Download Before The - Maryland Public Service Commission

Before The
Public Service Commission of Maryland
Case No.8700
Prepared Rebuttal Testimony
of
Ashmead Pringle
On Behalf of
Baltimore Gas and Electric Company
February 2, 1996
Case No. 8700
Prepared Rebuttal Testimony of Ashmead Pringle
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Q.
PLEASE STATE YOUR NAME AND ADDRESS.
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A.
My name is Ashmead Pringle. My business address is 3340 Peachtree Road, Suite 1452, Atlanta,
Georgia 30326.
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Q.
BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY?
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A.
I am the president of Grain Service Corporation and its energy division, GSC Energy. I founded
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the company in 1984 and started our energy division in 1989. GSC works with commercial
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hedgers and risk managers in the agribusiness and energy industries, providing hedging education,
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risk management consulting, and futures brokerage. I have taught over one hundred workshops on
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futures and hedging and authored numerous articles on risk management which have been
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published in industry magazines and periodicals. My resume is attached as Exhibit _____ (AP-1)
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Q.
IDEA OF YOUR CUSTOMER LIST.
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PLEASE OUTLINE THE SERVICES WHICH GSC ENERGY PROVIDES AND GIVE US AN
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GSC Energy is a leader in providing hedging education and brokerage services to the petroleum
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and natural gas industries. Mangers and professionals from over 1500 firms have attended our
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hedging workshops. In addition, GSC has conducted in-house risk management workshops for
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many major companies, including American Oil & Gas, Amoco Oil, CNG Energy Services,
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Consumers Gas of Toronto, Electronic Data Systems, Exxon, MAPCO Petroleum, Mobil Oil, Pan
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Canadian Petroleum, Sask Energy, Southern California Gas Company, Tehjas Power, Ultramar,
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Union Pacific Fuel and Western Gas Marketing, Ltd.
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GSC has consulted on natural gas price risk management with a number of LDCs including
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SoCalGas and Consolidated Edison of New York. For SoCal, GSC assisted with development and
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evaluation of a Pilot Program to reference its gas purchases to NYMEX natural gas futures
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contracts; educated SoCal managers about futures and hedging and assisted in the design and
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execution of hedge strategies to manage risk under the approved incentive mechanisms. For
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Consolidated Edison of New York, we provided in-house education on hedging for a cross-section
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of personnel and in-depth hedge training for those individuals charged with actively implementing
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its risk management program. In addition, we are assisting Con Edison in preparing a Gas Hedging
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Manual describing its policies, goals, internal control procedures, execution responsibilities and
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segregation of duties, authorization levels, accounting and financial reporting, tax considerations,
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internal audit and policy review. The manual is in final draft and will be completed shortly.
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Q.
AND RISK MANAGEMENT ISSUES?
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HAVE YOU TESTIFIED PREVIOUSLY IN REGULATORY PROCEEDINGS ON HEDGING
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No, however I have substantial experience. I have been involved in risk management since 1975,
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when my then-employer acquired facilities for handling and storing grain. I set up its grain
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hedging program and was responsible for managing it. In 1978 I became head of a company
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teaching hedging to grain elevator managers via seminars in the major grain producing states, co-
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sponsored by state grain & feed associations. In 1981, I traveled to Venezuela and Mexico and
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conducted workshops on grain hedging on behalf of the US Feed Grains Council. In 1984 I
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founded Grain Service Corporation to provide hedging education and brokerage services for
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agribusiness managers, and in 1989 expanded it to serve the energy industry. I have been involved
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in hedging and advising hedgers for over twenty-years.
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Q.
WHAT IS THE PURPOSE OF YOUR TESTIMONY?
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A.
The purpose of my testimony is to provide my opinion on BGE’s Risk Management Program,
Exhibit ____ (MDC-1).
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Q.
PROGRAMS HAVE IN COMMON?
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ARE THERE CERTAIN CHARACTERISTICS WHICH PROPERLY DESIGNED HEDGING
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Yes, in my work with risk managers and hedgers, I have found that successful hedge programs
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share certain characteristics. I list below the most important of these and comment briefly on each.
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1. There must be price risk to manage
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To a business, risk is the variability of earning or asset values due to unpredictable or uncertain
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external events. Price risk is the uncertainty due to fluctuating prices. A hedge is a transaction
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that reduces price risk, while a speculation is one that increases it. Positions in derivatives are
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hedges only if they reduce price risk, so an enterprise must first identify and quantify its price
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risks. Not all have price risk.
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For example, most LDCs continue to operate in an environment in which their costs are passed
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through to the ratepayer. The possibility of later disallowance upon review does introduce
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some price risk, but not in a fashion that’s practically hedgeable at the time of supply
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acquisition. Thus, many state utility commissions and LDCs are examining alternatives to
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prudency review, such as gas cost incentive mechanisms. Such mechanisms typically
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incorporate incentives which expose the LDC to market risk and reward via a shared pass-
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through of gas costs above and below a formula benchmark cost.
