13. Gas Procurement Costs

As a result of San Bernardino's protest of the Application, this proceeding addressed Southwest's gas procurement practices between June 2001 and May 2002. ORA stated it did not expect to address this matter and therefore did not provide testimony, although it essentially supports the position of San Bernardino. ORA recommends that we take official notice of Southwest's testimony in I.01-06-047, particularly with regard to the tradeoff between cost minimization and price certainty. In our review and analysis of this issue we have considered the testimony of all parties in I.01-06-047, and our findings in that proceeding. As ORA's position on this issue is essentially the same as San Bernardino, we discuss the San Bernardino position only.

San Bernardino contends that Southwest's gas procurement practices were imprudent during the June 2001 to May 2002 period, resulting in unreasonable gas prices. San Bernardino recommends disallowances due to unreasonable fixed-price gas supply contracts ($10.74 million) and due to excessive prices paid for gas supplies during the month of October 2001 ($1.43 million). San Bernardino argues that Southwest unreasonably purchased over 80% of its gas supplies through fixed-price contracts and thus limited its ability to use storage or to purchase gas at more favorable prices during the winter of 2001-2002. San Bernardino applies our recent decision, D.02-08-064 to Southwest's actions, and contends that Southwest's gas purchases were unreasonable, since these purchases did not follow a balanced, diversified approach to core gas procurement. San Bernardino asserts Southwest should have filled its storage with lower priced gas during the spring and summer of 2001.

San Bernardino applies a three-pronged reasonableness test⁷⁷ to Southwest's fixed-price contracts. First, San Bernardino asks whether Southwest's goals were reasonable. San Bernardino concludes that Southwest's focus on stabilizing prices, without retaining flexibility to purchase spot gas, was not a reasonable management strategy. San Bernardino further argues that Southwest's managers should have been extremely cautious about gas purchase strategies formulated during a time of dysfunctional gas prices Second, San Bernardino contends Southwest's gas costs during the winter of 2001-2002 substantially exceeded market prices, and as a result, a portion of core gas purchase costs had to be deferred. San Bernardino contends this outcome demonstrates that price stability was achieved, but Southwest failed to meet the goal of cost minimization. Third, San Bernardino questions whether Southwest's actions exhibited the steps of a prudent manger. San Bernardino compares the gas prices paid by SDG&E and SoCalGas to Southwest's prices and concludes that the comparison shows SDG&E and SoCalGas retained the flexibility to buy at lower market prices and Southwest did not.

San Bernardino also argues that Southwest purchased more than 50% of its core gas annual requirements, despite Southwest's assertion to the contrary. San Bernardino contends the relevant gas purchase period for winter 2001-2002 is April 2001 to March 2002, and not November 2001 through October 2002 as asserted by Southwest. Thus, San Bernardino argues that for the relevant period, Southwest purchased 63% of its forecasted core supplies for winter 2001-2002. San Bernardino also alleges that Southwest's fixed price contract negotiated in August 2001 was particularly unreasonable given declining gas prices at that time.

San Bernardino recommends that the Commission disallow 50% of all above-market costs for two 10,000 decatherm (Dth)⁷⁸/day contracts, and 100% of the August 2001 contract, or a total disallowance of $10.744 million.

Southwest asserts that its fixed price contracts were reasonable and prudent. Southwest argues that against the backdrop of high gas prices during winter 2000-2001, Southwest negotiated its first contract March 8, 2001, when gas forward-market gas prices were $7.75/Dth. Furthermore, Southwest states that in spring 2001 there was little certainty that gas prices would decline. Southwest notes that two months later in May 2001, forward-market gas prices had increased to $8.68/Dth. Southwest contends this demonstrates both the uncertainty of future gas prices, and the circumstances in existence when Southwest was planning and negotiating winter gas contracts. Southwest explains, that its gas purchase strategy was to maintain flexibility in gas purchases, and that it retained flexibility to purchase 100% of its gas requirements at spot market prices prior to October 31, 2002, and 20% of gas requirements during winter 2001-2002. Southwest adds that during the I.01-06-047 proceeding, San Bernardino did not express interest in comparisons of gas costs between SDG&E, SoCalGas and Southwest, despite evidence that Southwest's costs were lower than those of the other two utilities. Southwest maintains it is unfair to criticize its gas procurement contracts based on the ultimate results of gas prices, rather than the reality that faced buyers of gas during Spring 2001.

Southwest also provided an explanation of an apparent gas purchase that occurred in October 2001. Southwest states that this particular purchase, from Reliant Energy, was a result of a gas tolerance imbalance that actually occurred in February and March 2001. The imbalance gas was sold in March 2001, and then under the agreement, repurchased in October 2001. Since the sales price in March exceeded the repurchase price in October 2001, the net result was a slight gain that was credited to the benefit of ratepayers. Despite Southwest's explanation, San Bernardino contends the agreement with Reliant Energy could have been resulted in a less costly transaction, and therefore San Bernardino recommends a disallowance of approximately $1.435 million.

