[PDF] - Welcome! To the Power Supply Issues for Cooperatives: Forecasting PDF Document

SLIDE 1

1

To the Power Supply Issues for Cooperatives: Forecasting Fuel and Power Supply Cost Web conference.

July 28, 2010

Welcome!

How to Submit Your Questions

Step 1: Type your question here. Step 2: Press “Send” to submit your question.

3

Power Supply Issues for Cooperatives: Forecasting Fuel and Power Supply Cost

For: NRECA’s Cooperative Financial Professional Certificate

By: John Sturm, VP Corporate Development, ACES Power Marketing July 28, 2010

SLIDE 2

4

Polling Question

What is your biggest concern with fuel and power cost forecasting for your cooperative or your G&T?

A. I do not like the unpredictability fuel causes in the cost
f power

B. There is no transparency in measuring and reporting the uncertainty in fuel and/or power costs C. I do not understand the opportunities, costs, and benefits of hedging fuel and/or power costs

D. Uncertainty has a big impact on my margins and cash

management E. All the above

5

Training Objectives and Webinar Outline

Objectives

To identify the primary

commodities that cause power cost uncertainty

To explain fuel/power

price volatility

To examine how firms

forecast fuel/power costs

To summarize

alternative methods for managing commodity price risk

Webinar Outline

1. Fuel and power cost volatility 2. Primary energy risks 3. Methods of forecasting fuel and power prices 4. Hedging 101

6

Commodity price uncertainty is as common as

uncertainty in the forecast of future temperature, levels of rain and snow, the economy, the stock market, and the price of eggs.

Power prices are highly correlated with the primary

fuels used in the region, but many external factors influence power prices also.

An evaluation of historical prices can illustrate volatility

and explain some of the events that make forecasting fuel and power prices difficult.

Fuel and Power Cost Volatility

Overview

SLIDE 3

7

Fuel and Power Cost Volatility

Eastern Markets

Power prices

vary and are correlated with different variables in each region of the country.

For example, in

PJM, natural gas prices have a big influence on power prices while both natural gas and coal prices have a bigger influence on off- peak prices.

* Capp Big Sandy 1200 1.2

Historical Spot Prices $0.00 $50.00 $100.00 $150.00 $200.00 $250.00 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10

$/MWh

PJM West on peak PJM West off peak

$0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00

Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10

$/mmBtu (Gas)

$0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00 $9.00

$/mmBtu (Coal)

NYMEX Gas Eastern Coal *

8

Fuel and Power Cost Volatility

Texas Markets

In Texas (ERCOT

market) natural gas is the primary fuel stock for generation and correlates highly with power prices, both on and off peak.

However, the

addition of wind generation is beginning to affect power prices especially during

ff-peak hours.
Sometimes off

peak hours can have negative prices.

* PRB BNSF UP 8800 0.8

H is t o r ic a l S p o t P r ic e s $ 0 .0 0 $ 2 0 .0 0 $ 4 0 .0 0 $ 6 0 .0 0 $ 8 0 .0 0 $ 1 0 0 .0 0 $ 1 2 0 .0 0 $ 1 4 0 .0 0 $ 1 6 0 .0 0 $/MWh E R C O T - o n p e a k E R C O T - o ff p e a k

$ 0 .0 0 $ 2 .0 0 $ 4 .0 0 $ 6 .0 0 $ 8 .0 0 $ 1 0 .0 0 $ 1 2 .0 0 $ 1 4 .0 0

Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 $/mmBtu (Gas)

$ 0 .3 0 $ 0 .5 0 $ 0 .7 0 $ 0 .9 0 $ 1 .1 0 $ 1 .3 0 $ 1 .5 0 $ 1 .7 0 $ 1 .9 0

$/mmBtu (Coal) N Y M E X G a s W e s te r n C o a l *

9

In the Northwest, hydro generation is abundant and influences power prices heavily.
Rain, snow melt, and the resulting reservoir levels have a huge influence on the price of

power.

