CHARLES RIVER ASSOCIATES

Jack YeagerGEMI Conference

January 21, 2005

CRA Capital Management in Commercial Optimization

2

More Capital vs Risk could:

Reduce cash flows and earnings surprises

Reduce amount of “self-insured” risks

Increase Cost of Risk

Reduce availability of new investments with acceptable risk/return characteristics

Reduce ability to introduce new products to market

Reduce value of equity

Reduce strategic flexibility

Increase Strategic Risk

Sustain

Taking on too much risk could:

Increase profitability from investments / transactions

Increase amount of “self-insured” risks

Reduce quality of credit

Increase WACC

Reduce availability of investments that satisfy hurdle

Reduce availability of counterparties willing to do business

Reduce strategic flexibility

Increase Strategic Risk

Grow

Capital Management – Capital Adequacy in Context

The challenge for every company is to both ensure adequate capital to sustain the business while delivering returns that grow capital

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Capital Management - The Competitive Landscape

Capital Management Strategy

Private Equity

•Good deals seek capital

•Deal level Transparency

•Competition breed discipline

Investment Banks

•Capital seeks good deals

•Regulatory Assurance

•Compliance breeds discipline

Energy T&M

•Business model seeks capital

•SEC Financial Performance

•Ambiguity breeds complacency

Transparent Capital

Discipline

Regulated Capital

Requirements

Divest of Assets

Energy Trading & Marketing Businesses are feeling increasing competitive pressure from I-Banks & Private Equity to manage capital more effectively…

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Capital Management - Down & Dirty

The primary competitive advantage of Energy Trading & Marketing companies is their experience in employing a variety of complex commercial optimization strategies in delivering value…but this advantage is only temporary

Hedging • “hedge everything from

18 months to 6 months 50%, 6 months & in up to 90%”

• “hedge is part of portfolio strategy & is put on based on positions rules”

• “hedge is economic, but distinct from speculative trading, cost of collateral is considered”

• “hedge expected production plus 10%, rather be over than under hedged”

Balancing• “if you balance early, you

balance twice”

• “never carry more supply than your expected demand into the delivery month”

• “turn on swing within 2% of economic price, you can turn it off if you don’t need it”

• “never carry an imbalance into the on-the-day market”

• “never signal your true needs to the market until the afternoon”

Speculation• “the entire group trades a

single point-of-view”

• “each trader has the right to trade their own point-of-view”

• “we primarily take large positions on bets greater than 150% RAROC”

• “we diversify, lots of small bets, lots of locations & tenors, on RAROC of 50% or more”

• “ we are looking for the bid-ask spread, the goal is to close positions in 1 to 2 days”

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Capital Management - Down & Dirty

The challenge for energy companies is to learn how to effectively incorporate capital management discipline into their commercial optimization decisions

S1 represents a speculative strategy with 150% RAROC thresholds, while S2 represents a strategy with 30% RAROC thresholds

While S1 represents virtually no risk of capital lost, S2 provides the greater expected return to capital

Capital Comparison

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0.2

0.4

0.6

0.8

1

-100. -50. 0. 50. 100. 150. 200. 250. 300.

WACOG

Cu

m. P

rob

abili

ty

Capital - S1 Capital - S2

0

0.1

0.2

0.3

0.4

0.5

-60. -40. -20. 0. 20. 40. 60. 80. 100.

Delta Capital (s1-s2)

Prob

abili

ty

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Capital Management - Down & Dirty

As availability and cost of capital changes, so does the expected value of each strategy, so that commercial strategy and capital management become inter-related in optimizing portfolio value

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5

10

15

20

25

30

W/O Capital W/ Capital

CHARLES RIVER ASSOCIATES

Jack YeagerGEMI Conference

January 21, 2005

CRA Capital Management in Commercial Optimization