Network of Options for International Coal & Freight Businesses

Dr. Aram G. SogomonianConstellation Energy Commodities Group

Commodities 2007: Agriculturals, Energy & MetalsLondon, EnglandJanuary 19, 2007

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Constellation Energy Group (CEG) Review

• CEG provides energy services across the entire energy value chain

Our physical businesses scale and scope enable us to manage our risk at a lower cost than our peers when pursuing profitability

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Constellation Energy Commodities Group (CCG)

Business Overview• CCG operates in fuels and wholesale competitive supply. • CCG provides physical products to customers across the value chain.• CCG’s traditional base is power, with increasing focus on coal and gas.• Three business principles have driven our sustained growth:

– We focus where we have an edge Providing physical energy products to customers upstream and downstream.

– We compete to be the low cost provider Our portfolio management capabilities and scale have helped us to preserve margins.

– We deploy risk capital carefully We do not compete on risk tolerance or cost of capital. We stick to our strengths in managing physically delivered products.

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• Four business areas, all grounded in our business model of providing physical products to upstream and downstream customers, and relying on effective, conservative portfolio management

CCG Business Model

Natural Gas

CoalPower

Portfolio Management & Trading

Coal and Freight

Power

Gas

Coal

Generation

Production

Mining

Transmission

Midstream/ Interstates

Shipping/ Freight

Power Distributors/ Munis/Co-Ops

Gas Distributors/ Power Generators

Power Generators/ Industrial Users

Producers Consumers

• Integrated businesses that are suitable complements to our market-leading power business

– Intermediary role linking producers and consumers– Physical orientation with contractual assets along the value chain– Customer-centric model, leveraging knowledge of the physical system

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Coal Business OverviewCompetitive Focus• Transfer of successful power strategy to coal

– Global coal services business– Manage global coal supply portfolio– Provide structured contracts to meet domestic and international customer needs

• Focus on market areas of opportunity– Delivery Contracts

CCG works with downstream customers to maximize the flexibility in their supply channels

– Supply ContractsProducers prefer to sell coal “as is, where is” to accommodate production variability

– Transportation and logisticsCCG logistics expertise and transportation network reduces transport costs

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Changing Environment for Coal Industry Players

• Increasing competition in generation in many markets due to deregulation

• Increased risks in contract execution– Volatile freight market– Demurrage risks– Inland transport constraints – trains and barges– Emerging market risk in sourcing

• Changing domestic environmental regimes– Increasing SOx, NOx, and CO2 meaning less

certainty in future generation and more focus on coal quality

• Supply patterns changing– Declining domestic production in Europe and

USA– New coal mine developments in Pacific basin

• Changing Coal Market dynamics– European Power and Coal financial markets

driving world forward Coal Price– Influx of new players into markets increases

volatility.

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Value Provided to Coal Consumers

• CCG provides alternative structures for purchasing to meet customers’ needs

• CCG values fuel flexibility, both domestic and international, and will work with and reward customers with lower prices for quality expansion

• CCG provides logistics expertise in managing deliveries to station gate, including full outsource deals

– Managing shipping, demurrage, port, rail, barge deliveries

Structures can incorporate:

Ability to flex up and down on sulphur and volume

Ability to change from fixed price to floating price or floating price to fixed price

Cross-commodity transactions including tolling and cross-commodity indexation

Multiple currency capability

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Value Provided to Coal Producers

• Our strong credit rating allows term fixed or indexed price deals with adequate credit assurance

• Offer significant flexibility in pricing of purchases

– Ability to change from fixed price to floating price or floating price to fixed price allows producers to determine when to fix prices

– Multiple currency capability

CCG’s large shipment program means regular and sizable coal offtake with reliable logistics performance

Diverse, quality-flexible, global customer base means CCG can assist producers inmanaging unforeseen changes in production targets and quality

Term flexibility

Ability to contract for long terms to facilitate mine development/ capital investment

Ability to transact medium, spot, and afloat

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Freight Business Overview

Competitive Focus– Offshoot global coal business with primary responsibility to provide

services for Coal Business.– Provide structured contracts to meet Freight Owners and

international coal and Iron ore consumer’s needs.– Focus on Owners looking to look in a rate of return on the asset with

a player who is a significant user and shipper of coal with an exemplary record for performance and with a strong balance sheet.