Hydro power is somewhat “storable” so power prices are related to reservoir levels.
Fuels, mostly natural gas, impact western power price but its overall impact is highly

dependant on very specific locations.

Fuel and Power Cost Volatility

Northwest Market

Power Prices and Average Reservoir Levels

$0.00 $20.00 $40.00 $60.00 $80.00 $100.00 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10

$/MWh

7000000 7500000 8000000 8500000 9000000 9500000 10000000 J u l

7

S e p

7

N

v
7

J a n

8

M a r

8

M a y

8

J u l

8

S e p

8

N

v
8

J a n

9

M a r

9

M a y

9

J u l

9

S e p

9

N

v
9

J a n

1

M a r

1

M a y

1

J u l

1

Acre-feet

COB Power ($/MWh) Reservoir Level (Acre-feet)

SLIDE 4

10

Fuel and Power Cost Volatility

Coal, Oil, and Gas Markets

Natural gas and Heating
il (Diesel) have

correlated price movements.

Heating oil had a huge

downturn in prices beginning July of 2008, due to the economic recession and the decline in the value of the dollar (oil is traded globally in US $, so a weakening $ causes oil price declines).

Coal prices correlate

with oil because it requires diesel oil to run the mining process machines.

Coal delivery charges

(not illustrated) are highly correlated to oil prices.

Coal delivery can

represent 70% of the Western Coal prices. ** PRB BNSF UP 8800 0.8 * Capp Big Sandy 1200 1.2

Historical Spot Prices

$0.00 $5.00 $10.00 $15.00 $20.00 $25.00 $30.00 $35.00 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10

$/mmBtu (Heating Oil)

$0.00 $5.00 $10.00 $15.00 $20.00 $25.00 $30.00 $35.00

$/mmBtu (Gas)

Heating Oil NYMEX Gas $0.00 $5.00 $10.00 $15.00 $20.00 $25.00 $30.00 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 $/mmBtu (Heating Oil) $0.00 $1.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00 $/mmBtu (Coal) Heating Oil Eastern Coal * Western Coal **

11

Fuel and Power Cost Volatility

Other Influences

The economy (i.e. demand for electricity)
Location

– Primary generation sources – Generation reserve levels – Transmission availability to reach alternative markets/sources – Fuel availability and delivery cost

Your power supplier’s portfolio

– Types of generation, reliability, and reserve levels – Fuels used and level of fuel hedging activities – Ability to optimize the assets

Regulatory action, for example

– Carbon legislation – Renewable portfolio standards – Energy efficiency requirements

12

What fuel related factors do you believe affect your power cost uncertainty the most?

A. Cost of coal
B. Cost of natural gas
C. Availability of hydro power
D. Delivery of power or fuel
E. Other – please submit via the chat box

Polling Question

SLIDE 5

13

Primary Energy Risks

Commodity market price risk

Risk of loss due to potential fluctuations in the prices
f a commodity
Due to heavy reliance on fossil fuel generation units,

most cooperatives have a natural short position in fuel

Commodity market price risk occurs across all tenors,

from the hourly market to the long-term forward market (5 years +).

Cooperatives can be exposed to commodity price risk

for power, coal, natural gas, emission allowance (SO2 and NOX), fuel oil and various bulk materials (e.g. ammonium, limestone) that exhibit price volatility.

14

Operations Risk Volumetric Risk Commercial Operational Risk Congestion Risk Delivery Risk Credit & Margin Risk

Commodity Price Risk

Most risks eventually manifest themselves back to commodity price risk

Primary Energy Risks

15

Commercial operational risk

– Risk of loss due to inadequate or failed internal processes, people, and systems. A lack of skills or tools to manage risk.

Credit and margin risk

– The risk of a potential adverse occurrence of a counterparty’s ability to fulfill its obligations by declaring bankruptcy or abrogating a favorable contract – Cash margin risk is the risk associated with inadequate cash flow resulting from credit margin requirements of a contractual agreement.

