RSM Resources

More than a year ago, when natural gas prices were rising at an alarming rate, Charlie Martin wanted to send a message to his company energy supplier. So he instructed his engineering staff at Bommer Industries, a South Carolina-based manufacturer of spring hinges and postal specialties, to retrofit the boilers at one of the company’s manufacturing locations to handle both natural gas and fuel oil. That decision immediately cut the company’s energy costs by 40 percent.

This year, before back-to-back hurricanes lashed prime U.S. energy production sites in the Gulf of Mexico, Martin relied on another strategy: intuition.

"In early August, my plant engineer came tome and said he wanted to lock in our fuel-oil pricing for 18 months, because it would save us an additional 8 percent over what we had paid in our last contract," says Martin, Bommer’s president and chief operating officer. "I told him, ’If you think it’s the right thing to do, go ahead.’ Two weeks later, Hurricane Katrina hits, and that drives up the price of fuel oil by 30 or 40 percent. So I went to him after that and said, ’Sometimes it’s better to be lucky than to be smart.’"

The rising cost of energy and the threat of higher interest rates — that could make borrowing for expansions and improvements more expensive — weigh heavily on the minds of many business leaders. The most recent TEC Confidence Index, a quarterly survey of midsized business CEOs, fell sharply on concerns that the national economy was losing steam. On the other hand, a majority of those responding said they planned to continue with hiring and capital expansion plans into 2006.

"Given that the survey was conducted in the week following Hurricane Katrina, CEOs may have become more uncertain about prospects for the overall economy while remaining quite optimistic about the outlook for their own firms," says Richard Curtain, director of consumer surveys at the University of Michigan and a consultant on the TEC project.

Managing energy costs
In these uneasy economic times, what can midsized manufacturers do to manage their risks? Ehud Ronn, director of the Center for Energy Finance Education and Research at the University of Texas, says companies do have options when it comes to negotiating future energy pricing.

For example, Ronn says, a company can engage in a "commodities swap," in which companies lock in an average futures price for a defined time period. While this approach guarantees the price for natural gas,fuel oil or other energy commodities, a company could lose money if the price of that commodity falls during the contract period. On the other hand, if a company buys a call option on the average futures price of an energy commodity,the company is covered regardless of how prices move.

Structuring a commodities deal based on average future prices — rather than one for a monthly spot price — usually requires help from an investment bank, but Ronn says it can be well worth the cost.

"When you buy an option of this kind on the average futures price, you’re getting the protection you want without overinsuring," Ronn says. "It is essentially a premium you pay so that if prices go up, your company is covered. And if prices fall, you benefit by simply throwing away the option."

But managing energy supplies is only part of the issue. In a Conference Board white paper titled, "A Roadmap for Strategic Energy Planning and Management," author Charles Bennett notes that companies can save up to 10 percent of their annual energy costs by taking a more disciplined approach to conservation. To accomplish this, the report suggests companies create compensation incentives tied to energy-efficiency goals, and review all capital-equipment and facility plans to determine how planned changes will lower energy usage.

Planning for higher interest rates
Rising energy prices, meanwhile, are part of a more complex puzzle affecting U.S. interest rates. Despite post-hurricane misgivings by a number of economists, the Federal Reserve Board raised short-term rates to 3.75 percent in September. While the central bank claims it needed to raise rates upward to stave off the threat of inflation, many manufacturers say tightened credit will dampen their outlook.

For example, two surveys taken earlier this fall of manufacturers in the mid-Atlantic region and New York state showed sharp declines in the companies’ confidence in the U.S. economy. Many respondents cited the threat of higher interest rates as a key reason they had become more conservative about their growth prospects.

Despite regular short-term rate hikes by the Fed, the price of business credit is not likely to rise a great deal — at least in the near future. And business leaders can track the answer to that conundrum by following where U.S. Treasury securities have been sold in recent years.

"Not too long ago, the way things worked was that the developed world bought bonds in emerging economies," Ronn says. "Now those emerging and developing economies are buying our bonds, because the U.S. Treasury market is the only place that’s deep enough to handle the billions of dollars flowing into bonds right now. That’s good for interest rates — for as long as it lasts."

Central banks in Asia and the Far East are buying U.S. securities in large chunks, greatly because the returns on those investments are better than what they can earn in other world markets. As recently as 2004, the International Monetary Fund reported that foreign banks purchased nearly $900 billion in U.S.bonds — meaning that the majority of federal government debt is now held by non-U.S. interests.

However, experts warn that those governments are under increasing pressure to reduce their exposure to U.S.-based investments.If those overseas banks take steps to aggressively diversify their investments, Ronn says the dollar would plunge, and domestic interest rates would rise dramatically. Those scenarios, in turn, would hurt manufacturers’ ability to borrow money for expansion or capital investment.

"People need to look ahead at what the markets are telling them," Ronn says. "Clearly, the Federal Reserve seems to be more optimistic about interest rates and the economy than some of these polls would indicate. But inthe longer term, it’s unwise to expect that interest rates will stay artificially low for an extended period."