1. C HARLES R IVER A SSOCIATES Jack Yeager GEMI Conference January 21, 2005 CRA Capital Management in Commercial Optimization

2. 1 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

3. 2 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…

4. 3 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”

5. 4 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

6. 5 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

7. C HARLES R IVER A SSOCIATES Jack Yeager GEMI Conference January 21, 2005 CRA Capital Management in Commercial Optimization