Primary Energy Risks

SLIDE 6

16

Operations risk

– Risk associated with physical assets. – Failures or outages associated with generation units, fuel delivery systems, generation step-up transformers, the transmission system, control systems, or other critical components associated with the production or delivery of energy.

Operations risk example:

– Your power supplier relies on one - 500 MW coal plant to supply about 70% of its energy requirements. – Coal prices for the plant have been hedged and the variable production cost of the plant is expected to be $25/MWh. – Your average expected wholesale rate is $60/MWh, based

n the supplier’s expected total cost. Total sales is

6,257,150 MWh and total budget cost/revenue is $375,429,000.

Primary Energy Risks

17

Operations risk example (cont.):

– During April a tornado strikes the plant causing a 6 month

utage and leaving an unintended shortfall of 2,190,000

MWh of supply, or 35% of its annual power supply requirements. – Replacement power must be purchased from the market at a cost $55/MWh or $30/MWh more than the budgeted cost. The incremental cost is $65,700,000, or an 17.5% increase in annual rates (or depending on rate structure perhaps a 35% increase via the fuel adjustment for 6 months). – Instead of $60/MWh for the year, you pay $70.5/MWh for 12 months or $81/MWh for 6 months. – Hedging:

The cost of repairs is likely covered by business interruption

insurance.

Hedging replacement power cost can be done through some

sort of catastrophic hedging technique, but it would be expensive

Primary Energy Risks

18

Delivery risk is the risk that a cooperative cannot meet a

firm supply obligation with its intended resource due to a transmission or fuel delivery constraint.

Congestion risk is the risk of negative price differentials

between the location of power supplies and the demand

location. If a cooperative needs to buy electricity and the

transmission system is congested, it would pay a premium to secure what is needed.

Volumetric risk is the risk that energy commodity supply
r demand volumes will vary from expected needs causing an

unintended long or short commodity position. The most common volumetric risks are:

– Fuel volume estimate errors – Load forecast errors – Loss of a significant load

Primary Energy Risks

SLIDE 7

19

Polling Question

Aside from commodity price risk, what other specific primary energy market risk do you believe is of most concern to you or your power supplier?

A. Operations risk (Generating unit outages)

B. Credit and margin risk (Counter party default or cost to margin transactions) C. Volumetric risk (Loss of demand, inability to predict fuel requirements or hydro availability)

D. Delivery or Congestion risk (Located in a congested area

with few alternatives) E. Lack of a Diversified Portfolio

20

Methods of Forecasting Fuel and Power Prices

Overview

Forward Curves

A Forward Price Curve is an identifiable market price for a commodity for

future delivery dates. All market participants share the same forward price curve in liquid markets.

– The forward curve is based on current market perceptions of willing buyers and willing sellers. – Buyers and sellers base their perceptions on either fundamental or technical views. – Forward curves change everyday, so forecasting prices using forward curves yields a daily updated price “forecast “

Fundamental Price Forecast

A Fundamental Price Forecast represents someone’s proprietary view of future

prices based on a proprietary method of developing such a forecast.

– Consulting firms and governmental agencies are the primary entities that develop price forecasts – Forecasting entities typically provide several forecast scenarios depending on various key assumption differences (e.g. carbon legislation case vs. no legislation, slow economic recovery vs. rapid recovery)

Price forecasting involves extensive effort in modeling and estimating

numerous supply and demand factors in attempting to estimate future prices

21

Methods of Forecasting Fuel and Power Prices

Eastern Market

Forward price data show the seasonality of prices
Commodities with less storage have more seasonal price differences
Some commodities (e.g. coal) do not trade as far forward as others

