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New York. Mercantile Exchange. NYMEX/COMEX. Two divisions, one marketplace. United Nations Conference on Trade and Development Partners for Development Practical Use of Oil Price Risk Management Lyon, France November 11, 1998. Mark Seetin Vice President/Government Affairs.

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New York

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  1. New York Mercantile Exchange NYMEX/COMEX. Two divisions, one marketplace United Nations Conference on Trade and DevelopmentPartners for DevelopmentPractical Use of Oil Price Risk ManagementLyon, FranceNovember 11, 1998 • Mark Seetin Vice President/Government Affairs

  2. Primary Economic Role of Commodity Exchanges • Price Discovery • Commodity exchanges do not determine prices • They record prices made through trades in an open and competitive marketplace • Purchase and sales prices are transmitted immediately to be seen (discovered) by all • Hedging (Risk Shifting) Function • Price risk is hedged (shifted) by using futures and options, like insurance companies shift risk between premium payers and collectors

  3. History of NYMEX Division • 1872 - The Butter and Cheese Exchange of New York • 1882 - Name changed to New York Mercantile Exchange Futures Contracts Traded Eggs Poultry Lumber Nickel Apples Silver Dollars Lean Beef Gold Kilos Foreign Currency

  4. Growth in NYMEX Total Volumes 1983- 1998 Millions of Contracts

  5. NYMEX Organization NYMEX Membership 816 seats, 749 individual members Board of Directors COMEX Membership 772 seats, 663 individual members Executive Committee Chairman of the Board President Compliance Planning & Development Clearing Market Surveillance Financial Surveillance Trade Surveillance Strategic Planning Research Marketing Banking and Deliveries Position Processing

  6. Why Businesses and Governments Hedge Price Risk • Stabilize revenues • Protect value of stocks and inventories • Achieve budget targets • Lock in sales price for production • Lock in raw material costs • Establish known cash flow • Neutralize the adverse effects of price volatility • COMPETITION

  7. What is a Futures Contract? • A futures contract is a binding obligation to make or take delivery of a specified quantity and quality of a commodity at a specified location and time.

  8. What is a Hedge? The initiation of a position in a futures oroptions market that is intended as a temporary substitute for the sale or purchase of the actual commodity. The sale of futures contracts in anticipation of future sales of cash commodities as a protection against possible price declines, or the purchase of futures contracts in anticipation of future purchases of cash commodities as a protection against the possibility of increasing costs.

  9. Hedging Programs Manage Price Risk By Balancing Physical and Financial Markets Financial Market Physical Market Futures Contracts Crude Oil/Nat Gas Options Contracts Refined Products Over the Counter Marketing System (SWAPS) Gains/Losses in Physical Gains/Losses in Financial Price Objective Balance + =

  10. What is an Option? • An option is a contract between a buyer and seller whereby the buyer has the right-but not the obligation-to buy or sell the underlying commodity at a fixed price over a specified period of time in exchange for a one time premium payment

  11. At a Specified Price (Strike) • For a Specific Time Span • At a One-Time Cost (Premium) Options Contracts CALL OPTION • Right to Buy a Futures Contract • PUT OPTION • Right to Sell a Futures Contract

  12. State of Texas Oil Royalty Hedging Program

  13. Texas State Oil Royalty Hedging LAW PASSED 1991---AMENDED in 1993 • Comptroller • State Bank Commissioner • 1 Citizen Member TEXAS DEPOSITORY BOARD OVERSEES PROGRAM

  14. TEXAS OIL/GAS HEDGING LIMITS State Funds Invested $500,000* Maximum Risk of Loss $5,000,000 *With Put Cost at Delta .25 at $.25 - .50 BBL, This would Effectively Limit the Number of Active Options Contracts to 1,000-2,000 Contracts (1-2 Million Barrels)

  15. Texas Has Hedged State Oil Revenues since 1992 • Limitations on funding hedging strategies led to development of “Straddled Costless Collar” option approach to “lock in” royalty income stream • State Treasurer started program--office was abolished in 1996--now run by State Comptroller

  16. Southern California Gas Company A Regulated Utility

  17. Trading Futures Contracts Key Control Areas Board of Directors Authorize use of Futures Responsible for Hedge Strategy with Hedge Committee Direction from Sr. Management Futures Trader Buy/Sell Contracts Broker Executes Hedging Strategy Treasury Transmit or Request Margin Funds Record Transactions Accounting Southern California Gas Company

  18. SoCal Gas Cost Incentive Mechanism • establishes a benchmark comprised of market sensitive price indices • SoCal takes prudent risks to outperform the price benchmark • goal: reduce core customer gas costs • if gas costs are below benchmark, customers and shareholders share benefits • the GCIM has increased the efficiency of gas procurement and reduced customer gas costs