– Focus on end Consumers who need to outsource their freight requirements or looking for partners with strong backhaul presence looking to provide an efficient efficient and alternative supplier of competitively priced Front Haul rates

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International Freight Market

• One of the first truly global market in world history• Very volatile and cyclical – tightly linked to world economy • Standard routes, trusted indices, transparent pricing mechanism• Vessels are interchangeable • Willingness from most market participants to trade freight • Active market going out 2 years• Well established and court tested industry specific physical contracts• ISDA flavoured contracts becoming the norm for freight derivatives • Customer relationship paramount• Highly intermediated

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CCG Freight Business Growth Aspirations

• Natural growth alongside the Coal business which will be shipping 23 million metric tonne by 2008

• CCG Capesize Fleet to grow to 30 vessels by 2008• Building out into Panamax operating in 2007 to prepare for growth in coal shipments from

Indonesia into the USA.• Focus on supplying front haul services to Korean and Japanese Steel Mills.• Focus on supplying freight services direct to our present Coal customers.• Move into Vessel acquisition to support and compliment the Underlying trading business.

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Risk Management Challenges

• Complex logistical network• Lack of price transparency, outside of major coal indices• Multi-dimensional coal quality differences and vessel chartering options (ownership, time

charter, voyage charter; vessel size, age, etc.)• Presence of various flexibilities in the coal/freight network that are difficult to quantify

and measure• Migration of coal production to developing countries, which gives rise to Emerging market

risks: sovereign, political, mine contingency, currency.• Relatively weak creditworthiness of coal/freight counterparties• Operational risks related to physical movements of coal and port operations

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International Coal & Freight Network

• Optimize and trade around the position going forward• Strengthen competitive position with coal producers in availability and price• Fortify relationship with coal buyers

Proved Reserves by 2005 ('000 MMT)

0.4

19.9

50.3

254.4

287.1296.9

0.47.7

50.2

115.7 112.3

192.6

0

50

100

150

200

250

300

350

Mid East South &

Central

America

Africa North

America

Europe &

Eurasia

Asia

Pacific

Total Coal Anthracite & Bituminous Coal

Source: BP Statistical Review of World Energy 2006

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Contract Details & Risks Mitigants

•Buy coal at source A, sell coal at destination B, buy forward freight from A to B to lock in the profits

•Contract details– Coal: deal term, buy/sell quantity, contract prices, coal quality– Freight: charter term, vessel size, freight rate, freight route

•Risks and mitigations

Lay off price risk through physical positions Limited Liquidity

Hedge the currency exposure at the point of transacting Currency Risk

Provisional price setting and reconciliations Lengthy Time Lag

Hedging through, for example, US TIP Inflation risk

Rejection limits within our multi source contract rejection limits into Korea and Europe Quality risk

CCG Master Agreement with clauses for default protect Credit risks

Forward coal contracts, freight index, time charter contracts Market price uncertainty

Mitigant Risk

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Deal Evaluation

• Deal values– Expected profit margin– Credit worthiness and credit charge– Hedging cost– Miscellaneous charge

• Risk capital requirements– Market risk (1-day VaR, 4 sigma) of energy scaled by N days to liquidate residual open

position and basis– Credit risk (maximum potential exposure times default probability)– Margin risk (liquidity cost of issuing letter of credit and contingent liability costs)

• Incremental values/VaRs to current coal portfolio

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Coal & Freight Flexibilities

• Multiple coal sources and destinations– Differentiated by coal quality, prices, and availability

• Potential choices of vessel types and freight routes– Vessel type: CapeSize, PanaMax, HandyMax, HandySize– Freight routes: FrontHaul, BackHaul, TransAtlantic, TransPacific– Chartering options: Time charter, Voyage charter

