MANAGING NATURAL GAS PRICE VOLATILITY May 2008 Page 1 141 W Jackson Blvd Suite 1521 Chicago, IL 60604 312.373.8250 info@riskmgmt.net
TABLE OF CONTENTS Section 1 Macro Economic Influences on Commodity Pricing Section 2 Hedge Plan Structures for Managing Natural Gas Volatility Page 2
SECTION 1 MACRO ECONOMIC INFLUENCES Page 3 Page 3
MACRO-MARKET PRICE INFLUENCES Resource Abundance Scarcity Commercial Speculators Trading & Investors Houses ROW U.S. Led Demand Growth Strong Weak Dollar Weather Variability Extremes Environmental Concern Crisis Page 4
ROW -LED DEMAND GROWTH Page 5
WEATHER EXTREMES February blizzard in China Flooded Yallourn coal mine in Australia BP s Thunderhorse platform listing in Gulf of Mexico after Hurricane Katrina Page 6
Index Points WEAK DOLLAR $/barrel US Dollar and Crude Oil Price Relationship 140 120 120 100 100 80 80 60 60 40 40 20 20 0 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 0 ICE Prompt-Month US Dollar Index Futures NYMEX Prompt -Month Light, Sweet Crude Oil Futures Page 7
COMMODITY PRICE TRENDS WHAT CHANGED? Reuters/Jefferies-CRB Index (1967=100) (m onthly close) January 1992 - Decem ber 1999 350 300 250 200 150 Spot Price Change Of Selected Commodities (monthly close) January 1992 - December 1999 Sugar C o ffee C o co a Wheat So ybean Oil So ybean M eal C o rn N atural Gas 1992 1993 1994 1995 1996 1997 1998 1999 Reuters 100 C rude Oil -50% -25% 0% 25% 50% 75% 100% Reuters/Jefferies-CRB Index (1967=100) (monthly close) January 1992 - February 2008 450 400 350 300 250 200 150 100 Spot Price Change Of Selected Commodities (m onthly close) January 2000 - February 2008 Sugar C o ffee C o co a Wheat So ybean Oil So ybean M eal C o rn N atural Gas C rude Oil 1992 1994 1996 1998 2000 2002 2004 2006 2008 Reuters 0% 50% 100% 150% 200% 250% 300% 350% Page 8
SPECULATORS & INVESTORS BY THE NUMBERS Citigroup Inc. Global Commodity Investment Analysis (US$ billion) End 2007 Investment Total Q1 2008 Investment Increase Investment Total (3/31/08) Purely Coincidence? Indexes 145 40 185 CTA s 80 14 94 Hedge Funds 60 15 75 ETF s 35 11 46 Total 320 80 400 Page 9
SECTION 2 HEDGE PLAN STRUCTURES Page 10 Page 10
GETTING TO THE REAL ISSUES The Energy Hedger s Dilemma: How Did I Do? Why Didn t You Buy More? October 2005 Natural Gas Prices Hurricanes Katrina & Rita Hit in Fall 2005 Why Did You Buy So Much? October 2006 Natural Gas Prices No Hurricanes Hit in 2006 Page 11
HEDGE PROTECTION SINCE KATRINA & RITA $4.00 $4.00 $8.00 $12.00 $16.00 Cost Benefit Cost Benefit Natural Gas Prices Summer 2005 Hot Weather Hurricanes Hit 2008 & Beyond Winters and Summers to Date Below Normal Hurricane Activity Cooler Summers Normal Winters Jan 05 Apr 05 Oct 05 Apr 06 Oct 06 Apr 07 Oct 07 Jan 08 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Natural Gas Hedge Program Insurance Home Insurance Reduced gas costs Overall prices Increased Reduced rebuilding costs Security of protection given unforeseen events LOWER PRICES for the utility Hedge Premium associated with plan protection Security of protection given unforeseen events Rebuilding costs not an issue Plan protection provides security given unforeseen and catastrophic events. Homes destroyed Insurance Premium associated with plan protection Page 12
HEDGE PROTECTION/INSURANCE 2008 & BEYOND 2008 has proven that just because your house had not burned recently there was no guaranty that a fire would not have ensued at some point in the future Having a hedge program is analogous to securing a home insurance policy It is prudent to maintain home insurance just as it is prudent to maintain a hedge program The pending direction of natural gas prices is even far less certain. Page 13
PRICING OBJECTIVES OBJECTIVES Establish Price Stability Buy at Historic Low Value Protect Against Major Price Increases Reduce costs in future years WHAT TO DO? The best advice to offer is... Quantify your hedge strategy Maintain structure and discipline in your hedge program Think long term in a market with a short-term focus Page 14
