn't come to the citygate, we're the guys who have to re-light all the pilot lights, and I can assure you that re-lighting a million pilot lights in New York City would be a horrendous undertaking."

Olmsted pointed out that none of these new outsourcing deals "have been really tested by a really cold winter like we had in 1993-94 or an exceptionally high-priced winter like a couple of years after that. We're all praying for a return to normal weather, but if it gets really cold we just don't know how things will work."

Another problem is that total asset optimization it's "pretty much irrevocable," he noted. "Once you go whole hog, you can't go back because you're going to disperse the folks who have been doing it, and you're going to lose the expertise."

But the deciding factor, according to Olmsted, is the risk of making less money. "If it's an all-or-nothing thing, you have a lot to lose."

ConEd has done some partial outsourcing, sharing assets with marketers and splitting the results. But many times the benefits of these deals aren't worth the trouble, he said.

"In other cases what we've found is the activity of the marketer has not actually increased the value to us. It's possible that a marketer with national scale is putting our asset into this big picture, and if they do that, theoretically they can generate more value than I can. The problem has come after that in many cases," with marketer transaction fees and revenue sharing.

"I would never say never about doing the whole thing because the world could change and we might find that someone does give us more value than we can generate on our own. But when we look at our overall strategy for maximizing our bottom line and minimizing the cost of gas to our customers we look at outsourcing as one of many tools" and not the only solution for the changing needs of the LDC.

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