© 1999 VK ENERGY TRADING: IS THE TURNAROUND IN SIGHT? SECOND ANNUAL ENERGY TRADING AND MARKETING CONFERENCE GEMI Vincent Kaminski Houston, January 22, 2004

© 1999 VK Outline  General conclusion: very optimistic long-term but one has to be realistic and cautious in the short and medium-term  One should rather talk about the crisis of the merchant energy business and the contagion effect that undermined energy trading  The preconditions for the recovery of energy trading business

© 1999 VK ENERGY TRADING: WHAT WENT WRONG?

© 1999 VK The Incredibly Shrinking Energy Market  Collapse of energy trading  Shutdown or drastic reduction of the size and scope of most energy trading operations  Sharp drop in trading volumes and liquidity at most locations  The breakdown of the infrastructure of energy markets  Price discovery issues – lack of confidence in price indices  Dissolution of trading teams and research units  Regulatory uncertainty  Unrealistic perceptions of profitability of energy trading and marketing during and over expansion in terms of headcount

© 1999 VK Merchant Energy Business Market Making Proprietary Speculative Trading Hedging And Asset Optimization Long-term Structured Transactions Asset Development Short-term Price Fluctuations Long-term Price Trends RISK FACTORS

© 1999 VK Contagion Effect  Energy trading was affected primarily by adverse developments related to fixed assets and long-term structured transactions decisions  Weak balance sheets of merchant energy companies  Weak cash flows  Flawed business models  Excessive expansion of long-term transactions and overinvestment in fixed assets was caused by  Abuses of mark-to-market and fair value accounting  The incentive system rewarding originators and asset developers for concluded deals, not for profitable deals  Credit downgrades undermined energy trading

© 1999 VK Profitability of Energy Trading  Sources of profits in energy trading  Bid-offer spreads  Proprietary, directional trading  Sales of risk management tools  Stand alone derivatives  Management of the supply chain on customers’ behalf  Support of physical operations (trading around assets)  The perceptions of energy trading profitability were distorted by a combination of unique historical circumstances

© 1999 VK Bid-Offer Spreads  A market maker: contractual or implied commitment to post bid – offer spreads and to take either side of a transaction  Bid – offer spreads in the short-term and medium-term transactions were reduced to unsustainably low level due to excess capital allocated to energy trading  A hypothetical example  5,000 transactions a day  250 trading days per year  5,000 MMBtus per transaction  $0.005 bid – offer spread per MMBtu  Total profit: 5000 x 5000 x 250 x / 2 = $15,625,000  The spreads were too low to support a trading operation based on the pure market making activities, given over brokering of the industry

© 1999 VK Other Sources of Trading Profits  Proprietary trading: taking directional positions, based on the traders’ intuition, research contributions (weather forecasts, fundamental models), information flow from the market making activities  Proprietary trading can be a very profitable operation for a specific company. A zero-sum game operation cannot support the entire energy trading industry.  Growth of profits from year to year requires very aggressive escalation of trading operations and acceptable risks  Strong temptation to influence the market outcomes through artificial and often illegal actions

© 1999 VK Preconditions of Recovery of Energy Trading  A diversified universe of players, including energy majors and independent producers, big industrial users, regulated utilities and financial institutions  Rebuilding of the infrastructure of the energy trading business  The trust in published energy price indices is a critical condition of market recovery and future growth  Last scale energy trading is a very expensive operation, given fragmentation of the physical and institutional infrastructure of the energy industry  The industry will have to streamline the procedures for handling physical flows  Outsourcing of physical operations will become increasingly popular

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