Energy Commodity Markets from a Practical Perspective

1. Energy Commodity Markets from a Practical Perspective July 5, 2012 Tim Simard

2. NBC Commodities • 14-person Calgary-based team running both a client-driven and strategic trading operation • Largest trader of financial energy derivatives among Canadian banks • Collective team experience in excess of 250 years in the field of energy trading and risk management • strategic trading activities largely to support client-driven business • Energy capabilities: crude oil, refined products and both physical and financial natural gas • OTC swaps and broad range of options • first Canadian bank providing WCS (Canadian heavy crude), Edmonton Sweet and NGL risk management structures • Broad base of corporate flow hedging activity • 75% oil and gas producers along with midstream companies, utilities and energy consumers • Strong lending franchise supports energy hedging business • 150+ transactional clients over the past 12 months • Well-received daily commentary circulated to over 1,500 people • Trading desks provide the hedge for all the Horizons AlphaPro & BetaPro commodity ETFs: • Crude, natural gas, gold, silver, copper • Execution and warehousing counterparty to physically-backed Australian gold ETF • Participated in the design mechanics of HBP single- and inverse energy ETFs • Broad contact with institutional investors, providing market updates and offensive/defensive direct commodity trade ideas

3. What Drives Corporate Hedging Activity? • Hong & Yogo: • “producers are infinitely risk-averse and would like to hedge all uncertainty about the spot price.” • As they anticipate more demand for their product, they will sell more futures and open interest will rise • Acharaya, Lochster and Ramadorai: • “when firm-specific default risk is high, commodity producers are more likely to hedge” • Difficult to see this in practice in the energy sector • (i) producers are geared to increase their production even if economic indications suggest tepid demand for their product • (ii) investors want the commodity price upside (???) • (iii) price view is a primary driver of hedging activity • More likely to hedge when the price prospects are weak

4. Producer Activity – Crude Oil • Surge in activity late last year and early this year based on (i) absolute price levels; (ii) budget timing; (iii) unwillingness to hedge gas; (iv) gas experience; (v) risk perceptions

5. Producer Activity – Natural Gas

6. Comparative Large Gas Producer Hedge Positions • NYMEX pricing for 2010 during December 2009: $5.65 per MMBtu • NYMEX pricing for 2012 during December 2011: $3.51 per MMBtu • Even if one excludes Chesapeake, 46% hedged for 2010, 42% hedged for 2012

7. Price View or Default Risk? • “The amount of production we hedge is driven by the amount of debt on our balance sheet and the level of capital commitments we have in place.” St. Mary Land & Exploration Co. (90,000 BOE/d) • Chesapeake (600,000 BOE/d):

8. Price View or Default Risk? • Figure 3 from Achara et. al.:

9. Canadian Energy Producer Hedge Process in Practice • Reluctant to hedge given perception of shareholder desire for commodity price exposure • willingness to maintain very conservative debt levels in order to survive cyclical downturns • Differentiation from US producers • Incentive to hedge most often driven by desire to fund capex growth profile and/or maintain distributions • Less around default risk • Hedging can allow for incremental lending capacity in times of high prices • If forward prices are at or above management/board expectations, hedge positions are added • Hedging seldom occurs when management believes the price is going to rise • Much easier for producers to sell into a contango market than a backwardated market, but absolute price levels more important than the forward premium or discount

10. Price Decks & Forward Curves: CAD WTI Crude

11. Risk Aversion Impact of Management Teams • Viral et. al. discussion of risk-averse vs. risk-tolerant managers based on share ownership vs. option ownership • 20% more likely that managers tilted toward share compensation will hedge • Certainly makes sense from a theoretical perspective • If you were simply long options, why undertake management decisions that serve to reduce the volatility of the underlying? • Lower volatility = lower option value • Have not done any empirical studies on this effect in the Canadian energy sector but would be very interested to see the results!

12. Investor Issues: Impact on Crude Forward Curve Structure

13. Index Investments in Oil

14. Index Investments in Natural Gas

15. ETF Players Exacerbating Market Volatility: NO!!

16. ETF Investors in the Gas Market

17. Horizons Crude Bull & Bear Net Assets Under Management • ETF investors have a propensity to turn from buyers to sellers when WTI makes its way over $100

18. Comments on Investor Impact • No evidence from recent index investment flows/ETFs that investors are causing market volatility • In fact it is easier to argue the opposite • With most of the massive passive money now in the market, main effect is to increase contango in commodity markets • Investors have to sell the near month and buy the deferred month on a regular basis • Serves to relatively depress the spot price paid by consumers, while increasing forward prices • Sends signals to producers to add production and consumers to curtail consumption • Major influx of new investor money seems to appear in low-price environment • Are we that worse off that investors stampede into oil and gas markets when we move to very low price environments? • Again, it staves off future shortages and reduces volatility

19. Energy Commodity Markets from a Practical Perspective July 5, 2012 Tim Simard

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