Chris Fink

1
Managing Fuel Supply
Chris Fink Managing Director and Head of Public
Utilities Group Merrill Lynch Co., Inc.
January 19, 2006
CONFIDENTIAL
DRAFT
2
Managing Fuel Supply
1. Fuel Supply Risk Management 1 2. Coal Risk
Management 7 3. Natural Gas Prepayment
Financings 10
3
Fuel Supply Risk Management
4
Introduction to Commodity Risk Management
Risk Management Framework
1
5
Introduction to Commodity Risk Management
Risk Management Framework

• Changes in market fundamentals (supply and demand
  factors) drive price changes
• Natural gas and power prices exhibit high
  volatility because of frequent changes to market
  fundamentals
• Price volatility creates earnings risk (revenue
  or operating cost exposure)
• Earnings risk potentially results in
  shareholder/banker concerns which may inhibit
  growth and may result in increased
  cost-of-capital
• A risk management program addresses the impact of
  commodity price volatility in the context of
  corporate objectives and seeks to mitigate
  earnings volatility within acceptable bounds

2
6
Introduction to Commodity Risk Management
Risk Management Framework
Identify Risk Exposures

• NYMEX / Basis (Index / Volatility)
• Budgeted Energy Costs
• Return-On-Investment
• Swaps / Options / Combinations
• FAS-133 Hedge Effectiveness

Set Objectives / Price Targets
Choose Hedge Instruments
Check Accounting Impact
3
7
Introduction to Commodity Risk Management
Risk Management Objectives
Short-Term Tactical
Longer-Term Strategic
Competitive Advantage

• Marketing Advantage Through Pricing Alternatives
• Offer Physical Contracts With Embedded Hedges
  (Tailored Contracts)
• Manage Customers Price Exposures

• Corporate Budgeting
• Control Variable Costs
• Hedge Physical Transactions

• Reduce Cash Flow and Earnings Volatility
• Allow Greater Leverage
• Reduce Cost of Capital
• Hedge Against Industry Downturns
• Evaluate Marginal Investments
• Protect Return-on-Investment

4
8
Introduction to Commodity Risk Management
Types of Supply Risk

• Market Risk
• Price absolute value of a commodity
• Forward Curve difference between prompt and
  future delivery prices
• Basis difference between two price indices
• Volatility variability of prices over time
• Liquidity difference between bid and offer
  prices across the forward curve
• Counterparty Risk
• Credit ability of a counterparty to meet
  financial obligations
• Performance willingness of a counterparty to
  meet financial obligations
• Documentation ability of a counterparty to
  properly record and settle transactions

5
9
Introduction to Commodity Risk Management
Financial Hedge Building Blocks

• Swaps
• No initial cash payment
• Complete protection of prices rise (if long) or
  fall (if short)
• Opportunity loss if prices fall (if long) or rise
  (if short)
• Caps (Call Options)
• Upfront cash payment (premium)
• Complete protection if prices rise (if long)
• Buyer retains benefit if prices fall
• Floors (Put Options)
• Upfront cash payment (premium)
• Complete protection if prices fall (if long)
• Buyer retains benefit if prices rise
• Combinations
• Participating Swaps
• Collars

6
10
Coal Risk Management
11
Coal Risk Management
Trading Coal
Scope of Services
Coal and Emissions Trading Capabilities

• Established trading presence for physical and
  financial coal products
• Markets include US (East and West) and
  International (Physical, Financial and Freight)
• Product offerings for Eastern, Western and import
  coal markets Physical hedging and delivery,
  financial hedging, portfolio optimization, and
  producer financing
• Coal trading instruments include OTC forwards and
  options as well as NYMEX cleared contracts for
  Eastern and Western coals
• Emissions trading instruments for SO2 and NOx
  include OTC forward and financial products
  (NYMEX, Chicago Climate Exchange)

• Coal position management Purchasing,
  optimization, origination, analysis, and trading
• Emissions position management analysis,
  structuring, origination and trading
• Transportation management Negotiate rail,
  barge, and terminal agreements
• Scheduling and logistics management Provide
  rail, terminal, vessel and barge transportation

7
12
Coal Risk Management
Trading Coal
Coal and Emissions Trading Capabilities Overview

• Proprietary Trading
• Trading of standardized contracts in the OTC and
  Futures/NYMEX markets and U.S. emissions markets
• Integrate market knowledge into power, natural
  gas, and international coal trading businesses
• Coal Portfolio Optimization
• Additional service offering to clients
• Increase opportunities for physical arbitrage by
  utilizing trading and origination capability
• Structured Products
• Coal tolling
• Producer financing
• Long term coal hedging for development of new
  power plants
• Financial hedging of non-coal products
  synfuel/crude oil, ammonia nitrate, diesel

8
13
Coal Asset Optimization Overview

• Increased credit leverage against coal suppliers
  from aggregate portfolio
• Utilize market analytics to develop a long term
  strategic procurement plan for coal procurement
• Hedging strategy recommendations built on market
  analytics on the global coal marketplace
• Lower cost of hedging the coal portfolio
• Optimize the value of coal portfolio and plant
  combustion and storage flexibility
• Expanded market coverage and market intelligence
  (utility direct, producer direct, and OTC)
• Participation in optimization profits
• Anonymity to the marketplace

9
14
Natural Gas Prepayment Financings
15
Natural Gas Prepayment Financing
Executive Summary
Take advantage of favorable IRS regulations to
reduce natural gas costs

• The IRS has enacted very favorable final
  regulations which allow municipal utilities to
  use tax-exempt bond proceeds to purchase a future
  supply of natural gas or electricity
• The Municipal Utility could take advantage of
  these regulations by structuring pre-paid natural
  gas transactions to reduce the net cost of
  electricity funded with tax-exempt bond proceeds
• In todays interest rate environment, Municipal
  Utilities can prepay for natural gas or
  electricity using tax-exempt bonds and lock-in
  savings below index gas
• Under federal tax law, Municipal Utilities can
  contract for an amount of gas up to the level
  which is used to create electricity provided to
  both residential as well as commercial and
  industrial users
• These transactions can be structured so that the
  Municipal Utility deliveries are sculpted to
  match projected demand (i.e., no gas delivered in
  months in which gas-fired facilities are not
  expected to be used)

10
16
Natural Gas Prepayment Financing
Fixed Volume Prepayment Structure
Highly Rated Commodity Swap Provider
Index Gas Pmt.
Index Gas Pmt.
Fixed Gas Pmt.
Fixed Gas Pmt.
Monthly Flows
Scheduled Gas at Index minus predetermined
discount
Prepayment
Energy Trading Company
Municipal Utility
Issuer
Scheduled Gas
Payments (equal to a ratable percentage of fixed
debt service plus or minus adjustment)
Bond Proceeds
Principal Interest
Performance Surety Provider
Security Interest
Investors
Security Interest
11
17
Prepayment Transactions for Coal?
Why not?
Why prepayment transactions have yet to be
structured for coal?

• The current Treasury Regulations and Internal
  Revenue Code only allow for two specified
  commodities natural gas and electricity
• However, under the Treasury Regulations, the
  Commissioner of the IRS may, by published
  guidance, set forth additional circumstances in
  which a prepayment can be made for other types of
  fuel
• Query Can these rules be extended to coal supply?

12