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 in our investigation of Southwest's gas procurement practices for the period June 1, 1999 - May 31, 2001 (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 allowed itself the flexibility to purchase lower-priced gas during the spring and summer of 2001.

San Bernardino applies the Commission's three-pronged reasonableness test⁷⁴ 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 both inconsistent with the Commission's natural gas procurement policies, and not a reasonable management strategy. Referring to the record developed in I.01-06-047, San Bernardino believes that the Commission has articulated price stability and cost minimization as two goals that must be balanced, without pursuing one to the exclusion of the other. Against that backdrop, the County notes that Southwest's core procurement philosophy went from one extreme in 2000, when its portfolio focused almost exclusively on spot purchases with little to no storage or fixed-price contracts, to the opposite extreme in 2001, when it relied primarily on fixed-price contracts to meet winter demand.⁷⁵ San Bernardino questions why Southwest was unable to produce a policy statement or other written rationale for its decision in Spring 2001 to so significantly alter its procurement strategy.

San Bernardino also argues that Southwest's managers should have been extremely cautious about committing to fixed-price contracts for future periods during a time of dysfunctional gas prices, noting numerous factors in play in the Spring of 2001 that should have led Southwest to conclude that prices were likely to decline.⁷⁶

Second, San Bernardino compares Southwest's goal with the outcome. It concludes that Southwest's gas costs during the winter of 2001-2002 substantially exceeded market prices, noting that, as a result, a portion of core gas purchase costs had to be deferred for recovery at a later time in order to avoid imposing significantly higher rates on Southwest's customers. San Bernardino acknowledges that this outcome would demonstrate that price stability was achieved, but Southwest failed to meet the goal of cost minimization or even a balance between the two.

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 believes Southwest should have retained a more balanced core portfolio that contained no more than 50% in fixed-price contracts for the winter of 2000-2001. It recommends that the Commission disallow 50% of all above-market costs for two 10,000 Dth⁷⁷/day contracts signed in March and May, respectively, of 2001, and 100% of the August 2001 contract, or a total disallowance of $10.744 million.

San Bernardino also urges the Commission to disallow the costs of an apparent gas exchange Southwest initiated with Reliant Energy in early 2001. San Bernardino alleges that in February 2001 Southwest bought more supplies than its core customers needed at a price of $12.32 per Dth, sold the excess supplies to Reliant in March at $13.70 per Dth, and simultaneously agreed to buy a similar volume from Reliant in October 2001 at $13.20 per Dth. The County acknowledges the $0.40 per Dth net gain on the sale, but raises the possibility that the gain for Southwest's ratepayers could have been $11.18 per Dth had Southwest simply sold the gas without agreeing in March to repurchase it seven months later at the $13.20 per Dth price. The County recommends a further disallowance based on the relatively high cost and lost opportunity of this transaction, which totals $1.435 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.

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."⁷⁸

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."⁷⁹

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.⁸⁰ In D.02-08-064 we articulated a thorough analysis of our prior decisions on these issue and provided further guidance to utilities, noting that although D.89-04-080 relegated the goal of price stability to a secondary priority behind supply security and cost minimization, the overarching goal is a policy that avoids blindly striving to meet any one of those goals to the exclusion of the others. In other words, 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, we conclude that Southwest's gas procurement strategy for the Winter of 2001-2002 constituted imprudent managerial action. Southwest procured an excessive amount of gas for winter delivery to core customers at fixed prices, thus foreclosing the flexibility to purchase gas at spot or market prices, or fill storage. We acknowledge the fundamental need for fixed price contracts, however, consistent with D.02-08-064, 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 begin by considering whether Southwest's procurement goals were reasonable at the time. On this point, we note that there are three different time periods within which we could evaluate the fixed priced contracts. The time frame affects whether the 50% annual target advocated by San Bernardino should be considered in the context of a one year or two year period. Southwest asserts that the amount of fixed-price contract gas was about 50% of its annual requirement for its planning year that began on November 1, 2001 and ended October 31, 2002. Because some fixed price gas was delivered in October 2001, they should be considered over two years. San Bernardino, on the other hand, believes that a planning cycle of April to March is more appropriate, and therefore all of the fixed price contracts should be counted toward a 50% goal. And, as we noted above, the proceeding itself has been designed to evaluate Southwest's gas procurement practices between June 2001 and May 2002, picking up from the time period when investigation I.01-06-047 left off.

Our focus here is to evaluate the reasonableness of gas purchases as they affect core customers. In Southwest Gas' California districts, core customer demand tends to increase dramatically in the colder winter heating months. The contracts in question were all executed for delivery in continuous months beginning October 2001, clearly to meet that winter heating demand, and we will evaluate them in that context.

The record indicates that, for the 2001-2002 Winter, Southwest modified its procurement strategy so radically from spot purchases to fixed price contracts, that it effectively precluded itself from responding to changing market conditions. And, as both San Bernardino and Southwest point out, not only were the electricity and natural gas markets dysfunctional at the time these contracts were executed, but all indications were that those market conditions would continue to evolve. It is precisely the ability to respond to adapt to changes in the marketplace that has motivated our desire for utilities to balance the goals of cost minimization, price stability and supply security. We do not believe that committing 80% of its core winter procurement needs to fixed price contracts at a time of relative market dysfunction was a reasonable goal.

Second, we compare the actual outcome with the goal. Here, we find Southwest achieved price stability and certainty of supply by committing to relatively high-priced contracts for approximately 80% of its anticipated winter demand. These contracts were executed at a time of great market uncertainty although, as San Bernardino notes, many factors indicated prices were likely to decrease. Regardless, Southwest's actions to commit a significant portion of its winter portfolio to high priced fixed contracts during a time of such uncertainty hampered its ability to buy cheaper spot gas to burn in real time during the winter months, and also served as a disincentive to buy gas prior to winter for physical injection into Southwest's storage inventories. The result -- fixed, high priced gas - so drastically exceeded reasonable rates that Southwest requested regulatory intervention to spread the costs of its contracts to customers over a longer period of time. In other words, the goal of price stability was achieved only by spreading the costs of the high-priced contracts beyond the winter months. Absent that longer amortization, as San Bernardino notes, prices would have risen been even higher during the winter months. The resulting outcome was that neither the goal of price stability nor cost minimization was met.

Finally, 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. That information alone indicates that other utility gas procurement managers read something in the market signals that Southwest missed, and took steps to ensure they had the flexibility to react to those signals. 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 again fault Southwest for extreme behavior, and find that given the information available and known by Southwest, its decision to negotiate fixed price contracts was unreasonable, and did not exhibit the steps a prudent manger might take. We conclude that Southwest's commitment to purchase 80% of its core winter needs for 2001-2002 at fixed prices was unreasonable and imprudent. We agree with the methodology proposed by San Bernardino, and will disallow 50% of the above-market costs of the two 10,000 Dth per day contracts signed in March and May, 2001, 100% of the August 2001 contract and the above-market costs of the Reliant repurchase, for a total disallowance of $12.18 million. This disallowance should be returned to Southwest's core customers, with interest, as a bill credit based on each customer's usage during the 2001-2002 winter season.