Fuel for thought
P-cards, collared futures purchases, carefully timed fuel procurements, hedging – these are some of the tactics that public-sector purchasers are using in the face of skyrocketing energy prices.
In Naperville, Ill., the city is making its bulk energy buys through collared futures purchases, according to Chief Procurement Officer Michael Bevis, CPPO, C.P.M., PMP. Collared futures purchases involve hedging, or mitigating potential losses through counterbalancing commitments or investments.
The advantage of collared future purchases is that “they limit pricing to a set amount of validity for the next four years,” Bevis explained.
“Collars are a method to limit risk of all parties,” Bevis told Go Pro. “Essentially, a supplier or financial institution would fix the price of a commodity – say bulk energy – for each quarter during the period of the contract. As long as the market price – as determined by a mutually agreed upon index – remains within 10 percent (plus or minus) of the fixed price, there is no adjustment. If price variation exceeds the collar limits, contractual adjustments occur.”
Regardless of the financial tool being used to mitigate the impact of rising energy prices, procurement professionals always should exercise caution, Bevis added.
“All the financial tools, – hedges, collared pricing, indexing, etc. – they all bear the risk of overpaying,” Bevis said. “On fuels, there are a number of risky hedge tools, but the bottom line there is that reducing usage is the best way to improve the triple bottom line.”
On the subject of hedging and bulk energy purchases, Bevis concluded: “The bottom line is to understand how the markets work, and don’t be afraid to contract with financial institutions as opposed to ‘bricks-and-mortar’ contractors.”
To obtain better prices on gasoline, the state of Florida uses a fuel-purchasing card controlled by state fleet administrators. The card enables the state to leverage the purchasing power of Florida’s public-sector fleets to get fuel at an OPIS-based [Oil Price Information Service] wholesale price plus vendor markup. These fleets wield some significant buying power: State, county, federal and municipal agencies in Florida operate a total of 320,846 motor vehicles, according to the latest “Highway Statistics” report from the Federal Highway Administration.
State-government drivers use the card at convenience stores and other fuel retailers across the Sunshine State. For example, state drivers can fill up at a convenience store with the Comdata MasterCard, and the transaction gets reset to the state’s contract price under its bulk fuel contract. No matter where drivers fill up, they are assured of getting the same price per gallon at each retailer within that Florida region; state administrators have divided up the Sunshine State into four geographic regions that mesh with OPIS’ weekly average rack price by region.
Many Florida public agencies are taking advantage of the state’s P-card, according to David Bennett, CPPO, CPPB, FCPM, FCCN, FCCM, PMP-R, who is the team lead, transportation and energy contracts, for the Florida Department of Management Services’ Division of State Purchasing.
“It’s currently being used by all of our state agencies, as well as cities, counties, schools, universities and other agencies that can piggyback on it,” Bennett said. “Some of the larger eligible users include the Hillsborough County sheriff’s office, the entire fleet in Lake County, including the sheriff’s office, and Collier County – there’s a lot of piggybacking on the card.”
Governments continue to rely on third-party benchmarks for making adjustments in fixed-priced contracts covering energy commodities. In Naperville, Ill., the city’s natural gas and petroleum-based fuel contracts are based on markups against indexes.
“We use specific points for energy pricing, such as the Northern Illinois Hub price for bulk energy or the OPIS daily pricing for petroleum fuels,” Naperville’s Michael Bevis explained.
In Stearns County, Minn., the purchasing department also uses OPIS data, more specifically OPIS’ estimates covering the daily rack average price for the date of order. The county employs a bid constant, in which vendors bid a fixed cost per gallon for profit and transportation (currently 2 cents per gallon), according to Stearns County Purchasing Director Bill Davison. The cost of fuel is tied to the OPIS daily rack average.
The state of Florida relies on OPIS Plus, “which is a third-party independent wholesale price plus whatever the vendor’s markup is,” according to the Division of Purchasing’s David Bennett.
The state goes to a different source for other fuels, Bennett added.
“For propane pricing, we do a BPN (Butane Propane News) independent wholesale price, plus the vendor’s markup,” Bennett told Go Pro.
Other benchmarks that governments rely on in today’s volatile energy market include the U.S. Bureau of Labor Statistics’ Consumer Price Index (CPI) and Producer Price Index (PPI), according to William Irish, FNIGP, CPPO, C.P.M., who is associate director of procurement services for the University of Maryland-Baltimore.
As a consultant for municipalities in recent months, Irish has seen how escalating fuel prices can cause problems for agencies and vendors that are locked into firm fixed-price contracts “with no allowance for escalation or for unintended or unexpected circumstances such as the spiraling cost of diesel fuel.” That’s why some procurement departments are using the CPI, PPI and other benchmarks in escalation clauses that are part of firm fixed-price contracts for energy commodities, Irish told Go Pro.
“We had one instance in which a vendor on a no-bid contract had cut his profit margin so narrow that by the time the cost of diesel fuel had gone above $4 a gallon, he was losing money on every delivery that he made,” Irish told Go Pro. “He ultimately opted to default on the contract because he couldn’t afford to lose money at the rate that he was losing money.”
When it comes to purchasing fuel and other energy commodities, contract defaults usually don’t end well. The agency must open a new round of bidding to replace the contractor, “and chances are the prices that the agency is going to get will be much higher because they’re going to reflect the increased cost of fuel,” Irish asserted.
