Network of Options for International

Coal & Freight Businesses

Dr. Aram G. Sogomonian
Constellation Energy Commodities Group
Commodities 2007: Agriculturals, Energy & Metals
London, England
January 19, 2007
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Constellation Energy Group (CEG) Review
CEG provides energy services across the entire energy value chain
Our physical businesses scale and scope enable us to manage our risk at a
lower cost than our peers when pursuing profitability
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Constellation Energy Commodities Group (CCG)
Business Overview
CCG operates in fuels and wholesale competitive supply.
CCG provides physical products to customers across the value chain.
CCGs traditional base is power, with increasing focus on coal and gas.
Three business principles have driven our sustained growth:
We focus where we have an edge Providing physical energy
products to customers upstream and downstream.
We compete to be the low cost provider Our portfolio management
capabilities and scale have helped us to preserve margins.
We deploy risk capital carefully We do not compete on risk
tolerance or cost of capital. We stick to our strengths in managing
physically delivered products.
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Four business areas, all grounded in our business
model of providing physical products to upstream
and downstream customers, and relying on
effective, conservative portfolio management
CCG Business Model
Natural Gas
Coal
Power
Portfolio Management & Trading
Coal and Freight
Power
Gas
Coal
Generation
Production
Mining
Transmissio
n
Midstream/
Interstates
Shipping/
Freight
Power Distributors/
Munis/Co-Ops
Gas Distributors/
Power Generators
Power Generators/
Industrial Users
Producers Consumers
Integrated businesses that are suitable complements to our market-leading power
business
Intermediary role linking producers and consumers
Physical orientation with contractual assets along the value chain
Customer-centric model, leveraging knowledge of the physical system
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Coal Business Overview
Competitive Focus
Transfer of successful power strategy to coal
Global coal services business
Manage global coal supply portfolio
Provide structured contracts to meet domestic and international customer needs
Focus on market areas of opportunity
Delivery Contracts
CCG works with downstream customers to maximize the flexibility in their supply
channels
Supply Contracts
Producers prefer to sell coal as is, where is to accommodate production
variability
Transportation and logistics
CCG logistics expertise and transportation network reduces transport costs
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Changing Environment for Coal Industry Players
Increasing competition in generation in many
markets due to deregulation
Increased risks in contract execution
Volatile freight market
Demurrage risks
Inland transport constraints trains and barges
Emerging market risk in sourcing
Changing domestic environmental regimes
Increasing SOx, NOx, and CO2 meaning less
certainty in future generation and more focus on
coal quality
Supply patterns changing
Declining domestic production in Europe and
USA
New coal mine developments in Pacific basin
Changing Coal Market dynamics
European Power and Coal financial markets
driving world forward Coal Price
Influx of new players into markets increases
volatility.
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Value Provided to Coal Consumers
CCG provides alternative structures for
purchasing to meet customers needs
CCG values fuel flexibility, both domestic
and international, and will work with and
reward customers with lower prices for
quality expansion
CCG provides logistics expertise in managing
deliveries to station gate, including full
outsource deals
Managing shipping, demurrage, port,
rail, barge deliveries
Structures can incorporate:
Ability to flex up and down on sulphur and volume
Ability to change from fixed price to floating price or floating price to fixed price
Cross-commodity transactions including tolling and cross-commodity indexation
Multiple currency capability
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Value Provided to Coal Producers
Our strong credit rating allows term fixed
or indexed price deals with adequate
credit assurance
Offer significant flexibility in pricing of
purchases
Ability to change from fixed price to
floating price or floating price to fixed
price allows producers to determine
when to fix prices
Multiple currency capability
CCGs large shipment program means regular and sizable coal offtake with reliable
logistics performance
Diverse, quality-flexible, global customer base means CCG can assist producers in
managing unforeseen changes in production targets and quality
Term flexibility
Ability to contract for long terms to facilitate mine development/ capital investment
Ability to transact medium, spot, and afloat
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Freight Business Overview
Competitive Focus
Offshoot global coal business with primary responsibility to provide
services for Coal Business.
