Fortnightly
Firm Transportation Contracts: When They Expire A Five-Step Primer for Pipeline Shippers
March 01, 2000
By Bruce W. Radford
An interview with David A. Boger, Stephen D. Moritz and Joseph G. Baran of Strategic Energy Ltd.
The expiration and renegotiation of firm transportation contracts on the pipelines in North America is becoming increasingly complex. For example, TransCanada Pipeline ("TransCanada") in the past consistently renewed its expiring contracts for five- to 10-year periods at maximum rates. It also regularly expanded its capacity, requiring 10-year commitments two years in advance of availability. However, over the last few years rising gas prices in Alberta and the construction of competing projects have squeezed TransCanada. These events have increased the risk of capacity turn-back and created more competitive options for shippers.
We contacted three gas account managers at Strategic Energy Ltd. and asked them to comment on today's market in gas transportation contracts. How do these types of events affect you as a firm shipper? Will you have more or less leverage when your contract expires? How do you even assess your options?
NOTICE OF TERMINATION
How to React, What to Expect?
A shipper that receives a notice of contract termination out of the blue from an interstate natural gas pipeline is already a step behind. Typically, the termination notices must be provided six months to one year in advance of the expiration date. And some contracts have termination provisions that will automatically extend the contract for as much as five years if a termination notice is not given. So planning should have begun a lot earlier - at least six months prior to the notice deadline.
With so many viable options available today, the shipper must do its homework as to the competitive possibilities and have a game plan for negotiating new contract terms before the termination notice is provided. Nevertheless, with the notice in hand, it's time to get to work.
The pipeline will be busy as well. Consider what has to happen to a pipeline from a regulatory perspective when negotiating a new contract. If the new contract is to have a negotiated rate that is below the maximum billable rate, the contract may need to be filed at the U.S. Federal Energy Regulatory Commission, where FERC staffers and other shippers on the pipeline can review and file comments.
These other participants will have the opportunity to comment on the proposed contract rates. Pipelines will also be required to post any negotiated contract rate on their electronic bulletin board, which subjects the discounted rate to bidding. The incumbent shipper generally has the right of first refusal, however, if the contract gets an outside bid.
Think of the termination notice not so much as a burden, but as an opportunity to sever the old relationship with the pipeline and negotiate a new contract under market-indicative terms.
ADDING UP THE RISKS
Am I Set if Demand is Down?
Both the pipeline and the shippers are at risk when firm contracts expire.
Pipelines are looking to sell their firm capacity, preferably at maximum rates and for a long term (10 to 15 years). Shippers contracted for long-term capacity in the past because they had few options and were concerned about reliability. Today, however, many of the justifications for long-term capacity contracts no longer exist. The transportation market is unbundled; shippers have options to release capacity and pipelines face competitive pressures both from peers and marketers. Pipelines are now positioned to compete for shippers to renew contracts, and challenged in some cases to maintain the same return as the long-term contracts that are expiring. If the capacity is not sold, the pipeline needs to find an equitable way to spread the costs among ratepayers and shareholders.
Nevertheless, shippers that have contracts expiring may be at risk regardless of whether overall demand is up or down at the time of expiration.
If demand is up, shippers with expiring contracts that decide not to renew must either play the release market or depend on a marketer to deliver to the citygate. The release market or citygate purchases may provide discounting on a monthly basis, but there is always the risk of capacity not being consistently available or recalled during peak periods. The challenge for shippers is to identify viable options that can provide the same level of service as primary firm capacity at a competitive rate.
If demand is down, captive shippers are at risk even as the pipelines lose firm customers. Captive shippers are at risk because base rates could climb on the pipeline if the carrier cannot find a home for the turned-back capacity and then seeks to recover stranded costs. The remaining shippers may find themselves on the hook.
The issue of cost allocation is addressed in a rate case. The pipeline will seek to justify a passthrough of costs to customers rather than shareholders. That is why it is important for the shipper to pay attention to what other shippers are doing on the pipeline system at all times as well as what the pipeline is planning to do in terms of pending rate cases.
FIHT OR FLIGHT
Alternative Supply Options?
Shippers must clearly identify and evaluate their particular needs prior to negotiating a new transportation contract.
For example, a shipper needs to consider whether its demand levels will rise or fall over the long term due to market expansion or cutbacks (or, in the case of an end-user, because of anticipated changes in production). Seasonal variations in demand, which cause the contract load factor to drop during the summer months, also need to be considered. The shipper should identify ways to best manage its load factor and develop tools for managing contract utilization as part of negotiation.
The shipper's ability to benefit from turned-back capacity will be dependent upon the pipeline's ability to sell turned-back capacity at maximum rates and for the longest term. Whatever nets the pipeline the highest net present value (NPV) will dictate what it does with turned-back capacity. If the pipeline has exhausted all other maximum-rate, long-term options, it will consider shorter-term discounted contracts. Again, whatever yields the highest NPV is what the pipeline will pursue.
A shipper looking to replace an expired term contract with capacity from the release market should start by looking for longer-term releases. One good source of term releases is the utilities that may be willing to release term capacity at a discount. However, there may be limited recall provisions and specific receipt and delivery points attached to such deals. These issues need to be worked out with the releasing party prior to consummating the deal. Also, when looking for secondary deals, a shipper should look all along the pipeline system, not just from other shippers in its market area.
