CRA Capital Management in Commercial Optimization Jack Yeager

CRA Capital Management in Commercial Optimization Jack Yeager GEMI Conference CHARLES RIVER ASSOCIATES January 21, 2005

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 Grow Sustain More Capital vs Risk could: Taking on too much risk could: q Reduce cash flows and earnings surprises q Increase profitability from investments / transactions q Reduce amount of “selfinsured” risks q Increase Cost of Risk q Reduce quality of credit q Reduce availability of new investments with acceptable risk/return characteristics q Increase WACC q Reduce availability of investments that satisfy hurdle q Reduce availability of counterparties willing to do business q Reduce ability to introduce new products to market q Reduce value of equity q Reduce strategic flexibility q Increase Strategic Risk 1

Capital Management - The Competitive Landscape Energy Trading & Marketing Businesses are feeling increasing competitive pressure from I-Banks & Private Equity to manage capital more effectively… Capital Management Strategy Private Equity Investment Banks • Good deals seek capital • Capital seeks good deals • Deal level Transparency • Competition breed discipline Divest of Assets • Regulatory Assurance • Compliance breeds discipline Energy T&M Transparent Capital Discipline • Business model seeks capital • SEC Financial Performance • Ambiguity breeds complacency 2 Regulated Capital Requirements

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 Balancing Speculation • “hedge everything from 18 months to 6 months 50%, 6 months & in up to 90%” • “if you balance early, you balance twice” • “the entire group trades a single point-of-view” • “hedge is part of portfolio strategy & is put on based on positions rules” • “never carry more supply than your expected demand into the delivery month” • “each trader has the right to trade their own point-of -view” • “hedge is economic, but distinct from speculative trading, cost of collateral is considered” • “turn on swing within 2% of economic price, you can turn it off if you don’t need it” • “hedge expected production plus 10%, rather be over than under hedged” • “never carry an imbalance into the on-the-day market” • “never signal your true needs to the market until the afternoon” 3 • “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”

Capital Management - Down & Dirty The challenge for energy companies is to learn how to effectively incorporate capital management discipline into their commercial optimization decisions S 1 represents a speculative strategy with 150% RAROC thresholds, while S 2 represents a strategy with 30% RAROC thresholds While S 1 represents virtually no risk of capital lost, S 2 provides the greater expected return to capital 4

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 5

CRA Capital Management in Commercial Optimization Jack Yeager GEMI Conference CHARLES RIVER ASSOCIATES January 21, 2005