Place your chosen image here. The four corners must just cover the arrow tips. For covers, the three pictures should be the same size and in a straight line. A Utility’s use of Financial Products February 6, 2012

2 Derivative (Financial Product)  A security whose price is dependent upon or derived from one or more underlying assets.  A contract between two or more parties  Common underlying assets  Stocks  Bonds  Commodities  Currencies  Interest rates  Market indexes Reference: Investopedia.com

3 Three Basic Uses of Derivatives 1.Speculation  Attempts to make money based on predicted moves in the market 2.Arbitrage  Arbitrage occurs when an investor can take a position for no cost, with no risk, and make a positive profit 3.Hedging  Goal is Risk Minimization  Company or individual already has a position in the market and uses forwards, futures, options, to minimize risk

4 Arbitrage  Interstate Natural Gas Pipeline Capacity  Locational spread  Purchase in location “A” transport and sell in location “B”  Natural Gas Underground Storage  Time spread  Purchase in time period “A” hold in storage and sell in time period “B”  Power generator  Tolling (spark spread)  Purchase fuel and sell power  Refinery  Refining Spread (Crack spread)  Purchase crude oil and sell refined products (heating oil, gasoline, jet fuel)

5 Effective Use of Derivatives  First determine what are the risks.  Are the risks quantifiable?  timing and amount  Make sure the hedge matches your risk or that you understand when and where it doesn’t match your risk.  Shift risk to other market participants  What are the costs to execute the hedge?

6 Futures vs. OTC  New York Mercantile Exchange (NYMEX)  Standardized natural gas futures and options contracts  10,000 dt per contract  Priced for purchase or delivery at Henry Hub, LA  No credit exposure; post margins  Trade via Introducing Broker or directly with the floor  Settled monthly on third to last business day  Over-the-Counter  Terms customized to individual customer needs  Counterparty credit exposure  Bilateral ISDA master agreements

7 Basic Financial Instruments  Swaps, (Fixed price, Futures)  A swap is an obligation on both parties’ part  Options  Puts (Floor)  Calls (Ceiling or cap)  An option is a right, but not an obligation for one party (buyer); and an obligation for the other party (seller)  Options are price insurance  Premiums are paid to purchase insurance

8 Financial Products  Input graph of various derivative %

9 Absolute Price Risk  Reduce price volatility  Residential heating and electric customers  Budget  Certainty to future costs  Maintain competitiveness  Airlines  Fertilizer manufacturers

10 Why use financial products?  Standardized contracts  Market liquidity  Disconnect price from physical delivery  Better pricing

11 Physical to Financial Correlation  Input gas slide

12 Hedge Example with Swap  Results  Protected against adverse price movement  Removed volatility from price Buy a November 2012 swap contract for $6.00 settled against index. Utility purchases gas from producers for delivery in November at index. $8.00 Physical $2.00 Financial $6.00 Net On October 27 th : Market is at $8.00 $- $2.00 $4.00 $6.00 $8.00 $/dt $4.00 Physical $(2.00) Financial $6.00 Net Market at $4.00 $(2.00) $- $5.00 $4.00 $6.00 $8.00 $/dt

13 Natural Gas Physical and Financial Settlement Counter- party Utility Gas Producer/ Supplier Receive Floating Price (NYMEX last day) Pay Fix Price Receive Physical Gas Pay Floating Price (Index Price) +$8.00-$6.00 -$8.00

14 Swaps vs. Options  Buying swaps commits you to fixed price  Options give the buyer price security and also the benefit of potentially more favorable prices in the future.  The party buying the insurance pays a premium because they receive something of value.  Examples  Calls are purchased to have the right to pay a fixed price but not the obligation. (Consumer calls)  Puts are purchased to have the right to receive a fixed price but not the obligation. (Producer puts)

15 Option Terminology  Strike Price - the price beyond which the buyer of the option benefits  Premium - what the buyer pays for the option  Pay off - the benefit received by the option buyer  Difference between strike and settled price N ote: The customer may specify either the strike price or the premium. Once you know one, the other is calculated based upon market levels.

Types of Option Settlements  Options should match the physical and pricing aspects of your portfolio  European – exercised only on the expiration date itself  American – exercised any time up to the expiration date  Asian – average price options

17 Hedge Example with Call  Results  Protected against price spike  Participate in downward price moves. Buy November 2012 $6.00 Call option for $0.80 premium, settled against NYMEX last day (index). Utility purchases gas from producers for delivery in November at index. $8.00 Physical $2.00 less $0.80 Financial $6.80 Net On October 27 th, Market is at $8.00 $- $2.00 $4.00 $6.00 $8.00 $/dt $4.00 Physical $(0.80) Financial $4.80 Net Market at $4.00 $(1.00) $- $5.00 $4.00 $6.00 $8.00 $/dt

18 Hedge Example with Collar Buy November 2012 Collar: buy a $6.00 Call option and sell a $5.00 Put for $0.50 premium. Utility purchases gas from producers for delivery in November at index. Results - Protected against price spike - Set floor price. $8.00 Physical $2.00 less $0.50 Financial $6.50 Net On October 27 th, Market is at $8.00 $- $2.00 $4.00 $6.00 $8.00 $/dt $4.00 Physical Loss of $1.00 plus $0.50 Financial $5.50 Net Market at $4.00 $(1.50) $- $5.00 $4.00 $6.00 $8.00 $/dt Market at $5.25 $(0.50) $- $5.00 $4.00 $6.00 $8.00 $/dt $5.25 Physical Loss of $0.50 Financial $5.75 Net

19 Power Generation - Spark Spread  A spark spread is the price difference between the fuel cost input and market price for electricity.  Example  Sell July power for $50/MWh  Hedge $4/MMbtu natural gas fuel for July 2012, converted to $40/MWh* Power price$50/MWh Fuel price$40/MWh Spark Spread$10/MWh * Assumed heat rate of 10,000 Btu’s per MWh

20 Crude Oil Prices

21 Brent/WTI Spread

22 Dodd Frank Impact to Energy Industry  No impact to exchange traded transactions executed on NYMEX  Creation of swap repository  Clear all transactions  Margin requirements  Real time reporting  Increased recordkeeping  Market participants to registration with CFTC  End user exemption  Provide financial security documentation  Guarantee, LOC, credit support agreement, pledged asset  Establish position limits