HEDGING METHODOLOGY Quantitative variables to consider to achieve a rational purchase price Risk Analysis DEFINE RISK Historic Prices DEFINE VALUE Price Targets Beyond Current Year THINK LONG TERM Time Targets PRICE STABILITY The Application of Multiple Tools UTILIZE OPTIONS Page 15
DEFINE & QUANTIFY RISK On a daily basis, the price risk and opportunity of an energy or commodity portfolio can be measured using metrics like VaR and the RMI price matrix $17.00 $16.00 Risk Assessment Report Know-Risk UNHEDGED RISK AT 95% CI RAR quantifies the price risk by month during a calendar year $15.00 $14.00 $13.00 ELIMINATED RISK RISK WITH HEDGES IN PLACE The proximity of the forward curve to historical value can judged versus upside price risk $12.00 $11.00 $10.00 $9.00 FORWARD PRICE CURVE $8.00 $7.00 50th Decile: $7.94 - $766 (4 Year Median Value $7.94) 40th Decile - $7.66 - $7.40 30th Decile - $7.40 - $7.14 $6.00 Sep-07 Apr 08 May Oct-07 08 Jun Nov-07 08 Jul Dec-07 08 Aug Jan-08 08 Sep Feb-08 08 Oct Mar-08 08 Apr-08 Nov 08 May-08 Dec 08 Jan Jun-08 08 Page 16
VALUE MANAGEMENT Define what makes a price expensive or cheap, and develop a strategy to create a competitive advantage Identify prices that represent historical value and compare them to the current market Prices in the value area have inherently lower opportunity risk, and greater strategic value Aggressively contract the commodity at pre-determined value levels Median Value = $7.94 NATURAL GAS - NYMEX ANNUAL Mean 8.27 Median 7.94 90% - MAX 10.24-15.81 80% - 90% 8.84-10.24 70% - 80% 8.38-8.84 60% - 70% 8.15-8.38 50% - 60% 7.94-8.15 40% - 50% 7.66-7.94 30% - 40% 7.40-7.66 20% - 30% 7.14-7.40 10% - 20% 6.62-7.14 MIN - 10% 4.92-6.62 Value Area Compiles 4 years of data Weighted heavily to most recent year s data Adjusted for inflation using the PPI Page 17
DEVELOP STRATEGY A Successful Price Target Strategy: QUANTIFY EXECUTION Meets company hedge objectives Acknowledges quantified market risks and volatility Considers market opportunities beyond current year Contains objective execution parameters Value Target Define good long-term value, and match value with purchasing aggressiveness Example: Below Historical Median Time Target Mitigate risk by ensuring certain levels of minimum coverage prior to a season or planning period Example: Dollar Cost Averaging Pricing Tools Utilize judgment in the use of options in conjunction with fixed pricing and index gas. Example: Buy Caps, Collars, etc. Page 18
GENERIC WINTER 2008-2009 HEDGE PLAN Natural Gas Winter Strip 2008-2009 $13.50 $12.50 $11.50 $10.50 $9.50 $8.50 $7.50 Value $8.18 and Below 4 Quarters 3 Quarters 2 Quarters 1 Quarter ASSUMPTIONS: 1. Time Triggers, Value Triggers and Volumes Hedged will vary depending on customer s risk tolerance 2. The use of options can further diversify this pricing portfolio $6.50 $5.50 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Quantity Price Trigger 1 50 th Decile Trigger 2 40 th Decile VALUE TRIGGERS Trigger 3 30 th Decile Winter Strip 2008-2009 Trigger 4 20 th Decile Trigger 5 10 th Decile 15% 30%* 45%* 60%* 75%* $8.18 $7.98 $7.69 $7.43 $7.25 * Cumulative Totals Trigger Dec07 TIME TRIGGERS Trigger Mar08 Trigger Jun08 Trigger Sep08 10% 20%* 30%* 40%* $8.80 $10.97 Total Purchased as of 4/23/2008 20% $9.884 Page 19
GENERIC WINTER 2010-2011 STRIP HEDGE PLANS Natural Gas Winter Strips 2009-2011 ASSUMPTIONS: $11.50 $10.50 $9.50 1. Time Triggers, Value Triggers and Volumes Hedged will vary depending on customer s risk tolerance 2. The use of options can further diversify this pricing portfolio $8.50 $7.50 Value Tier 50 th $8.18 Value Tier 40 th $7.98 Value Tier 30 th $7.69 Value Tier 20 th $7.43 $6.50 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Value Tier 10 th $7.25 NOV/2009 - MAR/2010 NOV/2010 - MAR/2011 VALUE TRIGGERS 2010 2011 50th Decile 40th Decile 10% 30th Decile 10% 10% 20th Decile 10% 10% 10th Decile 10% 10% TOTAL 40% 30% Page 20
NEW RULES OF HEDGING 1. Better Define and Refine Your Objectives 2. Acknowledge and Adjust to Extraordinary Variables, e.g. Economical and Political Events 3. Utilize a More Mechanical and Quantifiable Approach 4. Compartmentalize Your Use of Discretion 5. Think Beyond the Current Year Page 21