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Energy risk-management tools can help Alaska businesses: stabilize operating costs during oil's wild ride.

Southwest Airlines is a success story in an industry where success has been rare in recent years. Of course the airline built its business in many ways, but in this decade, its earnings story has been driven by an aggressive risk-management strategy that has helped control the industry's least controllable cost--jet fuel.

Because of this strategy, Southwest is paying $51 per barrel of fuel for 70 percent of what it will use in 2008--far below the roller-coaster $100 to $150 per barrel oil prices other airlines and companies are coping with in today's market. While other airlines have hedged their fuel purchases too, none have done so in such a strategic and sustained way as Southwest, which started in 1999 when oil was $11 per barrel.

Southwest's positive earnings have netted the airline a huge marketing advantage that has resulted in its holding fares more steady and avoiding the introduction of fees for checked baggage this year. Over several years this decade, Southwest has earned more by fuel-hedging than by selling tickets.

For many industries, energy risk factors such as international conflicts, diminishing supplies, rising extraction costs and aging refinery infrastructure are creating anxiety and increasing price volatility.

ALASKA BUSINESSES NEED TO STABILIZE ENERGY COSTS

Businesses in Alaska that rely on large energy supplies--including energy intensive manufacturing companies, hospitals, universities and large retail distribution networks--should consider energy risk-management tools to stabilize costs.

Many companies cannot pass along rising energy costs to their customers. As one example, grocery business margins are so thin that increases in trucking costs hit these retailers hard.

Nevertheless, energy risk-management tools are becoming increasingly common and important to some industries. The hospital that locks in today's price for heating oil that will be delivered in the future to protect against price hikes is using an energy risk-management tool. So is the fishing or mining company that locks in energy prices early to ensure an affordable energy supply for the busier times ahead.

These are forward contracts, and they constitute a basic form of energy risk-management, based on derivatives. Any financial instrument whose value is derived from an underlying asset is a derivative. As with any financial instrument, using derivatives requires special expertise and a clear understanding of risks and benefits. Importantly, derivatives are not investments since no capital is at risk in using them.

Companies and institutions that seek to use energy risk-management tools to "beat the market" could be disappointed since the object of energy risk-management tools is to reduce volatility in energy costs over time.

EXPLAINING THE TERMS

Energy risk-management tools include forward contracts, as well as futures, options and swaps.

A future is simply a forward contract on quantities of hydrocarbons that are so large they are commonly traded in commodity markets. Appropriate only to very large energy consumers, futures are limited to large lots. In crude-oil futures trading for example, a lot is 1,000 barrels per month. In refined hydrocarbons (heating oil, gasoline, diesel or jet fuel) a lot is 42,000 gallons per month, and in natural gas a lot is 10,000 decatherms monthly.

A swap is a financial instrument that fixes a contract price so that the buyer avoids the risk of price jumps. A swap works like a fixed-rate mortgage, which provides stability to a homebuyer, versus a variable-rate mortgage in which the rate shifts with the interest rate trends. If the market price of the energy commodity covered by the swap goes above the contract price, the seller of the swap, which is typically a bank, pays the buyer the difference. If the market price drops below the contract price, the buyer still pays the market price, but will pay the bank the difference between the market price and the contact price, losing the opportunity to pay the lower price in exchange for the security of avoiding hikes above the contract price.

It's important to distinguish between an energy risk-management tool, which provides price protection, from the actual physical purchase of a commodity.

A school district might use a swap, for example, to manage the risk of price increases in diesel fuel for school buses--a useful strategy since school districts typically operate on yearlong budgets. If the district buys a swap at $4 per gallon, the district ultimately pays $4 per gallon regardless of what its dealer charges. If the market price rises to $5 per gallon, the district pays its dealer that price and the seller of the swap pays the district $1 per gallon, providing price stability at $3 per gallon. If the market price falls to $2 per gallon, the district buys diesel from its dealer at $2 per gallon and pays the seller of the swap $1 per gallon.

Options are similar, but are usually used to provide a range of acceptable prices rather than a single contract price. An option is a contract that confers the right (but not the obligation) to buy or sell an underlying asset at a set price and a set time.

A call option, or cap, works like an insurance policy, giving the buyer the right to buy at a specified (or "strike") price and receive payment if the market price exceeds it.

A put option or floor gives the user the right to sell at the strike price. Used in conjunction, these tools constitute a collar, providing both a floor price and a cap price to create a range of acceptable costs in between. An energy user will buy a call option and sell a put option, attempting to obtain price protection with minimal up-front financial impact--a strategy that commodity futures markets and the financial resources of banks make possible.

Working with a specialist experienced in energy risk-management strategies and using these tools carefully, businesses with substantial energy needs can stabilize costs and remain competitive.

Mike Milam, a senior vice president of KeyBank, manages its Alaska commercial-banking team from offices in Anchorage and Fairbanks. be reached at 459-3296 or Michael_L_Milam@KeyBank.com. For further information about energy risk management, see the following Web link to a short video: https:// www.key.com/html/J-2.1.errm_a.html.
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Title Annotation:ENERGY & FINANCE
Comment:Energy risk-management tools can help Alaska businesses: stabilize operating costs during oil's wild ride.(ENERGY & FINANCE)
Author:Milam, Mike
Publication:Alaska Business Monthly
Date:Dec 1, 2008
Words:1025
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