Asset Management Agreements Perils and Pitfalls

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Asset Management Agreements Perils and Pitfalls

• 2006 Annual Meeting of the
• National Association of State Utility Consumer
  Advocates
• Lawrence T. Oliver
• tommy.oliver_at_scc.virginia.gov
• Assistant Director - Economics and Finance
• Virginia State Corporation Commission
• www.scc.virginia.gov/

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Disclaimer

• I work for the Staff of the Virginia State
  Corporation Commission. The views expressed in
  this presentation are mine and do not necessarily
  reflect the views of the Commission.

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What does asset management involve?

• Gas procurement function physical transactions
  that can be hedged with financial derivatives
• Pipeline optimization through capacity release -
  physical transactions
• Storage optimization through either physical
  sales of gas already in storage or physical
  injections into storage with either transaction
  being hedged with a derivative transaction such
  as a swap or forward contract

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Example of Storage Transaction with a Derivative
Contract

• In November 06 an asset manager sells 10,000
  MMbtu of stored gas at a price of 5.00 with the
  expectation that it will buy back the 10,000
  MMbtu of gas in January at the then January Henry
  Hub Monthly Index price (which, for the sake of
  this example, is 6.00).
• Simultaneously, the asset manager enters into a
  January 07 fixed for floating swap where the
  manager is obligated to buy at a fixed price of
  4.85 and obligated to sell at the January Henry
  Hub Monthly Index price (6.00).
• At the conclusion of the transaction the asset
  manager nets 1,500 minus transaction costs.

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Example Continued

• Physical
• Sell 10,000 _at_ 5.00 50,000
• Buy 10,000 _at_ 6.00 (60,000)
• (10,000)
• Financial
• Sell 10,000 _at_ 6.00 60,000
• Buy 10,000 _at_ 4.85 (48,500)
• 11,500
• 1,500
• Asset manager nets 1,500 minus transaction costs

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Risks Associated With AMAs

• Incentive to over-subscribe to storage or
  pipeline capacity
• Assignment of assets may result in loss of assets
  in the event of bankruptcy
• If gas or storage is needed may need to unwind
  transaction at a substantial loss
• Derivatives
• Counterparty risk
• Impact on earnings
• Increased liquidity requirements

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Derivatives What are they?

• A derivative is a financial contract whose value
  is derived from, or depends on, the price of
  some underlying asset. Equivalently, the value
  of the derivative contract changes when there is
  a change in the price of the underlying asset.
• Under the terms of the contract, at some
  specified time in the future, cash (or the
  underlying asset) is required to be exchanged
  depending on where the underlying assets price
  settles relative to the strike price specified
  in the contract.
• During the life of the contract, under certain
  circumstances, the contract is required to be
  marked-to-market, sometimes creating wide swings
  in income.

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Derivates Risky?

• Warren Buffet in Berkshire Hathaways 2002
  Annual Report stated
• Charlie and I are of one mind in how we feel
  about derivatives and the trading activities that
  go with them We view them as time bombs, both
  for the parties that deal in them and the
  economic system.
• Buffet went on to say
• The derivative genie is now well out of the
  bottle, and these instruments will almost
  certainly multiply in variety and number until
  some event makes their toxicity clear. Knowledge
  of how dangerous they are has already permeated
  the electricity and gas businesses, in which the
  eruption of major troubles caused the use of
  derivatives to diminish dramatically. Elsewhere,
  however, the derivatives business continues to
  expand unchecked. Central banks and governments
  have so far found no effective way to control, or
  even monitor, the risks posed by these contracts.

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Risks with Non-Affiliate as Asset Manager

• Counterparty risk Is the asset manager solvent
  enough to
• Make required payment to utility?
• Buy and deliver gas when needed?
• Enter into storage transactions?
• If there is a sharing mechanism in place can
  you audit the non-affiliate?
• Does contract give you audit rights?
• Is data stored in an easily accessible and
  understandable database?

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Risks with Affiliated Asset Managers

• Can increase capital costs for entire corporate
  family
• - Equity higher risk ventures require higher
  returns
• - Impact on capital structure
• - Debt rating agencies
• - Rating agencies use a consolidated ratings
  approach
• - With regard to Duke Energy Trading and
  Marketing, SP stated
• Despite DETM's strong credit profile, the
  venture's primary activity, the physical and
  financial trading of energy, entails considerable
  business risk. More exposure to risk is likely as
  DETM builds out its financial trading portfolio
  to capture higher trading margins and expand its
  customer base.

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Continued

• Incentive to over buy assets so that affiliated
  asset manager benefits
• Incentive to give better deals and cheaper gas to
  non-regulated affiliates
• - NUI Brokers
• Increases liquidity requirements
• Higher lines of credit, more short-term debt
  outstanding when transactions are out of the
  money
• How is this treated for ratemaking purposes

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Continued

• Fixed price contract fair price?
• Sharing arrangement no incentive for utility to
  audit falls on Commissions (easier to audit
  affiliates than non-affiliates)
• Indirect billing of costs through service company
  result in double recovery of costs

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Your greatest risk is sometimes where you least
expect it!