It is concerning to observe a pattern of financial executives unaware of the terms of their own company’s energy supply agreements; particularly when to me it is so clear this is a necessity. These commitments represent substantial financial exposure that are arranged, in some cases, outside the company’s risk management policy and processes for financial commitments. Another very important reason for financial executives to have knowledge of their energy supply agreements is their treatment in the event of Chapter 11 bankruptcy. Obviously, no business plans for bankruptcy, but prudent financial executives should understand the potentially substantive risks that might arise in this unlikely event.
Contracts for the supply of goods and services are typically treated as executory contracts by the bankruptcy courts. That means that the bankrupt estate can evaluate contracts in the context of their value to the estate during the entire reorganization process. For example, if a company has a contract to buy pencils at a 20% discount to the current market price, the estate would be wise to retain that contract. Historically, arrangements for energy supply have been viewed as executory contracts. However, in some recent bankruptcy cases, the courts have found that energy supply contracts are forward contracts, rather than executory contracts.
The bankruptcy code stipulates that in bankruptcy a forward contract may be liquidated by the “forward contract merchant”; in this case, the energy supplier. To the extent the energy supplier elects to liquidate the supply agreement, it puts the estate in the position of having to pursue supply in the market…which is very likely at higher prices than the now terminated contract. The energy supplier could also make an argument for liquidated damages, depending on the contract terms. That’s a double-whammy.Knowing how crucial it is to understand liabilities and cash flow in a financial crisis, the importance of “mundane” energy supply contracts is certainly heightened and well worth the time, even if only to have a bird’s eye view! Prudent financial executives should therefore be aware of the financial exposure that energy supply contracts represent, and if substantive, monitor that exposure vis à vis market prices on a regular basis to ensure they are prepared to move quickly to minimize supply disruption and manage energy costs in the event of a Chapter 11 filing.