Do not ignore alternative supply options that may prompt a shift in primary receipt point specifications. If the current supply area pricing is consistently higher than another, and the transportation rates from both points are the same, then the shipper would benefit from renegotiating a change in the receipt points, assuming that supply reliability is not compromised.
For example, in the changing Canadian energy market, gas prices at Aeco have fluctuated considerably over the past couple of years but have increased steadily. Shippers continually must monitor gas supply prices to spot trends and have the flexibility in their transportation contracts to take advantage of them.
Also consider a possible aggregation of multiple company locations. If the shipper's multiple locations can be served off of the same pipeline, the shipper should evaluate how they can be aggregated. That could prove to be a difficult process, however, due to operational concerns on the pipeline. Nevertheless, it could prove very rewarding. The contract load factor would be better managed because the shipper would have alternative delivery points under one contract.
NEGOTIATING WITH THE PIPELINE
Flexibility, Cost, Reliability?
The shipper has several options when negotiating a new transportation contract. Ultimately the shipper wants to negotiate a contract that will maximize flexibility and lower costs without compromising reliability.
Leverage is the key for negotiating such contracts. Leverage can be derived from
* Delaying to negotiate with a pipeline until capacity is turned back and the pipeline is more willing to sell capacity at a discount;
* Competing pipelines that deliver to the same utility citygate or can be accessed via a bypass;
* Obtaining firm capacity from the secondary market;
* Using a gas marketer that has access to its own capacity, which can be incorporated in a citygate price offering;
* Using interruptible capacity with some type of backup;
* The threat of switching energy sourcing to an alternative fuel; and
* Shutting down the facility if certain cost parameters are not met.
To gain effective leverage, the options must be legitimate. Waiting to approach a pipeline regarding a new contract until after capacity has been turned back may offer an effective strategy if the shipper is confident that there is not a high demand for capacity on the system. Yet this strategy can backfire if the pipeline is successful in renegotiating the expiring contracts. The pipeline also will question whether a third-party marketer will provide the same level of service as the pipeline's primary firm deliveries. A pipeline expansion project that eventually may present a competitive threat may not be viewed as such by the pipeline until it is built. The bottom line is to know clearly the risks of each option and then develop viable alternatives.
EXPLORING COMBINATIONS
Aggregating Contracts, Services, Locations?
At Strategic Energy Ltd., we have often advocated aggregation of capacity under a single transportation contract for clients that have multiple facilities served either directly or indirectly by a common pipeline. The key for this strategy to work is for the pipeline to grant multiple primary delivery points, which can be negotiated if the shipper provides assurances that the alternative delivery points will be used only for deliveries to other company facilities. Pipelines typically will not provide multiple primary delivery points if it involves other points where the shipper can sell gas. Pipelines view such sales as competition for its own firm services.
The ability to aggregate is dependent upon the status of primary capacity to the target delivery points and the pipeline's ability to sell capacity at each point. Multiple delivery points can help the shipper optimize contract load factor and potentially enable the shipper to sell off excess supplies.
ICING THE DEAL
Operational Details?
The most important thing is to do your homework early and identify all options that can be used for leverage.
First, identify all competing pipelines to the same citygate market. There are many U.S. regions that have multiple interstate pipelines that provide alternative sources of transportation and supply. However, in Canada, TransCanada is the only major pipeline that carries supply from the major supply area to the major market areas. Therefore, this option may not be viable for some Canadian markets.
Evaluate the availability of released capacity or citygate sales options to the desired delivery point. The issue to consider is whether such options can replace the term capacity without compromising reliability and flexibility. Another issue is the ability to subscribe to storage fields downstream of your facilities and backhauling the gas to your facility. By developing backhaul opportunities, a shipper may be able to reduce the amount of forward-haul capacity reserved, thus reducing fixed costs.
Operational issues also bear consideration. Are you willing to install and use an alternative fuel to escape a primary firm transportation agreement? The shipper needs to analyze the cost of installing the alternate fuel equipment compared to the costs of firm capacity.
A willingness to alter production schedules or shut down a facility if certain cost parameters are not met also should be considered.
Once viable alternatives are established, know what you want out of the next contract for negotiating purposes. Some final points to consider:
* Multiple delivery points to accommodate load aggregation and capacity optimization,
* Primary receipt points that access competitive production,
* Flexible contract MDQ that reflects load profile,
* Discounted rates that are market-competitive and reflect the capacity release market, and
* Contract term that reflects corporate goals and provides opportunity to take advantage of future developments.
Strategic Energy Ltd. ("SEL") is an energy consulting and management company based in Pittsburgh. As a supply-side energy manager, SEL advises and represents customers in cost-effective energy purchases. SEL has provided energy management and consulting services nationwide since its inception in 1986. See www.sel.com.
David A. Boger is a senior energy consultant and manager of commercial accounts for SEL. His work focuses on developing and implementing supply and transportation procurement strategies and developing account management procedures. Stephen D. Moritz is a manager of natural gas strategic planning for SEL. His responsibilities involve the management and marketing efforts for SEL's strategic planning department, as well as developing new services for SEL. Joseph G. Baran is an energy consultant for SEL's natural gas strategic planning department. His focus is on market research, transportation and supply strategic planning and monitoring federal and state regulatory issues.
Bruce W. Radford is editor-in-chief at Public Utilities Fortnightly.
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