Managing Cost and Risk with a Supplier Portfolio

August 2008

In many situations it can be advantageous to develop close relationships with suppliers. For example, a car manufacturer may want to have close ties with the manufacturer of a key component of their cars. The advantages come from opportunities for joint product development, production integration, a clear understanding of each organization's commitment to quality, delivery logistics and cost management.  However, this level of collaboration is not needed with all suppliers, especially when the product purchased is a commodity that cannot be differentiated in any way to create a competitive advantage. When it comes to purchasing energy, a cost advantage is more often gained by having a portfolio of suppliers rather than using a single partner.

A supplier portfolio creates two key advantages. First, having multiple suppliers allows the purchaser to create a competitive buying environment, resulting in lower purchase prices. Secondly, risk is reduced because the buyer is not dependent on a sole supplier.

Creating a Competitive Buying Environment

When an energy marketer provides a price, the price offered is influenced by a number of factors including:

• The underlying price of the commodity.
• Perceived risk in the market. If the market is extremely volatile, does the marketer have to charge a risk premium to compensate themselves for market risk?
• The perceived creditworthiness of the purchaser.
• The market position of the marketer. In the case of a natural gas marketer, do they have excess natural gas that they need to get rid of? Are they short gas and need to find their own source to meet your request?
• Profit.
• Perceived competition.

At any given time, each marketer faces a different combination of these factors. Getting offers from more than one supplier during the procurement process helps the buyer break a supplier's "knowledge monopoly" by providing more information about the underlying price. It also creates the opportunity to find a supplier with conditions that allow for favourable pricing.

The example below provides a real-life illustration of the difference in prices offered by three suppliers at the same time for the same volume for the same period. In this example, a price was requested in June 2008 for 1,000 GJ's per day for the period between November 1, 2009 and March 31, 2010. A difference of nearly 7¢ per GJ exists between the highest and lowest price being offered. For a business consuming 1,000 GJ/day for 151 days, the pricing difference resulted in a savings of $10,117.

June - 08

When a buyer has only one supplier, the supplier soon learns that every offer is accepted. So naturally, the offer price starts to get a little fat. If the buyer has alternatives, then some offers will be rejected and the supplier learns that it is in competition for the business. The supplier will be motivated to offer its best price, aware that the buyer has a choice.

Supplier Failure

A second scenario in which multiple suppliers can be beneficial occurs when a supplier is unable to meet their commitment. While this is rare, the recent action of a large US energy marketer to seek creditor protection left some customers of its Canadian affiliate without a gas supply on short notice. For customers purchasing exclusively from that supplier, this created the prospect of a "failure to deliver" under the terms of the direct purchase contracts with the local distribution utilities. While the distribution company will continue to supply gas on a best efforts basis, they can also apply a penalty to the consumer for every gigajoule that their supplier failed to deliver, with the risk of a substantial impact to the bottom line.

In the recent case, the supplier stopped delivering gas on behalf of customers on July 24th. For a consumer whose contract with the utility requires delivery of 1,000 GJ/day, a "failure to deliver charge" could be incurred on 8,000 GJ for the period until the end of July. During this period, the distribution company provided natural gas to the facility, but applied a failure to deliver charge of $2.955 per GJ. In this case, the cost of not having an alternate supplier available for the last 8 days of July was $23,640.

Additional cost

Cost versus Benefit

Having a supplier portfolio does involve some cost. In the energy market, parties need to have a contract in place before they can transact any business. As such, a buyer will incur the legal and administrative expense of negotiating a new contract even before any business can be done. Some buyers are reluctant to incur this cost of time and money leading to a decision to sign contracts with a single marketer that they feel will consistently have the lowest price. It has been our experience that within a portfolio of suppliers a single supplier has yet to offer a consistently lower price than their competitors. As our examples have shown, the costs associated with developing a portfolio of suppliers can be recouped quickly in lower costs and lower risk.

Conclusion

Many organizations overlook the cost advantage that can be found through a simple and effective energy procurement strategy - the supplier portfolio. In the first example, a multi-supplier strategy provides a price advantage. In the second example, the use of a multi-supplier strategy ensures security of supply. The buyer reduces cost and risk.

In both of these examples, a real cost advantage can be found.  While some organizations attempt to achieve a cost advantage through speculative purchasing or market timing, consistent results are extremely rare. When large marketing organizations with expert resources fail while attempting to beat the market, a buyer's own resources must be viewed with rational scrutiny. A well planned, well executed, energy procurement process - with multiple suppliers as one element - is better suited for providing a sustained competitive advantage.

Aegent advocates the use of this strategy with our clients. As an independent advisor, Aegent has no affiliation with any single gas supplier. Should you be interested in learning more about how Aegent can help you develop a procurement plan that includes using multiple suppliers, contact us at 416-622-9449.

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