Provide structured contracts to meet Freight Owners and
international coal and Iron ore consumers needs.
Focus on Owners looking to look in a rate of return on the asset with
a player who is a significant user and shipper of coal with an
exemplary record for performance and with a strong balance sheet.
Focus on end Consumers who need to outsource their freight
requirements or looking for partners with strong backhaul presence
looking to provide an efficient efficient and alternative supplier of
competitively priced Front Haul rates
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International Freight Market
One of the first truly global market in world history
Very volatile and cyclical tightly linked to world economy
Standard routes, trusted indices, transparent pricing mechanism
Vessels are interchangeable
Willingness from most market participants to trade freight
Active market going out 2 years
Well established and court tested industry specific physical contracts
ISDA flavoured contracts becoming the norm for freight derivatives
Customer relationship paramount
Highly intermediated
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CCG Freight Business Growth Aspirations
Natural growth alongside the Coal business which will be shipping 23 million metric tonne
by 2008
CCG Capesize Fleet to grow to 30 vessels by 2008
Building out into Panamax operating in 2007 to prepare for growth in coal shipments from
Indonesia into the USA.
Focus on supplying front haul services to Korean and Japanese Steel Mills.
Focus on supplying freight services direct to our present Coal customers.
Move into Vessel acquisition to support and compliment the Underlying trading business.
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Risk Management Challenges
Complex logistical network
Lack of price transparency, outside of major coal indices
Multi-dimensional coal quality differences and vessel chartering options (ownership, time
charter, voyage charter; vessel size, age, etc.)
Presence of various flexibilities in the coal/freight network that are difficult to quantify
and measure
Migration of coal production to developing countries, which gives rise to Emerging market
risks: sovereign, political, mine contingency, currency.
Relatively weak creditworthiness of coal/freight counterparties
Operational risks related to physical movements of coal and port operations
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International Coal & Freight Network
Optimize and trade around the position going forward
Strengthen competitive position with coal producers in availability and price
Fortify relationship with coal buyers
Proved Reserves by 2005 ('000 MMT)
0.4
19.9
50.3
254.4
287.1
296.9
0.4
7.7
50.2
115.7
112.3
192.6
0
50
100
150
200
250
300
350
Mid East South &
Central
America
Africa North
America
Europe &
Eurasia
Asia
Pacific
Total Coal Anthracite & Bituminous Coal
Source: BP Statistical Review of World Energy 2006
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Contract Details & Risks Mitigants
Buy coal at source A, sell coal at destination B, buy forward freight from A to B to lock in
the profits
Contract details
Coal: deal term, buy/sell quantity, contract prices, coal quality
Freight: charter term, vessel size, freight rate, freight route
Risks and mitigations
Lay off price risk through physical positions Limited Liquidity
Hedge the currency exposure at the point of transacting Currency Risk
Provisional price setting and reconciliations Lengthy Time Lag
Hedging through, for example, US TIP Inflation risk
Rejection limits within our multi source contract rejection
limits into Korea and Europe Quality risk
CCG Master Agreement with clauses for default protect Credit risks
Forward coal contracts, freight index, time charter contracts Market price uncertainty
Mitigant Risk
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Deal Evaluation
Deal values
Expected profit margin
Credit worthiness and credit charge
Hedging cost
Miscellaneous charge
Risk capital requirements
Market risk (1-day VaR, 4 sigma) of energy scaled by N days to liquidate residual open
position and basis
Credit risk (maximum potential exposure times default probability)
Margin risk (liquidity cost of issuing letter of credit and contingent liability costs)
Incremental values/VaRs to current coal portfolio
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Coal & Freight Flexibilities
Multiple coal sources and destinations
Differentiated by coal quality, prices, and availability
Potential choices of vessel types and freight routes
Vessel type: CapeSize, PanaMax, HandyMax, HandySize
Freight routes: FrontHaul, BackHaul, TransAtlantic, TransPacific
