Asset Management Agreements

Perils and Pitfalls2006 Annual Meeting of the

National Association of State Utility Consumer Advocates

Lawrence T. Olivertommy.oliver@scc.virginia.gov

Assistant Director - Economics and FinanceVirginia State Corporation Commission

www.scc.virginia.gov/

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.

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

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.

Example Continued

Physical

Sell 10,000 @ $5.00 = $50,000Buy 10,000 @ $6.00 = ($60,000)

($10,000)FinancialSell 10,000 @ $6.00 = $60,000 Buy 10,000 @ $4.85 = ($48,500)

$11,500 $1,500

Asset manager nets $1,500 minus transaction costs

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

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 asset’s 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.

Derivates – Risky?Warren Buffet in Berkshire Hathaway’s 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.

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?

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, S&P 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.

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

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

Your greatest risk is sometimes where you least expect it!