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Risk Management

Risk Management. John E. Parsons March 25, 2014 Financing Energy Investments Université Paris Dauphine. EnCana Corp. One of Canada’s largest energy producers. Formed in 2002 out of the merger of the PanCanadian Petroleum Corp. and the Alberta Energy Co. Ltd.

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Risk Management

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  1. Risk Management John E. Parsons March 25, 2014 Financing Energy Investments Université Paris Dauphine

  2. EnCana Corp. • One of Canada’s largest energy producers. • Formed in 2002 out of the merger of the PanCanadian Petroleum Corp. and the Alberta Energy Co. Ltd. • In 2008, management proposed to spinoff its oil production and refining business into the company Cenovus Energy Inc., leaving EnCana as a pure play natural gas producer. The announcement increased the company’s stock price by 6%.The spinoff was completed in November 2009. • EnCana’s new strategy was focused on unconventional gas exploration and development, including shale gas produced with the new hydraulic fracturing techniques.

  3. EnCana Corp. at year end 2009 • Production of 3.0 Bcfe/d or 1.1 Tcfe/year • Proved reserves of 12.8 Tcfe. • Probable of 6.7 Tcfe. • Possible of 4.2 Tcfe. • Total of 23.7 Tcfe. • Available economic resources 16-58 Tcfe. • Finding and development costs of $1.62/Mcfe.

  4. Growth Plan • Cash flow of $5 billion. • Operating earnings of $1.8 billion. • Free cash flow of $1.3 billion. • Capital investment of $3.8 billion. “Encana has set a goal to double in size over the next five years.” Randy Eresman, President & CEO

  5. A Key Challenge: Volatile Natural Gas Prices

  6. Hedging at EnCana • “While natural gas prices trended downward in 2009, our hedging program provided a buffer from the impacts of low prices for much of the year. Hedging in advance of weak natural gas prices of 2009 contributed $2.3 billion in after-tax cash flow and allowed us to pursue our capital and operating plans without interruption.” • Ongoing hedging… • 2 Bcf/d of expected 2010 gas production using NYMEX fixed price contracts at an average price of $6.04/Mcf • 0.935 Bcf/d of expected 2011 production at $6.52/Mcf, and • 0.870 Bcf/d of expected 2012 production at $6.47/Mcf.

  7. Natural Gas Prices Have Remained Depressed

  8. How Things Played Out • October 2010, EnCana warns that its ability to grow may be constrained as its hedges expire and prices remain low. • Pares its capital spending budget modestly from its peak, but its growth plan remains. • April 2011, cash flow continues to fall due to low natural gas prices, now at $4.11/Mcf. EnCana is now redirecting a portion of its capital investment to oil and natural gas liquids development and exploration. • “We haven’t abandoned out goal to double our size… We’ve just accepted that it may take a little longer than originally planned to achieve it. • February 2012, after a year of asset sales, EnCana begins to cutback production, cut its capital expenditures dramatically to conserve cash, brings in Mitsubishi as an investment partner. Lets hedges roll off. • From year end 2009 to the start of 2012, the stock lost 1/3 of its value, falling from $30 to $20.

  9. Key Takeaway:Short-Run versus Long-Run • Even the simplest risk, like commodity price volatility, has a short run and a long-run component. • How much of the volatility reflects temporary, short-run factors? • What are the underlying drivers for the long-run? • Untangling short-run volatility and long-run volatility is difficult. But it’s always easier once you recognize the task. • Most hedging with financial instruments is for short-run risks and cannot address long-run risks. • Hedges are usually for cash flows in 1, 2 or sometimes 3 years. • When financial risk beyond 3 years is being shared, your starting to describe a specialized creditor or a partner. • Long-run risks need to be managed through changes to operations and investments.

  10. Other Risks & Other Types of Risk Management

  11. Constellation Energy 1999-2008 Source: “CRSP.

  12. Constellation Energy 1999-2008 Source: “CRSP.

  13. What Happened? • The short version: they suddenly came to need $1 billion, and this in September 2008. • The longer version: • They had a major failure in their internal risk management processes leading to an extremely significant mis-reporting of contingent collateral requirements associated with their new expansion into the coal trading business. • This followed from their recent decision to make trading the strategic centerpiece of their growth plans. John E. Parsons, Do Trading and Power Operations Mix? The Case of Constellation Energy Group 2008, web.mit.edu/ceepr/www/publications/workingpapers/2008-014.pdf

  14. EDF’s Deal with the UK for a New Nuclear Power Plant

  15. Contract for Difference ̶ CfD Source: UK Electricity Market Reform White Paper.

  16. CfDs as a Stalking Horse Notes to the UK DECC Press Release… • “Arrangements whereby the Strike Price would be adjusted downwards to reflect changes to the amount of tax payable by the project company in certain circumstances. • Arrangements whereby the Strike Price could be adjusted, upwards or downwards, in relation to operational and certain other costs (including balancing and transmission charges and business rates) at certain fixed points, and in relation to certain future changes in law (including in respect of specific nuclear taxes, and uranium and generation taxes). • Arrangements whereby Hinkley Point C would be protected from being curtailed without appropriate compensation, with reviews expected to occur at 7.5 years, 15 years and 25 years after the commercial operations date of the first reactor as well at the end of the contract term. • Protection would be provided for any increases in nuclear insurance costs as a result of withdrawal of HMG cover or in certain circumstances where market cover in the nuclear insurance market is no longer available, with compensation limited to the cost of additional capital required to self-insure. • Compensation to the Hinkley Point C investors for their expected equity return would be payable in the event of a Government directed shut down of Hinkley Point C other than for reasons of health, safety, security, environmental, transport or safeguards concerns. The arrangements include the right to transfer to Government, and for Government to call for the transfer to it of, the project company which owns Hinkley Point C in the event of a shutdown covered by these provisions. The compensation arrangements would be supported by an agreement between the Secretary of State for DECC and the investors.”

  17. Risk Management Guide • What can you do about risks? • Assessment and measurement pays off no matter what. • Frame operating and investment decisions to manage risks. • Frame financial policy to manage risks • Understand the relationship between risk and value. • Which risks are your job? • Which are not? • Where is your value-added? • What are the obstacles and pitfalls? • Foolish precision. • Fetishizing finance.

  18. The End

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