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F I S C A L I M P A C T R E P O R T

SPONSOR HBIC

ORIGINAL DATE

LAST UPDATED

2/10/06

2/13/06 HB 874/HBICS

SHORT TITLE

Public Peace, Health, Safety & Welfare

SB

ANALYST Francis

REVENUE (dollars in thousands)

Estimated Revenue

Recurring

or Non-Rec

Fund

Affected

FY06

FY07

FY08

Indeterminate

See Narrative for Detail

(Parenthesis ( ) Indicate Expenditure Decreases)

SOURCES OF INFORMATION

LFC Files

SUMMARY

Synopsis of Bill

House Bill 874 substituted by the House Business and Industry Committee would allow the State

Board of Finance to enter into contracts with qualified entities to use up to 50 percent of sever-

ance tax revenues going to the general fund or the severance tax permanent fund to purchase de-

rivatives relating to energy prices. The effective date is upon signing into law due to an emer-

gency clause.

Investopedia.com defines derivative as a security whose price is dependent upon or derived from

one or more underlying assets. The derivative itself is merely a contract between two or more

parties. Its value is determined by fluctuations in the underlying asset. The most common under-

lying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options

and swaps are the most common types of derivatives and are examples of hedging contracts re-

ferred to in HB 874.

The maximum length of any hedging contract will be ten years.

FISCAL IMPLICATIONS

Energy price hedging is used to reduce the risk of volatility in the energy markets. In recent

House Bill 874/HBICS – Page

2

months, natural gas prices have moved from $6 per thousand cubic feet (MCF) to $14/MCF.

Likewise, oil prices have moved up to as high as $68/barrel and have been fluctuating in a four

to five dollar range. These uncertainties have driven the market in energy hedging. Once the

purview of utilities that rely on long term contracts and are risk intolerant, other entities who rely

on oil and gas as revenue streams have entered the market.

The fiscal implications are uncertain because of the volatility of oil and gas. However, assuming

that the state board of finance (BOF) negotiates a contract above the consensus revenue group

estimate the impact would be positive to the extent that the consensus revenue group forecast is

accurate.

The application of energy hedges to the severance tax permanent fund revenues will also affect

bonding capacity. To the extent that there is an increase in revenue due to the hedge, there will

be additional bonding capacity both for the senior STB bonds and the supplemental STB bonds.

If the hedge results in a loss or an unrealized gain, the bonding capacity will be less than it would

have been without the hedge.

SIGNIFICANT ISSUES

There are three main types of hedges: a floor, a swap, and a collar. These can be structured in

many ways if they are purchased over-the-counter (OTC). Typically, the hedge uses the

NYMEX future prices as the baseline but BOF has indicated that the hedge could be narrowly

defined as the wellhead price of the San Juan or Permian basins so that the hedge price more ac-

curately reflects the New Mexico gas prices.

The way the hedge works is that BOF enters into an agreement with a counterparty to establish

certain prices of natural gas or oil. The contract is usually at a set price per unit of commodity.

The unit for natural gas would be one thousand cubic feet (MCF) and the unit for oil would be on

barrel. This is an important distinction. The state is entering into an agreement to buy or sell a

certain amount of oil or natural gas at a given price.

For the purposes of illustration, this fiscal impact report focuses on natural gas but the same me-

chanics apply to oil.

If the contract is a “floor,” then the contract sets a minimum price per MCF. The state pays a

premium depending on the duration of the contract and the level of the floor. If the price of natu-

ral gas stays above the floor price, the state has lost only the premium that it paid for the con-

tract. If the price of natural gas goes below the floor price, the counterparty pays the state the

difference. In other words, if it costs $0.20 per MCF to establish a floor of $6.00 per MCF, the

state is guaranteed a price of $5.80 per MCF (the guaranteed floor less the premium).

If the contract is a “swap,” the state is locking in a price per MCF. In this case, if the swap price

is $6.00, the state will benefit when the price goes below $6.00. If the price is above $6.00 then

the state pays the counterparty the amount above the swap. So for a contract, the state will break

even at $6/MCF, will have to pay the counterparty if the price falls below $6.00 and will receive

payment if the price is above $6.00.

A “collar” is somewhat different. A collar sets both a floor and a ceiling by issuing “puts” and

“calls.” A “put” is an option to sell a commodity at a certain price before a certain date and a

House Bill 874/HBICS – Page

3

“call” is an option to buy a commodity at a certain price before a certain date. By matching put

orders with call orders, the BOF creates a band of price certainty.