13.1. Discussion

This is the second time in two years we have been asked to evaluate and address Southwest's gas procurement practices. In D.02-08-064 we determined that Southwest failed to use its gas storage or to secure contracts for winter delivery of gas at rates equivalent to the cost of gas that could have been stored during summer 2000. D.02-08-064 also found that these decisions constituted an imprudent managerial action, and as a result, Southwest's Purchased Gas Account was reduced by $2,691,675 to reflect our disallowance of unreasonable gas procurement costs.

As stated in D.02-08-064, our standard for prudent managerial action in a reasonableness review is:

"Utilities are held to a standard of reasonableness based upon the facts that are known or should be known at the time. While this reasonableness standard can be clarified through the adoption of guidelines, the utilities should be aware that guidelines are only advisory in nature and do not relieve the utility of its burden to show that its actions were reasonable in light of circumstances existent at the time. Whatever guidelines are in place, the utility always will be required to demonstrate that its actions are reasonable through clear and convincing evidence."⁷⁹

As we stated in D.02-08-064, "the reasonableness of a particular management action depends on what the utility knew or should have known at the time that the managerial decision was made, not how the decision holds up in light of future developments."⁸⁰

We apply this reasonableness standard to Southwest's gas procurement decisions for its winter 2001-2002 gas purchases.

In addition to our reasonableness standard, we have previously stated our expectations, and goals to help guide utilities on gas procurement. As cited by San Bernardino, we encourage utilities to purchase diversified portfolios of gas supplies, with the goal of mitigation of price risks, reliability of core supplies, and low prices.⁸¹ In D.89-04-080 we provided further guidance to utilities stating "Although we seek to promote flexibility in procurement practices, we do not intend that utilities should eliminate firm supplies - which may contribute to price stability- from core portfolios..."⁸² We have not directed utilities to purchase specific amounts of gas requirements through fixed-price contracts, or at spot market prices, but rather we have emphasized flexibility, and the need for utility management to balance the sometimes-competing goals of cost minimization and price stability, while maintaining supply security. These same principles we apply in addressing Southwest's gas procurement policies.

In the instant proceeding, Southwest's gas procurement policies are a reversal of those we found deficient in D.02-08-064. In D.02-08-064, we determined Southwest failed to store low priced gas, and to use gas futures contracts to stabilize prices during the months of greatest gas demand. I.01-06-047 examined Southwest's storage practices, indicators of future prices, and Southwest's reaction to, then current, unprecedented gas prices. We found that Southwest should have secured contracts for future delivery of at least 50% of its gas requirements and reduced its exposure to potentially increasing prices. We also criticized Southwest for its exclusive reliance on providing low-cost gas to the detriment of price stability. Finally, we compared Southwest to similar gas utilities that stored gas and found Southwest's actions unreasonable.

Here, San Bernardino concludes Southwest procured an excessive amount of gas at fixed prices, thus foreclosing the flexibility to purchase gas at spot or market prices. At the time of delivery, these spot prices were less than Southwest's contract prices. San Bernardino does not dispute the need for fixed price contracts, but argues that the volume of fixed-price gas should not have exceeded approximately 50% of total annual requirements.

In applying our standard of reasonableness to purchases for winter 2001-2002, we address the central issue of whether Southwest's gas procurement was reasonable. We look first to the information available to Southwest at the time of making its gas procurement decisions. Southwest's testimony indicates that it faced a number of concerns as it purchased gas for winter 2001-2002. Most importantly, during winter 2000-2001, gas prices substantially exceeded any previous gas price. In spring 2001, when Southwest began negotiating fixed-price contracts, substantial uncertainty existed regarding future gas prices. It was unclear at that time why gas prices had increased to unprecedented levels. Furthermore, gas futures prices did not indicate declining gas prices, instead between April and May 2001, futures prices actually increased. In order to avoid a repeat of the price and delivery problems that occurred in winter 2000-2001, Southwest focused its future contracts on the winter months, the time of greatest demand. Concerned over its experience in winter 2000-2001, when most of its gas was purchased at volatile, high, spot prices and not through fixed-cost contracts, it is difficult to fault Southwest for desiring price stability through fixed-price contacts, particularly for the winter months.

In addition, Southwest explains that it was quite concerned over the potential for gas disruptions in winter 2001-2002, and that its fixed-price contracts were intended to avoid gas supply problems. As Southwest points out, it minimized the risk that future prices might decline by negotiating fixed-price contracts for one-year, rather than for multiple years. By not signing long-term contracts, Southwest provided itself flexibility in the event that gas costs might decline. With hindsight, and eventual declining gas prices, Southwest may have reduced its procured gas costs during winter 2001-2002, but this is speculative, and does not determine the reasonableness of Southwest's management policies. Given the knowledge and information available to Southwest at the time of its gas procurement decisions, Southwest's actions appear reasonable.