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2. Price risk must be quantifiable
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Ideally, the price risks should be well-defined and easily measured. For LDCs with gas cost
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incentive mechanisms, the benchmark price or cost is usually a market-related function of
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futures prices, published indices, or both. Benchmarks should correlate well to actual costs
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over time, should be visible and not susceptible to manipulation or distortion.
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3. There should be a clear statement of purpose
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Given price risk, the key to a successful hedge program to manage that risk is a clear statement
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of purpose, which is typically different for a producer, marketer or user. The producer and the
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user are both concerned with price and their hedging is basically just a time shift of their
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purchases or sales. The marketer, on the other hand, is usually interested only in margins, not
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price, and thus stays neither long nor short but flat, to protect margins and to pass through to
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customers the price flexibility they want.
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4. The program should be broadly understood and accepted
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Management from the top down must understand basic hedging concepts, and accept and
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approve the program’s purpose. Those with direct responsibility for developing and executing
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hedge strategies should receive appropriate education and training.
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5. Policy and procedures should be formal and specific
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Policy and procedures relating to hedge management should be detailed in writing and should
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include sections on all of these points, with special emphasis on: prohibitions on speculation;
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strict segregation of duties and responsibilities between and among trading, treasury and
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accounting; and limits on net risk, not just on individual instrument types. Too many hedge
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programs have instrument limits rather than net exposure limits. Risk is a function of a
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company’s net position and so risk limits should be set in terms of the net position.
6. Hedge performance should be evaluated correctly
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Open positions should be valued at market and evaluation based on the combined outcomes of
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the hedge and the transaction or position it was intended to hedge.
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7. Proper controls and safeguards must be developed
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Risk management tools are a valid way to reduce risk but they can be very powerful. Controls
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and oversight are vital to ensure that the right tools and strategies are chosen. One cornerstone
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of any hedge program is a prohibition on speculation. Not only is it bad policy, it can “taint the
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barrel” and cause legitimate hedges to lose their preferred tax status. Another cornerstone is
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segregation of responsibilities. Traders should not be given authority over funds flows or trade
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accounting. Doing so invites unauthorized trading and makes it difficult to detect.
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Cornerstone three is to set net exposure limits. Risk comes from the net position, not just from
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components of it. Limiting the use of financial instruments may actually force retention of a
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speculative position. For example, BGE’s proposed benchmark cost is based half on index
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prices and half on futures prices. To the extent its purchases for a given month do not mirror
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this pricing structure, it will have exposure. To move to a risk-neutral position might require a
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futures position of 300 contracts, say. A futures position limit of 200 contracts would then
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operate to force the retention of risk on the remaining unhedged position. The final
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cornerstone is to monitor trading activity daily. The hedge position report should summarize
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all the company’s open positions in physicals and financial instruments into a net market
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exposure.
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Other good rules include monitoring counterparty credit risk. Credit risk in futures is very low
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because the NYMEX clearinghouse is counterparty to all market participants. Swaps and other
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Over the Counter (OTC) transactions are another matter because they are unregulated. OTC
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credit risk is therefore a deal-specific and counterparty-specific matter. It is also wise to have
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several independent paths for trading information to enter the company, to avoid overly
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complex hedge strategies, and to choose futures brokers and OTC counterparties with care.
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Q.
HAVE YOU REVIEWED BGE’S RISK MANAGEMENT PROGRAM?
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A.
Yes. In connection with my review I have read the following sections of its Natural Gas Risk
Management Policy as contained in the draft dated January 26, 1996:
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Mr. Case’s testimony (Exhibit MDC-1)
BGE’s Risk Management Program document (pages 1-13)
Appendix A, pages 1-4
Appendix B, pages 1-6
Appendix C, pages 1-4
Appendix D, pages 1-5
Appendix E, pages 1-2
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I have also reviewed slides from presentations on the risk management program. The presentations
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occurred on June 1, 1995 to BGE’s Executive Leadership Team, on July 14, 1995 to Mr. Crooke,
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on July 21, 1995 to the Board of Directors and on November 17, 1995 to certain BGE personnel.
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I have also read Supplement 231 to PSC Md. G-9, pages 5-10 and Exhibits 1-5 as well as the
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resolution of BGE’s Board of Directors, dated July 21, 1995, which authorizes risk management
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activities up to 5 million in cumulative net exposure.
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Q.
WHAT IS YOUR OPINION REGARDING BGE’S RISK MANAGEMENT PROGRAM?
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A.
In my opinion, BGE’s Risk Management Program contains the characteristics necessary for a
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properly designed hedging program. As I will make apparent in more detail below, BGE has
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developed a careful and complete blueprint for a hedge program that should allow it to successfully
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implement and manage its risk management program.
