NATURAL GAS ECONOMICS AND BUSINESS ISSUES

©UH IELE, 2 No reproduction, distribution or attribution without permission. What is the natural gas business… …and how should it be regulated? Is it a competitive, upstream-driven business? Is it an economies of scale, monopoly midstream-downstream business that affects the public interest? How much of direct end use and conversion is competitive? If the goal is to build the “natural gas factory,” then policy/regulatory approaches need to facilitate value chain development – “commercial frameworks.” Where does most profit, value creation take place?

©UH IELE, 3 No reproduction, distribution or attribution without permission. Building the Natural Gas Factory UPSTREAM Exploration and Production (E&P) MIDSTREAM Processing Storage Pipeline Transportation LNG Liquefaction Shipping Re-gasification DOWNSTREAM Distribution and End Use Residential Commercial Industrial Power Generation Transmission Distribution to End Use Investor Goals Commercialize natural gas production, by: Increasing diversity of midstream options Gaining access to downstream participation where supported by markets (“power the world with gas”) Export

©UH IELE, 4 No reproduction, distribution or attribution without permission. Worldwide Natural Gas System Dynamics: Framework Issues E&P (LNG) Profit driven; ROR decision based on expected prices; monetize stranded reserves Power Gen Profit driven; ROR decision based on expected prices; fuel competition for gen Pipelines Transmission Regulated asset optimization; market rates? LDCs Regulated asset optimization; proximity to final customers (gas, power); market rates? End Users End use based on expected prices; access to competitive supply Benefits of Competitive Supply

©UH IELE, 5 No reproduction, distribution or attribution without permission. The Overall Challenge: Balancing the Market LOW Prices HIGH SUPPLYDEMAND Mean reversion is a reality if market- clearing participants exist

©UH IELE, 6 No reproduction, distribution or attribution without permission. Achieving Competitive Supply COMPETITIVE SALES Wellhead producers Third party wholesalers Pricing Supply The challenges: Entry of new suppliers Managing common pools Developing liquidity to establish locational basis Protecting market transparency Dealing with third party wholesalers that are affiliated with regulated infrastructure Access for new supplies Balancing short term cycles and long term capital requirements for resource development

©UH IELE, 7 No reproduction, distribution or attribution without permission. Regulated Infrastructure as the Conduit for Supply Competition RESERVATION (DEMAND) Fixed cost of investment Return on equity Taxes Long term debt A&G, DA, O&M COMMODITY (USAGE) Variable cost of operation O&M The challenges: Rate-making transitions Setting maximum allowable rates with market transparency Pricing new capacity Dealing with access for new capacity Determining contestable transportation markets Dealing with market power Balancing short term cycles and long term capital requirements for delivery Pricing Transport, Distribution

©UH IELE, 8 No reproduction, distribution or attribution without permission. Achieving Competitive Demand Wholesale Cost Retail Cost Margin Market Price The challenges: Political will to allow wholesale price fluctuations to flow to retail users Price discovery and transparency Market structure (unbundling) Market power Market oversight Balancing short term cycles and long term capital requirements for delivery Pricing Consumption

©UH IELE, 9 No reproduction, distribution or attribution without permission. Market Trade Off As unbundling for C&I customers proceeded, more cost behind the citygate is absorbed by residential.

©UH IELE, 10 No reproduction, distribution or attribution without permission. Price Volatility and Risk are the Trade Offs for Competition E&PPipelinesLDCsEnd UsersPower Commodity price risk flows (blue) Capacity price risk flows (gray) Risk accepting entities

©UH IELE, 11 No reproduction, distribution or attribution without permission. The U.S. Case Pre-Natural Gas Restructuring PRODUCERS PIPELINESLDCs Locate + Produce Sell to Pipelines Aggregate Storage Sell to LDCs Purchase from Pipelines Serve End User FERC PUCs

©UH IELE, 12 No reproduction, distribution or attribution without permission. The U.S. Case Post-Natural Gas Restructuring Marketers Gatherers & Aggregators Service Companies End Users Producers Storage Companies PipelinesLDCs Production Storage Services TransportDistribution AggregationGatheringMarketing Transport Services Capacity Brokering LNG Information Services Processing Risk Management FERCPUCs

©UH IELE, 13 No reproduction, distribution or attribution without permission. U.S./Canada Natural Gas Value Chains Industrial Electric Generation (fuel, bulk market for power) Residential, Small Commercial Physical Bypass Interstate Pipelines “City Gate” “LDC” Transportation (pipe)Sales (commodity) “Unbundling” is the separation of transportation from sales (supply) to allow third party marketing with pipelines providing “open access” and comparable service to all shippers. Most Competitive Competitive Least Competitive Commercial Production 1,2 Gathering 1,2 Processing 1 Intrastate Pipelines 2 1,2 Often vertically integrated

©UH IELE, 14 No reproduction, distribution or attribution without permission. U.S. Case – How Well Is the Model Performing? Market Issues Transparency of price signals Price volatility Role of pipeline affiliates Demand response Problems in retail competition Supply security and capital to drill Policy/Regulatory Response Encourage market solution to price information No action (but debate) FERC Order 637 Under discussion Georgia re-bundling, absence of state programs Producer incentives and LNG

©UH IELE, 15 No reproduction, distribution or attribution without permission. Investment Trends: IEA Outlook, , U.S.$trillions E&P$1.73 LNG$0.25 Power Gen$4.20 Pipelines$0.71 Transmission$1.60 LDCs$4.29 WORLD TOTAL $12.78 Issues: Impact on cash flow funded E&P with industry consolidation Energy financing with fewer merchant risk managers Sovereign debt with fiscal scrutiny and liberalization Development assistance with budget and performance scrutiny in donor countries Incentives to attract capital Source: IEA Global Investment Outlook, 2003

©UH IELE, 16 No reproduction, distribution or attribution without permission. Strongest progress toward markets No real progress toward marketization Progress made, but weak institutions and/or tendency to backtrack; political risk Canada/U.S. Mexico Chile Colombia Venezuela Brazil Peru Argentina S. Africa England Rest of W. Europe C/E Europe Russia and Other CIS China Petroleum Heartland India Northeast Asia Australia New Zealand Southeast Asia W. Africa Uncertain regulatory response on price reporting is inhibiting investment In general, where options for private investment upstream are limited, midstream/downstream marketization is also limited World Trends: Gas/Power “Marketization”