Common Energy Derivatives and Their Use to Manage Risk Presenter: Jeff Jewell, DTE Energy

Agenda Common Derivative Structures Common Energy Products Common Risk Management Strategies

Common Energy Derivatives Physical vs. Financial Contracts Physical transaction A contract in which the actual (physical) commodity is transferred between parties to the contract. (i.e., Party A sells and delivers gas to Party B) Financial transaction A contract in which no commodity is transferred between parties and parties only exchange cash payments in amount equal to the financial benefit of holding the contract (i.e., Party A pays Party B the change in the contract value from inception to expiration)

Common Energy Derivatives Futures Exchange traded Essentially financial Forwards Over the counter (OTC) Physicals Swaps OTC Financials Options Exchange traded or OTC Physical or financial

Common Energy Markets New York Mercantile Exchange (NYMEX) Intercontinental Exchange Independent System Operator (ISO) Over-the-Counter Broker

Common Energy Derivatives Exchange Traded Futures and Options A legal agreement between a buyer or seller and the clearinghouse of a futures exchange Futures contracts generally have the following characteristics: They obligate the purchaser (seller) to accept (make) delivery of a standardized quantity of a commodity or financial instrument at a specified date or during a specified period, or they provide for cash settlement rather than delivery They are defined by standard delivery points and volumes They effectively can be canceled before the delivery date by entering into an offsetting contract All changes in value of open contracts are settled on a regular basis, usually daily. They carry no credit risk

Common Energy Derivatives Exchange Traded Futures and Options New York Mercantile Exchange (NYMEX) PJM Monthly Peak (JM) The Exchange provides financially settled monthly futures contracts for on-peak and off-peak electricity transactions based on the daily floating price for each peak day of the month at the PJM western hub (swap-like) Trading Unit: 2.5 MWs, equivalent to 40 megawatts (Mw) per peak day (between 19 and 23 days) depending on the month. Depending on the number of peak days in the month, the number of megawatt hours will vary (between 760 Mwh and 920 Mwh). Trading Months: The current year plus the next five calendar years. Termination of Trading: One business day before the last peak day of the month. Settlement: Financial, based on the arithmetic average of the PJM western hub real-time locational marginal price (LMP) for the peak hours of each day. Similar Off-peak Product available (JP)

Common Energy Derivatives Exchange Traded Futures and Options New York Mercantile Exchange (NYMEX) Natural Gas (NG) Futures Contract Trading Unit: 10,000 million British thermal units (mmBtu). Trading Months: The current year and the next five years Last Trading Day: Trading terminates three business days prior to the first calendar day of the delivery month. Delivery: The Sabine Pipe Line Co. Henry Hub in Louisiana Crude Option (LO) Trading Unit: Option: One NYMEX Division light sweet crude oil futures contract. Future: 1,000 US barrels (12,000 gallons) Trading Months: Crude oil options are listed seven years forward Last Trading Day: Option trading ends three business days before the underlying futures contract. Futures: Trading terminates three business days prior to the 25th of the month preceding the delivery month Delivery: West Texas Intermediate

Common Energy Derivatives OTC – Forwards (Physicals) Symmetrical exposure Over-the-counter contract to purchase or sell a specific quantity of a financial instrument, a commodity or a foreign currency Pre-determined specified price Settlement at a specified future date Can be settled by actual delivery of the item in the contract, or net cash settlement Credit Risk Exchange of Collateral, Letters of Credit, Parental Guarantee

Common Energy Derivatives OTC - Forwards Forward Sale of Power at $70 Delivers 100 MW Utility Marketer Pays $70/MW

Common Energy Derivatives OTC - Swaps Over-the-counter contracts to exchange cash flows as of a series of specified dates (swap) Based on agreed upon notional amount Pre-agreed fixed rate; pre-agreed variable index Symmetrical exposure Credit Risk Exchange of Collateral, Letters of Credit, Parental Guarantee Examples: Basis Swap (Natural Gas) Fixed vs. Float Swap

Common Energy Derivatives OTC - Swaps Fixed vs. Float swap Pay: $6/mmbtu Receive: Gas Daily Index $/mmbtu Pay Fixed ($6) Utility Financial Institution Receives Float (Gas Daily Index Price)

Common Energy Derivatives OTC - Options A financial instrument which represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a financial or physical asset at an agreed-upon price (strike price) during a certain period of time or on a specific date (exercise date). Option Premium: price the option holder pays for the right to buy or sell the financial or physical at a specified price in the future Accounting for Premium is over the life of the option, not the delivery period.

Common Energy Products/Contracts - Gas Natural Gas Transportation Full Requirements contracts Trigger contracts Park and loans Storage contracts Swing contracts Basis contract Take or pay contract

Common Energy Products/Contracts - Power Electricity Capacity Financial Transmission Rights (FTR) Auction Revenue Rights (ARR) Transmission & Distribution Spark spreads Tolling agreements Full requirements contracts Renewable Energy Credits Energy Products There are several different commodities that are traded in the Energy Industry. In general, they are power and the fuel required to produce electricity or heat homes (i.e. oil, gas, coal, etc). The two most heavily traded commodities are power and gas, and due to their unique infrastructures have several associated products that can be traded in the market. Power: Electricity – actual electricity that is generated and delivered counterparty Capacity – electricity that may be generated and delivered at the option of the purchaser of the capacity Transmission & Distribution – provides the purchaser with the capability to deliver electricity to from point-to-point within a region (transmission) or to retail end-users (distribution). Gas Gas – actual gas that is delivered to the counterparty Storage – the capability to store a fixed volume of gas in a third-parties storage facility. Transportation – provides the purchaser with the capability to deliver gas from location-to-location across the country.

Common Energy Derivatives and Their Use to Manage Risk How are these Products/Contracts Used? “Lock-in” prices To fix the purchase or sales price of an energy commodity at a future point in time Protect against unfavorable price movements Example: Collar (put and call) Swap Basis is the differential between the market price of a commodity and the market price of the same commodity, due to differences in the delivery point, time of delivery, or contract settlement. Basis Risk is the risk that the fluctuations in the differentials will adversely affect the company. Credit Risk is the risk that the counterparty (or customer) to the contract will not pay the amount owed for delivery of a commodity. Energy markets are particularly susceptible to this risk due to the nature of physical delivery and size of the corresponding payments. The risk that an energy trader is unable to deliver the agreed upon commodity to a counterparty is called Operational Risk. Operational risk is typically the result of failure in the commodity production or delivery infrastructure. If a fuel supplier or a power producer cannot deliver the commodity to the counterparty as agreed the seller can be responsible for liquidated damages.

Common Energy Derivatives and Their Use to Manage Risk Option Collar - A Zero Cost Collar strategy combines the sale of a Call Option and the purchase of a Put Option The Option premium collected by the sale of the Call Option with a higher strike price (capped sale price) will fund the purchase of a Put Option with a lower strike price (capped purchase price).

Sources of derivative value movement Changes in spot market rates – scratches surface Changes in forward market rates over the entire duration (tenor) of the instrument – present value of these changes affects current value Unusual terms (combined derivatives; leverage factors) Additional market factors (volatilities, correlations, spreads) Changes in creditworthiness (e.g., non-performance risk) of either or both counterparties, often mitigated by credit support agreements (collateral) and master netting arrangements to offset derivative assets and liabilities between the same two counterparties

Common Energy Derivatives and Their Use to Manage Risk Reduce earning volatility Investors/Capital Markets may desire predicable future earnings May be achieved by locking-in both the purchase and sales price of a product, regardless of future price movements Manage other risks Basis risk (locational) Credit risk Operational risk (physical delivery, plant outages)

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