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  • 1. DRAFT Merrrill Lynch April 4 th , 2006 CONFIDENTIAL Securing Revenues in a Volatile Crude Market NOT AN OFFICIAL UNCTAD RECORD
  • 2. Securing Revenues in a Volatile Crude Market 1. Oil Market Outlook 2. Securing Oil Revenues 3. Securing Revenues from Energy Distribution Table of Contents
  • 3. 1. Oil Market Outlook
  • 4. 1 Oil Price Outlook: Short Term Support, Long Term Threat Oil Market Outlook
    • Strong demand (particularly in Asia and South America) combined with bottlenecks in the refining sector (due to lack of investment) and a fundamental shift in oil production (from sweet/light to sour/heavy) have driven oil prices higher over the past 3 years
    • After 2007, forces driving oil prices lower might become dominant:
      • Upstream and downstream investments coming on-line in 2008
      • Chinese economic growth slow down
      • Risk of pandemics such as Avian Flu
      • Iraqi oil production recovering from current low levels
      • Development of a global gas market with the LNG production coming on-line
    • As seen during the oil shocks in the 1970’s, fear of a long term high oil price environment will stimulate
      • Development and production of high marginal cost oil fields (Venezuela, Canadian Oil sands) where majors are already making heavy investments
      • Investment in alternative technologies such as electric engines, fuel cells, hydrogen propulsion
    Canada’s Reserves: Oil Sands: 163 mmbbls Conventional: 16 mmbbls Conventional Oil Sands ____________________ (1) Source: Alberta Department of Energy and Oil and Gas Journal. Historical and Forward IPE Brent Curves Global Market for Crude Oil High Marginal Cost Oil Fields : Oil Sands (1)
  • 5. Boom and Bust of Commodity Markets: Cause, Effect & Remedies 2 5-6 years New Copper Mine 3-4 years Copper Smelter 7-10 years Oil Field (new area) 2-3 years Oil Field (existing area) 5-7 years Oil Pipeline 5-7 years New Refinery 2-3 years Refinery Upgrade 2 years Ship (wet) 1-2 years Ship (dry bulk) Average Construction Lead-Times for Major Commodity Supply Infrastructure Projects (1)
    • ____________________
    • Merrill Lynch Commodity Research
    • Low investment returns have led to a lack of capital flowing into the industry over the last decades (instead chasing more ‘desirable’ sectors, such as pharma, technology, telecoms)
    • As a result, we are looking at a chain of bottlenecks throughout the industry …
      • Exploration
      • Transportation
      • Refining
      • Labour
      • Etc …
    • … requiring high and sustained prices to justify investment
    In any case many of these bottlenecks will take a long time to fix Oil Market Outlook Paying for Decades of Underinvestment
  • 6. 3 The high forward oil price environment is stimulating production in unconventional oil which poses a threat to conventional producers
    • The current high forward oil price environment encourages the production of low margin product
      • Canadian Oil Sands
      • Venezuela Heavy Oil
    • Even at low margins, Unconventional Oil represents a clear threat to convention oil producing nations
      • The elevated forward curve allows low margin producers to lock in profit and potentially steal North American market share
      • High oil prices are stimulating increased investment in technology to efficiently extract unconventional oil
      • This flood of new crude will ultimately place downward pressure on commodity prices
    High Forward Oil Price Environment as a Potential Threat kboed Oil Market Outlook Unconventional Low Margin Product Coming Online Unconventional Crude Production
  • 7. 4 The current growth in oil demand despite rising prices is unsustainable in the long term Fear of an extended period of high commodity prices will drive investment in alternative technology
    • To date, global demand has proven to be highly resilient to the steady growth in oil prices
    • However, the fact that demand has failed to slow down despite the high prices does not mean that demand is price-insensitive in the long-run
    • As seen during the oil shocks in the 1970’s, fear of a long term high oil price environment will stimulate conservation efforts and fuel investment in environmentally friendly technologies such as:
      • Gas / Electric hybrid engines
      • Fuel Cells
      • Hydrogen propulsion
      • Gas fired Vehicles
    • The ultimate effect will be long term price elasticity of demand as consumers look to return disposable income from fuel expense to their pockets
    Long Term High Oil Prices Will Lead to a Softening in Demand Oil Market Outlook Current Inelasticity of Demand is not Sustainable in the Long Term