* Capp Big Sandy 1200 1.2

Forward Prices

$40.00 $45.00 $50.00 $55.00 $60.00 $65.00 $70.00 $75.00 $80.00 A u g

1

N

v
1

F e b

1

1 M a y

1

1 A u g

1

1 N

v
1

1 F e b

1

2 M a y

1

2 A u g

1

2 N

v
1

2 F e b

1

3 M a y

1

3 A u g

1

3 N

v
1

3 F e b

1

4 M a y

1

4 A u g

1

4 N

v
1

4 F e b

1

5 M a y

1

5 A u g

1

5 N

v
1

5 $/MWh $0.000 $1.000 $2.000 $3.000 $4.000 $5.000 $6.000 $7.000 $8.000 $/mmBtu

PJM West ($/MWh) NYMEX Gas ($/mmBtu) Eastern Coal ($/mmBtu) *

SLIDE 8

22

Methods of Forecasting Fuel and Power Prices

Texas Market

Notice that natural gas seasonal prices are highest in the winter while ERCOT power prices

are highest in the summer. This is due to demand factors of each commodity.

Remember that delivery costs for Western Coal (PRB) are highly influenced by oil prices,

Delivered prices are not reflected below and delivery can represent 70% of total cost.

Fundamental forecasts must be relied upon after observable forward prices end.

* Western Coal = PRB BNSF UP 8800 0.8 Forward Prices

$0.00 $10.00 $20.00 $30.00 $40.00 $50.00 $60.00 $70.00 $80.00 $90.00 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 $/MWh $0.000 $1.000 $2.000 $3.000 $4.000 $5.000 $6.000 $7.000 $8.000 $/mmBtu

ERCOT ($/MWh) NYMEX Gas ($/mmBtu) Western Coal ($/mmBtu) *

23

Methods of Forecasting Fuel and Power Prices

Northwest Market

While COB spot market prices are highly influenced by hydro reservoir levels, the forward

prices trend with natural gas prices. Much of this is due to uncertainty in hydro levels beyond the immediate season.

COB forward prices show 3 seasonal peaks. Summer and Winter - during the high demand

periods and Spring during the rain and snow melt run-off periods.

* Western Coal = PRB BNSF UP 8800 0.8 * Forwards curves from March of each year Forward Prices

30.00 35.00 40.00 45.00 50.00 55.00 60.00 65.00 70.00 75.00 80.00 A u g

1

N

v
1

F e b

1

1 M a y

1

1 A u g

1

1 N

v
1

1 F e b

1

2 M a y

1

2 A u g

1

2 N

v
1

2 F e b

1

3 M a y

1

3 A u g

1

3 N

v
1

3 F e b

1

4 M a y

1

4 A u g

1

4 N

v
1

4 F e b

1

5 M a y

1

5 A u g

1

5 N

v
1

5 $/MWh 0.000 1.000 2.000 3.000 4.000 5.000 6.000 7.000 8.000 $/mmBtu

COB ($/MWh) NYMEX Gas ($/mmBtu) Western Coal ($/mmBtu) *

24

Methods of Forecasting Fuel and Power Prices

PJM History of Forwards

Forward prices change everyday. These charts show how forward power prices have

changed over the three “snap shots” of time, each in March of the respective year.

In 2009 during the financial meltdown, several trading shops (many of which were

bank affiliates) ceased power trading or shut down their energy trading units

altogether. This caused illiquidity in forward trading and reduced the duration of

forward curves for a while.

* Forwards curves from March of each year

PJM West Forward Curves

$40.00 $50.00 $60.00 $70.00 $80.00 $90.00 $100.00 $110.00 $120.00 $130.00 $140.00 J u l

1

O c t

1

J a n

1

1 A p r

1

1 J u l

1

1 O c t

1

1 J a n

1

2 A p r

1

2 J u l

1

2 O c t

1

2 J a n

1

3 A p r

1

3 J u l

1

3 O c t

1

3 J a n

1

4 A p r

1

4 J u l

1

4 O c t

1

4 J a n

1

5 A p r

1

5 J u l

1

5 O c t

1

5 $/MWh 2010 2009 2008

SLIDE 9

25

Methods of Forecasting Fuel and Power Prices

Gas History of Forwards

Natural gas curves were clearly backwardated (downward sloping) in 2008

indicating consensus that that a short term supply shortage existed and prices would eventually settle into a lower price range.

