Hedging Natural Gas Price Risk presentation to APPA 2004 Joint Action Workshop Dec. 5-7, 2004

2 Hedging Natural Gas Price Risk  Why risk manage?  FMPA’s situation  Hedge products pros and cons  Product mix

3 Why Risk Manage?  The electric generation business has many inherent risks  Some of these risks bear significant financial impacts  Develop a program to “manage” or mitigate these risks  Avoid bad outcomes

4 FMPA’s Precipitating Event

5 Other Precipitating Events  Catastrophic failure of generation  Fuel supplier insolvency  Loss of transmission or fuel transportation  Non-performance under long-term commitment

6 FMPA’s Response  Identified major risk – i.e. natural gas prices  Educated staff  Hired expertise, staff or consulting  Drafted energy risk management policy  Started slowly

7 Natural Gas Price Risks  Some entities may have a fixed price for natural gas imbedded in their rate structure  Others may be exposed to market based prices  Two different approaches  FMPA falls into the former category

8 How Much to Hedge?  Varies depending on risk appetite  FMPA started with a:  33% fixed price, 33% first-of-month index price, 33% daily spot price mixture  Determined that this didn’t provide enough protection  Moved to more fixed price protection

9 How Long to Hedge?  FMPA began with hedging the near-term period – roughly 6 months to 1 year  Empirical evidence that showed a month hedge profile showed greater success  FMPA moved to a longer-term program  Hedge % more heavily weighted toward near-term

10 Hedge Products  Products vary depending on price exposure  NYMEX Futures  Good liquidity for one year to eighteen months  Recognized standard for natural gas market  Works best for fixed price exposure  Margin requirements can be burdensome of cash flow

11 Hedge Products Continued  Swaps  Good liquidity for 1-6 years  Requires ISDA agreements with multiple parties  Depending on credit, may or may not require margining  Premium to NYMEX for added liquidity

12 Hedge Products Continued  Options  Calls - upside protection while allowing for downside participation  Puts – downside protection of fixed price hedges  Depending on market volatility, can be “expensive” protection

13 Hedge Products Continued  Collars  Combination of calls and puts  Sale of puts buys down cost of call  Spreads  Purchase a call, sell a higher strike price call  If market moves above higher strike, have spread advantage over market

14 Hedge Products Continued  Fixed price physical purchases  Good liquidity for 1-3 years  If load doesn’t materialize, must sell into market  Contracts with multiple counterparties  Credit becomes a concern

15 Hedge Products Continued  Basis Swaps  Good protection for market price exposure  Minimizes exposure to regionalized market swings  Doesn’t protect commodity exposure

16 What Products to Use?  Experimentation with a variety of products  Over time optimal mix will become evident  FMPA started with fixed price physical and futures  Current program has mixture of many product

17 How Much Does It Cost?  Hire some expertise, staff or consultant  Exchange broker fees are minimal  Option premiums can add up but can help avoid embarrassing outcomes  FMPA has allocated $2 million/year  Costs have run less than half of this

18 Final Comments  Determine where your exposures lie  Start slowly and educate staff and board  Hire expertise  Find the optimal product mix  Set expenditure limits and stay within them

19 Hedging Natural Gas Price Risk Questions?