  19. GCIM Bands (Losses shared by 50/50 Utility customers/Utility stockholders) Sharing Tolerance Band +2% Benchmark Price (100%) -1/2% (Profits shared by 50/50 Customers/Stockholders) Sharing Southern California Gas Co

  20. SoCal Gas has 5 Years of Success in Risk Management • Hedging programs exist for gas procurement for physical storage • Gas cost for customer purchase is hedged • Savings for California consumers and SoCal Gas have been over U.S. $60 million

  21. Public Service New Mexico State Regulated Utility

  22. New Mexico Utility Hedging Background • In many states, including New Mexico, there was a broad public reaction to the sharp increase in natural gas prices in 1996. Many state Public Utilities Commissions held hearings and utility purchasing practices came under severe scrutiny • U.S. Senators requested the U.S. General Accounting Office to conduct an investigation of the natural gas market, including NYMEX. • State Commissions in some states, including New Mexico, have now begun to require utilities to purchase fixed price gas and to take other actions to mitigate the risk of gas price spikes in the future • An increasing number of utilities began to propose experimental programs to allow suppliers other than the utility to serve residential and small commercial customers • Smaller local distribution companies have begun to use financial instruments as hedging tools

  23. Actions Taken By PNM Gas Services to Mitigate Impacts of Price Volatility A hearing was held in 1996 by the New Mexico PUC to review PNMGS’ natural gas procurement practices for the winter of 1996-97. The Commission ordered several actions, including: • A restructuring of cost-of-service rates to increase the monthly fixed charge and reduce the variable per unit charge. • Information on customer bills indicating the anticipated price for the upcoming month. • PNMGS should procure more fixed price gas--hedging was encouraged • Conduct a pilot program to open the residential and small commercial markets to other suppliers. • Implement a monthly gas cost and billing practice whereby the Company can levelize its commodity gas rates to customers by shifting peak month gas costs to lower priced months.

  24. Public Service New Mexico Risk Management Illustration of Hedging Program Evolution 1996-98

  25. PEMEX State Owned Oil Company Hedging Program

  26. Pemex Functional Structure Pemex Pemex Exploration & Production Pemex Refining & Distribution Pemex Gas Pemex Chemicals PMI Comercio Internacional

  27. PMI Identification of Risk Exposure PMI International Market PEMEX PEMEX P E & Refining Internal Market Exposure PEMEX E & P -- Long Crude Oil PEMEX Refining -- Long Crack Spread Internal Market -- Short Products PMI -- Exposure depends on pricing mechanisms used in international mkt vs PEMEX pricing mechanisms Different Profit Centers Different Portfolios Source: Martha Navarro Risk Manager--PMI Different Risk Exposure

  28. Risk Management Strategies Tactical Strategic Speculative Use of hedging instruments to increase flexibility in physical transactions Use of hedging instruments to decrease cash flow volatility Take positions by “outguessing” market trends MAIN OBJECTIVE Optimize profits by increasing risk exposure Minimize Risk Exposure Optimize profits maintaining risks in “acceptable” levels

  29. Strategic Tactical Speculative PMI Risk Policies Control Strategy Limitations • Working capital available • Opportunity cost that can be absorbed • Limits in volume • Limits in types of instruments to be used • Limits in time fence • Working capital available • Losses than can be absorbed • Limits in types of risks • Force to hedge a specific exposure percentage • Working capital available • Losses that can be absorbed • Limits in total outright positions • Limits in time frame • Limits in capital at risk

  30. PMI Risk Management Evolution Risk Management Activity No activity in financial markets (back-to-back physical deals) Hedging for refined products arbitrages Hedging for products storage and blending operations Risk management for Pemex Petrochemicals Risk management for small Mexican consumers Hedging for crude oil in a small scale Consolidation of the Refined Products Portfolio Risk management for Pemex Gas in Natural Gas and LPG´s Risk management for Crude Oil arbitrages Risk management for Pemex Refining Time º Before 1992 July 1992 1993 1994 1995 Current

  31. Government Focus on Risk Management is Increasing • Many state level government regulated utilities have risk management programs (California, Missouri, New Jersey, New York, Texas, Wisconsin and others) • GAO is studying U.S. budget benefits from hedging government fuel purchases • Internationally--state owned/controlled oil producing companies expand use of risk management

  32. Futures Markets Offer Governments and Managers Valuable Tools • A “minute by minute” window to the marketplace • A price reference for budgets and planning • Financial tools to manage price risk • Tools to buffer budgets from unanticipated price shocks Why Hedge?? Because if you do nothing, you accept TOTAL PRICE RISK And . . . You Become a SPECULATOR

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