Note that prices for natural gas quoted for 2015 have not changed much in the

past 3 years.

Normally the forward curve rises in future periods. This is called contango, or a

forward curve that is upward sloping like we see in the current market.

* Forwards curves from March of each year Natural Gas Forward Curves

$4.000 $5.000 $6.000 $7.000 $8.000 $9.000 $10.000 $11.000 $12.000 A u g

1

N

v
1

F e b

1

1 M a y

1

1 A u g

1

1 N

v
1

1 F e b

1

2 M a y

1

2 A u g

1

2 N

v
1

2 F e b

1

3 M a y

1

3 A u g

1

3 N

v
1

3 F e b

1

4 M a y

1

4 A u g

1

4 N

v
1

4 F e b

1

5 M a y

1

5 A u g

1

5 N

v
1

5 $/mmBtu 2010 2009 2008

26

Methods of Forecasting Fuel and Power Prices

Heating Oil History of Forwards

Heating oil trading is fairly liquid about 30 months out.

* Forwards curves from March of each year

Heating Oil Forward Curves

$10.00 $12.00 $14.00 $16.00 $18.00 $20.00 $22.00 $24.00 $26.00 $28.00 $30.00 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 $/mmBtu 2010 2009 2008

27

Methods of Forecasting Fuel and Power Prices

Central Appalachian Coal Forward History

Coal is the least liquid (ability to readily buy or sell) commodity of those described in this

presentation.

Trading coal out beyond 2-3 years is difficult to accomplish.
Coal forward prices indicate the trend in expected prices, but coal contracts are typically

structured so that coal prices adjust to key inputs (oil and labor) in the cost to produce coal.

Sophisticated risk managers may hedge the oil input cost of a coal contract with oil

hedging instruments

* Forwards curves from March of each year C APP B ig Sandy C oal Forw ard C urves

$55.00 $65.00 $75.00 $85.00 $95.00 $105.00 $115.00 $125.00 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 $/ton 2010 2009 2008

SLIDE 10

28

Methods of Forecasting Fuel and Power Prices

Powder River Basin 8,800 Forward History

Delivery charges can represent a significant portion of the delivered cost of coal, especially

with PRB coal.

For PRB coal, the delivered cost can run 2-3 times higher than the cost represented below,

especially for generating units far from the PRB producing region.

Oil prices dictate a large percentage of delivery cost, but rail availability also contributes to

the delivery cost of PRB coal.

* Forwards curves from March of each year PRB Coal Forward Curves

5.00 7.00 9.00 11.00 13.00 15.00 17.00 19.00 21.00 23.00 25.00 Aug- 10 Sep- 10 Oct- 10 Nov- 10 Dec- 10 Jan- 11 Feb- 11 Mar- 11 Apr- 11 May- 11 Jun- 11 Jul- 11 Aug- 11 Sep- 11 Oct- 11 Nov- 11 Dec- 11 Jan- 12 Feb- 12 Mar- 12 Apr- 12

$/mmBtu 2010 2009 2008

29

There are 33 liquidly traded power locations…

– But there are 1,000s of relevant pricing locations depending on YOUR situation – APM produces forward price curves for 17 traded locations – APM produces another 15 forward curves for non-traded locations

There are 91 liquidly traded natural gas locations….

– But there are 1,000s of relevant pricing locations – APM produces forward price curves (forecasts) for 39 locations

Heating oil (#2) is liquidly traded and fungible, and delivery of oil

products has relatively little influence on overall cost.