Although gas prices declined during summer 2001, Southwest points out that substantial price decreases did not occur until August 2001. Southwest explains that early in August 2001, it found an opportunity for additional gas at a price of $4.33/Dth. In July the gas border index was $4.71/Dth, and given this information, Southwest signed an additional fixed-price contract. Although San Bernardino argues that it was clear in August 2001 that prices were declining, the principle price decline occurred in July 2001, and it is not apparent from San Bernardino Exhibits 200 and 203 that future prices would continue to decline further. A review of Exhibit 203 shows that between July 2, 2001, and August 6, 2001, gas futures prices appear to level out, indicating that gas prices might again increase in the following months. On August 7, 2001, when Southwest signed its last winter contract, gas futures prices appear comparable to the contract price. Therefore, we do not find Southwest's actions on this contract unreasonable.

In response to San Bernardino that the volume of fixed-price contracts was excessive, Southwest asserts that the amount of fixed-price contract gas was about 50% of its annual requirement for its planning year that commenced November 1, 2000 and ended October 31, 2001. Southwest asserts that the calculation of an 80% figure by San Bernardino is in error as it is based on two planning years and not one. A revised calculation by Southwest that includes the summer months, as well as winter months, indicates Southwest purchased approximately 50.2% of its forecasted 2001-2002 annual gas requirements using fixed price contracts, although San Bernardino disputes this calculation and argues a more appropriate number is 63%. As winter 2001-2002 was warmer than normal,⁸³ a factor Southwest could not foresee when it negotiated its fixed-price contracts, Southwest asserts it's proposed fixed price annual volume was close to the 50% recommended by San Bernardino, and thus at the time of negotiating fixed price contracts, it maintained adequate flexibility to purchase gas at spot prices. Although San Bernardino argues differently, the calculation of the fixed price volume, based on Southwest's planning cycle and its purchase of gas at spot prices during summer 2001, indicates that the percentage of gas under fixed-prices is not the 80% amount calculated by San Bernardino, but is closer to 50%. Given Southwest's extreme concern over events during the past winter, a warmer than normal winter 2001-2002 and uncertainties regarding future gas prices, it is understandable that its fixed price contract volumes for winter 2001-2002 might exceed 50%. Although we have addressed this issue raised by San Bernardino, we point out that our guidelines for gas procurement do not specify the amounts or percentages of gas purchases at spot or market prices, or through fixed-price contracts. Instead, we emphasize the need for maintaining flexibility in order to provide gas to customers at reasonable prices consistent with a secure supply.

In summary, we have applied the three steps articulated by the Commission in D.02-08-064,⁸⁴ and advocated by San Bernardino, to determine the reasonableness of Southwest's decisions. However, we have reached a conclusion different from that of San Bernardino. First, we examined the goals that Southwest hoped to achieve and whether the goals were reasonable. Unlike its reliance on spot prices for gas articulated in I.01-06-047, Southwest states it desired price stability, and certainty of supply for Winter 2000-2001, while procuring gas at prices that given available information appeared reasonable. As discussed, these goals were reasonable and intended to balance out the conflicting goals of price stability and low-cost gas.

Second, we compare the actual outcome with the goal. Here, we find Southwest achieved price stability and certainty of supply, although the actual costs exceeded market or spot costs at the time of delivery. However, we cannot merely compare the actual costs to costs at time-of-delivery, since at the time of the decisions, future costs were very uncertain. Even at the beginning of August, when Southwest negotiated its last fixed-price contract for winter 2001-2002, there still existed uncertainty regarding the actual causes of the dysfunctional energy market in 2000-2001, and uncertainty regarding prices in winter 2001-2002. We also observe that Southwest intended it would not become reliant on fixed prices beyond winter 2001-2002, as the contract terms are only for one year. If actual gas costs in winter 2001-2002 had increased again to levels experienced in winter 2000-2001, Southwest's fixed-price contracts would have been quite reasonable by comparison.

Third, we consider whether a reasonable and prudent utility would have taken other steps to achieving these goals. Here, the record does not include the actions taken by comparable utilities, such as SoCalGas and SDG&E, regarding the goals of price stability, supply and low-cost gas. San Bernardino provides that the core costs of gas for SDG&E and SoCalGas were less than those for Southwest and concludes that SoCalGas and SDG&E thus retained flexibility to take advantage of declining market prices. However, this is not a totally valid comparison as it does not consider the other goals of stability and supply, and relies instead on the outcome of price comparisons. In D.02-08-064 we faulted Southwest for extreme reliance on spot market gas, and its imprudence in not fixing the cost for future gas deliveries. In the instant proceeding, we find that given the information available and known by Southwest, its decision to negotiate fixed price contracts was not unreasonable, and exhibited the steps a prudent manger might take in light of the recent past.