Chartering options: Time charter, Voyage charter
Coal quality differentials and values in emission market
Calorific value, Sulfur content, Ash content
Coal buy/sell quantity
x% swing options
Timing flexibilities
Scheduling deliveries at a preferable time during a quarter or beyond
Option to break IWL (institute warranty limits) on this vessel
Access to ice bound areas restricted between 15
th
December and 31
st
April
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Problem Description
Evaluate coal/freight deals
Modeling of stochastic processes of coal prices and freight rates
Dependence structure should be captured
Deal evaluated based on contract details and market forecasts
Identify individual new promising coal/freight deals through Heuristics
Compare coal prices at potential source/destination and the freight rate in between
Identify promising new coal/freight deals, schedule time chartered vessels and optimize
all resources through Portfolio Optimization
Maximize profitability with risk control
Observe all contractual and operational constraints
Take market uncertainty into account via stochastic programming
Locations of forward buys/sells, forward prices and spread curves
CCG and counterpartys swing option +/- x% on contracted quantity
Different vessel sizes / voyage routes for coal delivery
Scheduling of coal deliveries at preferable time within contract allowance
Reduce problem complexity by identifying potential coal sources/destinations and
freight routes
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Portfolio Optimization Problem Formulation
Objective: Maximize risk adjusted profit
Constraints
Coal buy/supply contractual positions
Coal supply at source and demand at destinations
Vessel capacity and portability
Voyage time of coal delivery
Warehouse inventory control
Uncertainty
Coal prices / freight rates
Define scenarios of discrete price levels
Coal quantity swing option
For option buyer: relaxed constraints in our buy contract
For option seller: define scenarios of counterpartys exercising option
Coal grade flexibility
Connect different coal grades by defining a grade replacement exercise cost matrix,
and relax constraints to specific coal grade
Methodology
Deterministic programming: for market estimation
Stochastic programming: formulate as a multi-stage problem and determine scenario
dependent business plans
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Model Output
For individual deals valuation based on forward coal prices / freight rates
Expected value and risks of the current coal contract
Expected value and risks of the time charter freight contract
Expected value and risks of the current portfolio
For portfolio valuation based on portfolio optimization
Promising new coal deals (time, from, to, quantity)
Voyage scheduling of time chartered vessels (time, from, to, quantity)
Voyage charter to be acquired from market in future for coal delivered (time, from,
to, quantity)
Incremental value and risks of adding one new coal contract into the portfolio
Value of the time charter freight contract based on the projected vessel schedules
Scenario-dependent business plans
Evaluate each coal/freight flexibility
Identify and understand variables impacting the value of each flexibility
Prioritize available flexibilities in terms of value
Value of flexibilities at the portfolio level
Focus Commercial efforts on most valuable flexibilities
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Literatures
Asset liability management
Wang and Neufville (2004), Building real options into physical systems with
stochastic mixed-integer programming. 8th Real Options Annual International
Conference in Montreal, Canada.
Energy market
Knittel (2002), Alternative regulatory methods and firm efficiency: stochastic
frontier evidence from the U.S. electricity industry, the Review of Economics and
Statistics
Sekar (2005), Carbon dioxide capture from coal-fired power plants: A Real Options
Analysis, MIT Laboratory for Energy & the Environment report.
Deng, Shen, and Sun (2006), Stochastic co-optimization for hydro-electric power
generation in multi markets, to appear, IEEE Trans. Power Systems.
Stochastic programming
Birge and Louveaux (1997), Introduction to Stochastic Programming, Springer, New
York.
Freund (2004), Optimization under uncertainty, working paper.
Dantzig and Infanger (1997), Intelligent control and optimization under uncertainty
with application to hydro power, European Journal of Operational Research.
Wallace and Fleten (2003), Stochastic Programming Models in Energy, in:
Ruszczynski and Shapiro (eds.), Stochastic Programming, Handbooks in Operations
Research and Management Science.