Coal is not always a fungible commodity since there are hundreds of

coal qualities with varying heat content, levels of ash, moisture, sulfur, etc…

– Coal markets are very localized – There are about 16 liquidly traded hubs (APM produces forward price curves for all 16). APM also develops 16 curves for other locations/coal types – Theoretically, every mine produces a different type of coal that must be priced according to its make-up – Coal delivery is a significant cost component

The New York Mercantile exchange (www.nymex.com) trades selected

energy commodities and provides forward curves for each commodity it lists.

Methods of Forecasting Fuel and Power Prices

Challenges of Maintaining Forward Curves

30

Forecasting Volatility

Understanding potential future volatility in commodity

prices is just as valuable as understanding the level of potential prices.

Key Uses for Volatility Forecasting

Several risk management processes rely on volatility

forecasts, including:

– Measuring and reporting the level of risk/uncertainty in “forecasts” – Cash management – Evaluating cost and risk trade-offs of commodity hedging decisions

Methods of Forecasting Fuel and Power Prices

Volatility Forecasting and Uses

SLIDE 11

31

Stochastic forecast models (Monte Carlo simulations) can utilize available

market data (using options) to determine the anticipated volatility that can be expected in a particular commodity.

Volatility forecasting can provide a sense of the floor and ceiling on future

commodity prices.

Hedging can remove some of the anticipated volatility

Methods of Forecasting Fuel and Power Prices

Volatility Forecasting Method

32
The forward price curve should be the same for all

participants, but fundamental price forecasts will vary

A forward price curve may not be available for long

term prices so a fundamental price forecast(s) may be essential for long term evaluations

Forecasts must be very specific to the delivery location
Do not rely on past prices or historical volatility to

represent a forecast of future prices or volatility

Methods of Forecasting Fuel and Power Prices

Summary

33

Which applies to a forward price curve?

A. The forward view of prices can change everyday
B. There is no mathematical model that predicts the

forward price

C. The duration (how far into the future prices are

available) of forward price curves is the same for all commodities

D. All the above
E. A and B only

Polling Question

SLIDE 12

34

Which applies to a fundamental price forecast?

A. It is an entity’s proprietary view of future prices
B. They are relatively easy to produce and update daily
C. You can find many parties in the market to transact at

a price produced from a fundamental price forecast

D. All the above
E. A and B only

Polling Question

35

Hedging 101

Definitions

“Hedging is any transaction that moves the corporate risk

profile toward the shareholder’s desired risk profile in the most efficient manner possible.”

Energy & Power Risk Management, February 2002

The Management and Board should strive to achieve a

consistent understanding of what a “hedge” means to the Cooperative

Hedging can partially or totally eliminate power supply

cost risks Hedge: A transaction that offsets risk. Hedge: A transaction intended to reduce the risk of commodity price fluctuations.

36

Hedging 101

Why Hedge? or Not?

Alternative reasons to hedge fuel and power, or

not:

– Create Stable and Predictable Rates (Reduce Volatility), or – Maintain Rates Within Acceptable Ranges, or – Remain at Market

Whether you hedge, or not, is not as important as

knowing why you choose to hedge or not

Board consensus is a fiduciary responsibility
Doing nothing is a risk management decision

SLIDE 13

37

Hedging 101

What is Your Risk Tolerance?

The amount of risk an entity is willing to take in meeting its hedging objectives:

Low risk tolerance

− Disciplined price averaging of hedges

High risk tolerance

− Market timing strategies

38

Hedging 101

A Balancing Act Risk Tolerance Hedging Objectives Alignment: Board=>Mgmt=>Staff A Hedge Policy Creates A Disciplined Approach to Hedging

39

Hedging 101

Hedge Policy/Plan Illustrations

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Q 2 Q 3 2 1 Q 4 2 1 Q 1 2 1 1 Q 2 2 1 1 Q 3 2 1 1 Q 4 2 1 1 Q 1 2 1 2 Required History

Energy Hedge Ranges Time Horizon Current Quarter Quarters 1 and 2 Quarters 3 and 4 Quarters 5 and 6 Measurement Period Monthly Calendar Quarter Calendar Quarter Calendar Quarter Range (%) 50-80 40-60 30-50 20-40

SLIDE 14

40

Hedging 101

Key Points

Hedging can reduce some fuel or power cost

forecasting uncertainty

Entities that choose not to hedge will have more

volatility and uncertainty and must address this through rates and cash management

41

Entities hedge for which of the following reasons?

