As an energy consumer, there are certain tasks you need to perform each year. One of them is setting a gas cost budget. Sometimes this can be a difficult and time-consuming job. Here are some considerations that will make the process a little easier and more meaningful.
Budget too low and your organization has unforeseen costs to meet, perhaps at the expense of other programs. Budget too high and perhaps there is an opportunity cost, when other spending is not authorized then it is later determined the funds could have been made available. It is important to get it right.
If the natural gas portfolio consists of fixed price supply, then the budgeting process is less of an issue since the consumption volume is the only item that is at risk. Nevertheless, it is important to recognize that volume uncertainty creates budget uncertainty that is difficult to manage. A colder than normal winter will mean you will need more gas than normal, but it may also mean the price of that gas is high, so the budget impact could be magnified.
To develop a realistic volume forecast, one can begin with the utility’s estimate, based on historical consumption that has been normalized for weather, and then apply any adjustments for changes expected to occur over the forecast period. These adjustments may reflect conservation programs, increased or decreased production levels, and addition or deletion of facilities.
Once the volume forecast has been developed, the next step is to apply gas prices to the volumes to arrive at a gas cost budget. If the supply portfolio consists of fixed price gas, then the process is relatively straightforward.
If the supply portfolio consists of some indexed priced gas, then there is the price risk to consider. An assumption must be made about what the market price of that gas will be as the year unfolds. In making this assumption, we have seen buyers use several different approaches – some of which are bound to fail.
Some take last year’s price and escalate it by a percentage. This may work when budgeting for photocopy paper, but escalating last year’s energy prices by an arbitrary percentage assumes that gas prices are always going to rise. Rather, experience shows prices may be up or down year over year, and often by a larger amount than an “inflation” type assumption such as 2-3%.
Likewise, using the current forward price isn’t wise. Today’s forward price is simply a snapshot in time; there is a very high probability that actual prices will differ significantly as the year unfolds.
If you want a high degree of confidence you will meet your budget, then there needs to be some contingency built into the price forecast to recognize that there is a significant chance actual prices can be higher than current forward prices. Contingency is a common concept when budgeting for a capital project, and it is simply a recognition that while you are budgeting the prices you expect to pay, you have to make an allowance for the reasonable expectation that actual prices may be higher.
This approach may meet some resistance internally. Aren’t you just “sandbagging”? Picking a high number so you can be sure to meet it? Not at all! Contingency is necessary, and the concept of contingency can be made more credible when you can quantify how much contingency you need, and how much more confident that contingency allows you to be about staying within budget.
For example, the forward strip for 2015 AECO prices as of December 31, 2014 was $2.64/GJ. However, according to Aegent’s analysis, on that date there was about a 10% chance that prices could rise by about 40 cents by the end of January 2015. It is not a good feeling to be 15% over budget 30 days after you submitted the budget!
In this circumstance, it makes more sense to budget $3.00/GJ instead of $2.64/GJ. Doing so makes you 90% confident you can meet your budget. If prices start to rise during January, you have time to lock in some of your portfolio before your costs exceed $3, thus protecting your budget. If prices fall, your costs go down, and you are still under budget.
You can review your position relative to budget regularly, locking in price to protect the budget if necessary, or lowering the budget estimate if lower market prices are indicating you can meet a lower budget target with confidence. Resetting your budget expectations this way allows you to free up budget dollars for use elsewhere while there is still time to do so.
Market prices for energy are unpredictable. But with rational energy budgeting and risk management approaches you can nevertheless set a budget that can be met with confidence.