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1. There will be price risk to manage
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If BGE’s filing with the Maryland Public Service Commission (PSC) for Market-Based Rates
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(MBR) is approved substantially as filed, including incentive features limiting BGE’s ability to
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pass through gas costs above a certain benchmark (the Commodity Market Cost or the City
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Gate Storage Index) and allowing it to share in savings if gas costs are below the benchmark,
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then BGE will have risk to natural gas price changes. The volatility of natural gas prices has
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been high relative to other commodities, especially in the past few months, fully justifying a
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well-supported risk management program.
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2. The price risk will be quantifiable
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Based on Supplement 231 to PSC Md. G-9, “BGE will develop rates that are reflective of the
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current spot market prices. Gas prices. . . will be based on . . . . the spot market as reflected in
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the NYMEX and Inside FERC indices.”
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The NYMEX portion is easily quantifiable since standardized NYMEX natural gas futures
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contracts trade in large volume (averaging over 30,000 contracts per day, the equivalent of 300
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bcf) and since traded NYMEX prices are instantly disseminated and easily observed. The
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index portion is a less visible and less hedgeable risk, though the Inside FERC indices are the
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most widely used in the industry. However, index values over time relate well to NYMEX
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prices, and there is a large and active over the counter market in risk management instruments
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tied to index values.
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It is also important in a benchmark-driven program that the benchmark be easily observed,
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hedgeable, market-related, and not subject to manipulation. Both NYMEX prices and Inside
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FERC indices meet these criteria.
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3. There is a clear statement of purpose
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BGE’s Risk Management Objectives are set out on page 1 of the BGE draft:
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to manage customer and stockholder exposure to natural gas price volatility
to hedge the value of gas storage inventory
to provide new services and pricing alternatives to its customers
4. The program is broadly understood and accepted by the necessary constituents
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Based upon my review of the presentations made to BGE’s Board of Directors and others, I
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believe that the Program is broadly understood and accepted by top management, and those
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responsible for implementing the risk management program and exercising oversight of it.
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There are a number of aspects of the Program which will ensure the involvement of many
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individuals in addition to those doing the hedging transactions. BGE cites the recommendation
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by the Group of Thirty that it should “determine at the highest level. . . the scope of its
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involvement in derivatives. . . .”
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Further, BGE’s policy requires that “Senior Management (President level or higher) must
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approve and authorize BGE’s Risk Management policy and program and is to periodically
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review the strategies, controls and exposure. . .” The Hedging Committee will be chaired by
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the Director, Gas Management. The Hedging Committee is charged with ensuring “that all
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personnel involved in . . . trading are thoroughly familiar with the concepts, terminology and
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trading practices of the futures and OTC markets.”
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5. Policy and procedures are formal, specific and appropriate
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BGE’s policies and procedures relating to hedge management are detailed in writing, and
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include sections on all of these points, with special emphasis on: prohibitions on speculation;
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documentation of trades and positions; strict segregation of duties and responsibilities between
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and among trading, treasury and accounting; and limits on net risk, not just on individual
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instrument types. Too many hedge programs have instrument limits rather than net exposure
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limits. Risk is a function of a company’s net position and so risk limits are set in terms of the
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net position.
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6. Hedge performance will be evaluated correctly
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BGE’s program correctly cautions against misinterpreting hedging results and emphasizes that
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“hedging is not a profit center.” This is another way of saying that the hedge itself may
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produce a gain or a loss. That uncertainty of course, is the rationale behind hedging in the first
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place: prices may change for better or worse, for profit or loss. What is important to the
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hedger is the combined outcome of the hedge and the item or position being hedged, and that
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approach is taken by BGE.
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Because of price movement, a hedge position will over time tend to develop an unrealized gain
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or loss. Since a hedge exists only because of the likelihood of price movement, it should be
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valued based on current prices. This “mark-to-market” procedure is a feature of futures
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markets, which require all participants to calculate position gains or losses based on each day’s
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closing prices. These calculations are performed by the futures broker daily and easily verified
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by the hedger.
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In the case of OTC instruments, such valuation is not automatic. The prudent hedger should
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therefore apply mark-to-market valuation to any open OTC or physicals positions it has at the
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end of significant accounting periods. It is clear that BGE intends to apply the mark-to-market
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valuation method to its open cash, futures and OTC positions.
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7. Proper controls and safeguards have been developed
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BGE’s draft policy spells out detailed and appropriate procedures for monitoring trading
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activity, documenting trades and positions, segregating responsibilities and duties, choosing
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futures brokers and OTC counterparties, reconciling cash flows with positions, marking open
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positions to market, periodic review of positions, maintenance and review of net exposure
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limits.
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Q.
DOES THIS CONCLUDE YOUR TESTIMONY?
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A.
Yes.
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