Picking the price becomes of paramount importance to minimize the risk. Currently, the consen-

sus revenue group, made up of representatives of the Department of Finance and Administration,

the Legislative Finance Committee, Taxation and Revenue Department and Department of

Transportation, forecasts natural gas oil prices out five fiscal years. These estimates are used in

the appropriations each year and are updated periodically throughout the year. As the chart be-

low shows, the forecast has had significant error due to the volatility of oil and gas prices. For

example, the February 2005 estimate of natural gas price for FY06 was $4.80/MCF. The most

recent estimate for FY06 is $7.50, a difference of $2.70. If the state had purchased a swap for

$4.80/MCF based on the estimate, the state could have lost over $175 million in natural gas reve-

nues (up to half of severance tax revenues are authorized for hedge contracts).

Consensus revenue estimate accuracy

Consens us Revenue Group's 18 Month Es timating Error for Re curring

Revenues and Natural Res ource Revenues

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05

Tot al Rec urring

Natural Resources

Actual revenue higher than forecast

Act ual revenue lower t han forecas t

For a long time, these types of hedges were primarily used by utilities, railroads and airlines

(Southwest Airlines has been in the news recently with their successful fuel hedging). These are

entities who depend on cost controls for profitability and so they favor locking in a price for fac-

tor inputs like fuel. They are actually purchasing the energy whether its barrels of oil or cubic

feet of gas and using it. The state however depends on the revenue derived from the sale of oil

and natural gas rather than from the use of them. This is an important distinction to make. Re-

gardless of hedging, the state will receive tax revenues on severance activities. The hedge is out-

side of the tax revenues. The hedge is equivalent to investing those revenues because the state

will never be on the hook to actually deliver oil or gas to a purchaser of one of the hedge con-

tracts. So, hedging is an investment strategy to insure against volatility in the energy markets.

The simple model below demonstrates where the hedge fits into the current model.

Current Model:

Oil and Gas is Severed

Taxable event

Revenues to State General Fund based on Value (volume x price)

House Bill 874/HBICS – Page

4

Hedge Model:

Oil and Gas is Severed

Taxable event

Revenues to State Board of Finance based on Value (volume x price)

50 percent or more General or Severance Tax Permanent Fund

Up to 50 percent to Hedge Investment

Proceeds to/from General or Severance Tax Permanent Fund

OTHER SUBSTANTIVE ISSUES

TRD:

The proposal represents a worthwhile attempt to take advantage of financial instruments that

could be utilized to stabilize the state’s revenues. To this end, it is inevitable that some dis-

cretion must be delegated to the Board to evaluate and choose among alternative financial in-

struments. However, given the importance of the trade-off between potential return and the

risk assumed on these investments, it is important that the proposal provide guidance for the

Board as it makes decisions involving these transactions. As it stands, the proposal merely

requires the Board to determine that the transactions are “in the best interests of the state.”

Thus, the proposal is completely silent on what the Legislature views as the appropriate

amount of risk to be assumed in order to achieve a specified return. Such guidance could

take into account, for example, the differences in how General Fund revenues are budgeted

compared with Severance Tax Bonding Fund revenues. The General Fund budget encom-

passes the current year and one additional year. Thus, hedging transactions designed to guar-

antee revenue through the budget year are more important -- and also less risky -- than those

for longer time periods. Severance Tax Bonding Fund revenue is used for capital outlay pro-

jects rather than operating, and a portion of the revenue is used for bond debt service. Thus,

the risk/return criteria for this fund should be quite different than those for the General Fund.

Given the novelty of the proposed new program, it is probably advisable to initiate the pro-

gram on a “pilot” basis at first, to test the potential benefits prior to committing large sums.

The authorization allowing the Board to commit as much as 50 percent of these revenues is

far beyond a pilot program in scale.

The Board should be required to provide detailed reports to the Legislature on a regular basis

concerning the nature of the decisions it has made under the program, the financial trade-offs

implied in any contracts into which it has entered, the net effects of the program on state

revenues, etc. These reports could be made annually but also on a more frequent basis to the

Legislative Finance Committee.

It will be critical to have appropriate staff training in these investment strategies.

ALTERNATIVES

As TRD indicates, the current bill opens up a significant amount of the state’s revenue to an un-

tested investment strategy (untested by New Mexican agencies) and as an alternative a lower

threshold may be established such as 10 percent.

As written, only the State Board of Finance makes the decisions. It may be useful to include the

House Bill 874/HBICS – Page

5

State Investment Council or the State Treasurer in the decision making.

WHAT WILL BE THE CONSEQUENCES OF NOT ENACTING THIS BILL

What is a down-side scenario. What is the potential for losses.

What are the fees for preparing structured over the counter contracts. Are these included in the

premium or separate.

Does the State Board of Finance have the staff resources to effectively analyze and evaluate an

energy hedge contract.

NF/mt