A. To create more stable and predictable costs
B. To buy at the bottom of the market
C. To maintain commodity prices within desired

boundaries

D. All the above
E. A and C only

Polling Question

42

Conclusion

Forecasting power and fuel is complex and challenging
Forward curves are the most suitable method of forecasting

commodity prices because they represent the price at which you can hedge

Forward curves change everyday
Understanding the potential volatility in your future forecast and

how to manage it is equally important to understanding the price level of power and fuels

Your location and portfolio make-up dictates the risks, and power

and fuel hedging necessary to manage

Hedging can eliminate some uncertainty in power and fuel prices

and forecasted costs

The degree of hedging depends on your company’s objectives

and risk tolerance…and the Management and Board of Directors has a fiduciary responsibility to determine consensus on such

SLIDE 15

43

Examining Energy Derivatives August 11, 2010, 1:30 – 3:00 PM

Objectives

To define a derivative
To explain the most

common derivatives transacted by electric utilities

To demonstrate how

selected derivatives work and their uses

To provide a summary of

key considerations before using derivatives

Outline

1. What is a derivative? 2. Widely used derivative instruments (Futures, swaps, options) 3. Uses and examples of selected derivatives 4. Key considerations (contracts, margining, 85/15, accounting treatment)

44

Trading Instruments – Power and Gas

Physical Power Instruments

Spot Market

– Hourly, Daily, Balance of (week, month)

Index

– Hourly – Daily – Monthly

Forward Contracts Examples (Monthly,

seasonal, annual, Long term)

– 7X24, 5X16 (Mon - Fri on peak block), 6X16(Mon - Sat on peak block), 5X8 (Mon - Fri off peak block), 2X24(Sat, Sun block), 7X8 (Mon - Sun off peak block), Wrap (5X8 + 2X24), others

Options

– Hourly put/call options – Daily put/call options – Monthly put/call options – Heat Rate Options

Structured products

– Endless alternatives

Physical Natural Gas Instruments

Spot Market

– Hourly, Daily, Balance of (week, month)

Index

– Daily – Monthly

Forward Contracts

– Ratable daily delivery – Monthly, Seasonal, Long Term

Options

– Daily put/call options – Monthly put/call options

Financial Derivatives

RTO LMP (financial spot market)
Futures contracts
Swaps
Unit outage insurance
Put and call options
Heat rate options
Weather derivative
Structured financial products

45

What is a Derivative?

Trading Definition: An instrument in which the underlying asset is based on

energy products including oil, natural gas, coal, and power, which trade either

n an exchange or over-the-counter. Energy derivatives generally included are
ptions, futures, or swaps, but other derivatives exist.
SFAS 133 Accounting Definition: A financial instrument or other contract with all

three of the following characteristics:

– It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions, or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required. – It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. – Its terms require or permit net settlement, it can readily be settled by a means

utside the contract, or it provides for delivery of an asset that puts the recipient in a

position not substantially different from net settlement.

There are physical and financial derivatives
The accounting definition of a derivative, and the products requiring derivative

accounting treatment differ from the trading definition.

For the August 11 seminar the focus will be on financial derivatives including

swaps, futures, and financial options.

SLIDE 16

How to Submit Your Questions

Step 1: Type your question here. Step 2: Press “Send” to submit your question.

John Sturm Vice President of Corporate Development ACES Power Marketing Email: johnst@acespower.com Office Phone: (317)344-7034

47