Using a third-party benchmark such as the CPI or PPI to evaluate the vendor’s price-adjustment request makes sense, Irish added, because it ensures that the contract “is not just saying that on a quarterly, semiannual or annual basis the vendor submits a request for an increase and we’re automatically going to sign off on it.”
To illustrate why it is important to have third-party benchmarks included in such escalation clauses, Irish noted that some agencies’ bid specifications state that the vendor can increase its prices if the vendor provides a letter from its distributor confirming that the vendor’s costs have gone up X percent – say 10 percent, for example.
“And the distributor says, ‘Not a problem,’ and off comes the letter. “That’s all well and good, but if you look at the Producer Price Index and it shows that the industry’s costs have gone up 3.5 percent, and the vendor is coming back with a request for 10 percent, you’re just dealing with somebody that’s tremendously more inefficient that the rest of the industry.”
Seek outside help
In the face of skyrocketing costs, public purchasers may want to work with a consultant on energy buys, said Stephen Fernands, who is president of Philadelphia-based Customized Energy Solutions (CES).
“We’ve seen a range – some public power entities do a pretty good job on their own, but in general, it is a complex decision-making process, and if [public agencies] haven’t negotiated energy contracts recently, they should go out and get some independent help,” Fernands told Go Pro. “Whether it’s a consulting firm or somebody else that’s independent and doesn’t own generation, they can help agencies with the process, because things have changed a lot in the last 10 years, and it does help to have someone who’s doing this kind of work regularly.”
CES counts local governments, state agencies and other public entities among its customers. Although higher-learning institutions, including the University of Chicago and State University of New York, have relied on the firm to help source their power, the firm’s biggest customer base remains city governments.
“In a municipality, we often work with the purchasing or utilities departments, depending on the organization’s structure,” Fernands explained. “We do work with purchasing directors, and we help them to evaluate options in the wholesale and retail markets – everything from developing procurement strategies to evaluating options in conservation and demand-side response, as well as looking at the option of building generating capacity or entering into long-term contracts for their supplies.”
Fernands offered this advice to purchasing directors: Plan ahead.
“To the extent that they can plan two or three years in advance, there are a lot more options,” he said. “When you get to just a couple of months before your contract expires, the number of options you have available are smaller. So, try to get ahead of the curve, which is always challenging, but that’s one piece of advice. The second is: Really look at the full range of options, not necessarily continuing with what your jurisdiction has historically done.”
Among the trends that Fernands has observed, he has seen a growing number of agencies enter into financial contracts with firms such as Goldman Sachs “to hedge their power.”
“In addition, more cities are looking at alternatives, including green energy and wind power,” he said.
Government agencies also are regulating their power purchases.
“It used to be that they would enter contracts for full requirements, essentially contracts for everything,” Fernands explained. “But now we see them buying a smaller amount at different times – so buying some power now and then waiting and then locking in some more power. When I started the firm in 1998, most just bought everything at once and went home for three years or five years. They would lock in everything.”
Conservation and using more energy-efficient equipment are becoming increasingly important components of agencies’ energy-procurement plans, according to Kent Evans, who is marketing manager at the Louisville, Ky.-based energy-management consulting firm Summit Energy Services Inc.
“In the energy business, one of the best ways to buy smarter is to use less,” Evans said. “The cheapest kilowatt you can buy is the one you let the utility keep.”
One of Summit’s clients, Western Michigan University, has added 3.5 million square feet of facilities in recent years but still has managed to lower its energy demand by a significant amount. The university, which has around 30,000 students, relies on a sophisticated energy load-management system as one of its tools to keep energy costs in line, according to Evans.
Another tool to help keep energy costs in line can be found on the U.S. Department of Energy’s Energy Efficient Products Web site, which is part of the Federal Energy Management program. The site provides links to product specifications, interactive energy-cost calculators, model procurement language and other resources to help in the purchase of energy-efficient items of all types.
“We encourage all government purchasing officials to use the Energy Efficient Products site,” said Don Mauritz, who is research associate principal at the Department of Energy’s Lawrence Berkeley National Laboratory in Berkeley, Calif.
Mauritz told Go Pro the life-cycle cost calculations on the site are based on the lower rates that larger users of energy – such as governments – might pay. Using the lower rate, Mauritz noted, makes it more difficult for a product to earn the Energy Star or FEMP designation. Products that qualify for these designations are in the upper 25 percent of energy efficiency in their class.
More training needed
For the procurement profession to come out ahead in the battle against rising energy prices, Florida’s David Bennett believes that more training is needed.
“I certainly believe there’s much more need for education on different strategies for acquiring commodities, such as hedging,” Bennett said. “Thinking outside the box and developing the skill sets in-house, I think, is where things ought to be going.”
Energy-purchasing tactics are addressed in the Body of Knowledge for CPPO certification, according to Ann Peshoff, program administrator for the Universal Public Purchasing Certification Council (UPPCC).
“The Forecasting and Strategies section within the Body of Knowledge is one area where energy purchasing is covered,” explained Peshoff, who added that green and sustainable purchasing as well as purchasing in a volatile market are other topics within the Body of Knowledge that apply to these concepts. “Questions regarding fuel purchasing appear throughout the certification exams.”
Visit these links for more information on resources mentioned in the story:
- Oil Price Information Service
- Consumer Price Index
- Producer Price Index
- Butane Propane News (BPN) – BPN’s Weekly Propane Newsletter is a subscription-based publication that reports wholesale propane prices across the United States. Prices are updated two times a week. Besides the regular newsletter, BPN offers subscriptions that report the twice-a-week price changes.
- Department of Energy’s Energy Efficient Products Web site