• Coal quality differentials and values in emission market – Calorific value, Sulfur content, Ash content

• Coal buy/sell quantity– x% swing options

• Timing flexibilities– Scheduling deliveries at a preferable time during a quarter or beyond

• Option to break IWL (institute warranty limits) on this vessel– Access to ice bound areas restricted between 15th December and 31st April

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Problem Description

• Evaluate coal/freight deals– Modeling of stochastic processes of coal prices and freight rates– Dependence structure should be captured– Deal evaluated based on contract details and market forecasts

• Identify individual new promising coal/freight deals through Heuristics– Compare coal prices at potential source/destination and the freight rate in between

• Identify promising new coal/freight deals, schedule time chartered vessels and optimize all resources through Portfolio Optimization– Maximize profitability with risk control– Observe all contractual and operational constraints– Take market uncertainty into account via stochastic programming

Locations of forward buys/sells, forward prices and spread curvesCCG and counterparty’s swing option +/- x% on contracted quantityDifferent vessel sizes / voyage routes for coal deliveryScheduling of coal deliveries at preferable time within contract allowance

– Reduce problem complexity by identifying potential coal sources/destinations and freight routes

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Portfolio Optimization Problem Formulation

• Objective: Maximize risk adjusted profit • Constraints

– Coal buy/supply contractual positions– Coal supply at source and demand at destinations– Vessel capacity and portability– Voyage time of coal delivery– Warehouse inventory control

• Uncertainty– Coal prices / freight rates

Define scenarios of discrete price levels– Coal quantity swing option

For option buyer: relaxed constraints in our buy contractFor option seller: define scenarios of counterparty’s exercising option

– Coal grade flexibilityConnect different coal grades by defining a grade replacement exercise cost matrix, and relax constraints to specific coal grade

• Methodology– Deterministic programming: for market estimation – Stochastic programming: formulate as a multi-stage problem and determine scenario

dependent business plans

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Model Output

• For individual deals valuation based on forward coal prices / freight rates– Expected value and risks of the current coal contract – Expected value and risks of the time charter freight contract– Expected value and risks of the current portfolio

• For portfolio valuation based on portfolio optimization– Promising new coal deals (time, from, to, quantity)– Voyage scheduling of time chartered vessels (time, from, to, quantity)– Voyage charter to be acquired from market in future for coal delivered (time, from,

to, quantity)– Incremental value and risks of adding one new coal contract into the portfolio– Value of the time charter freight contract based on the projected vessel schedules– Scenario-dependent business plans

• Evaluate each coal/freight flexibility– Identify and understand variables impacting the value of each flexibility– Prioritize available flexibilities in terms of value– Value of flexibilities at the portfolio level– Focus Commercial efforts on most valuable flexibilities

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Literatures

• Asset liability management– Wang and Neufville (2004), Building real options into physical systems with

stochastic mixed-integer programming. 8th Real Options Annual International Conference in Montreal, Canada.

• Energy market– Knittel (2002), Alternative regulatory methods and firm efficiency: stochastic

frontier evidence from the U.S. electricity industry, the Review of Economics and Statistics

– Sekar (2005), Carbon dioxide capture from coal-fired power plants: A Real Options Analysis, MIT Laboratory for Energy & the Environment report.

– Deng, Shen, and Sun (2006), Stochastic co-optimization for hydro-electric power generation in multi markets, to appear, IEEE Trans. Power Systems.

• Stochastic programming– Birge and Louveaux (1997), Introduction to Stochastic Programming, Springer, New

York.– Freund (2004), Optimization under uncertainty, working paper.– Dantzig and Infanger (1997), Intelligent control and optimization under uncertainty

with application to hydro power, European Journal of Operational Research.– Wallace and Fleten (2003), Stochastic Programming Models in Energy, in:

Ruszczynski and Shapiro (eds.), Stochastic Programming, Handbooks in Operations Research and Management Science.