  • 8. 5 High Demand will Lead to Increased Efficiency and Substitution ____________________ (1) Rolling regression coefficient on a 100-month window where the latest data point signals current price elasticities of gasoline demand, as estimated over the past 100 month US gasoline demand has become more price inelastic over time A shift from SUVs to hybrid vehicles in the US could result in phenomenal energy savings Oil Market Outlook Increasing Inelasticity of Gasoline Demand (1) … … Leading to Higher Fuel Efficiencies
  • 9. 6 Though it may be unlikely that the oil and gas price divergence will persist into the long term, should it occur, a significant amount of switching out of oil and into gas would be expected
    • Long dated crude oil prices have nearly doubled over the past 12 months, but long dated gas prices have not kept up
    • The emerging LNG market which is poised to increase substantially on both sides of the Atlantic will likely lead to an LNG spot market and …
    • Environmental reforms will increase pressure to take advantage of the disconnect in oil and gas prices as high pollution industries such as the power generation sector seek cleaner burning fuels
    • Any further divergence in oil and gas prices will accelerate the pace of demand adjustment
    Fuel Substitution: Relative Value in Natural Gas vs. Crude Oil Oil Market Outlook Overlap in the End Use of Oil and Gas may Lead to Substitution Overlap in the End Use of Oil and Gas Growth of Global LNG Fleet
  • 10. 2. Securing Oil Revenues
  • 11. Oil Price and Borrowing Cost 7 Source: Merrill Lynch Securing Oil Revenues
    • Over the past 7 years, oil producing countries have faced both historically low and historically high oil price environments
    • The volatility creates challenges to policy makers and jeopardizes sustainable and stable economic growth
    • Currently oil producing countries are enjoying low credit spreads resulting from high oil prices, and this translates into cheap and ample access to Capital Markets
    • However, 7 years ago these same countries were facing capital outflows, limited access to capital markets, and high borrowing costs (wide credit spreads) mostly as a result of historically low oil prices…
    Cost and Access to Capital Markets Highly Correlated to Oil Prices… Credit Spread of Russia and Borrower (bps) vs Oil Price (Brent $/bbL) Credit Spread of Borrower (bps) vs Oil Price (Brent $/bbL) Credit Spreads vs. Oil Price
  • 12.
    • Client issue Oil Linked Notes (OLNs) and receive Issuance Proceeds from Investors
    • Investors may choose to keep indexation to oil price or swap out price exposure with Merrill Lynch
    • Investors may require security over the Producing Assets against the possibility of default by Client
    • Client continue to sell oil in the market as usual:
      • Merrill Lynch may act as an offtaker for the transaction in order to improve credit quality of offtakers and potentially transaction rating
    • Client make debt service payments to Investors fluctuate in conjunction with movements in oil prices:
      • Lower debt service when oil price is low
      • Higher debt service when oil price is high
        • Greater ability to meet payments
    Oil Price Swap (optional) 8 Oil Linked Financing 1 2 3 4 5 Client OLNs ($) Issuance Proceeds Security (optional) Producing Assets 100% Ownership Investors Merrill Lynch 1 2 3 ($) Payment for Oil Oil Client Producing Assets ($) Oil Linked Payments ML/ Customers Investors 4 5 4 Oil Securing Oil Revenues Description Flows At Issuance Ongoing Transaction Flows
  • 13. Coupon Linked to Oil Price Issuer: Client Principal Amount: USD 300,000,000 Effective Date: March 2006 Maturity Date: X years after Effective Date Interest Rate: 12M USD LIBOR - 50bppa + Oil Spread Oil Spread 95bp p.a. × Max [ Oil Price – USD 65/ bbl, 0 ] capped above USD 70/bbl at 425bppa Volume equivalent: 2,885,000 bbls per annual Coupon Period Oil Price: Annual average of PLATTS mid prices for Dated Brent crude oil * Assumes Client standard funding at 100 bppa 9
    • Client issue USD bullet bond with 5-year maturity for which credit spread is indexed to oil price
    • Oil price indexation results in credit spread subsidy in low oil price environment
    • Investor will receive enhanced coupon payment in high oil price environment but this will be capped allowing Client to participate above this level
    Securing Oil Revenues Coupon Linked to Oil Price Illustration of Credit Spread vs. Oil Price Indicative Terms and Conditions / Sample
  • 14.
    • Client issues USD amortising bond with 5-year maturity for which amortisation payments are indexed to oil price
    • Credit spread over LIBOR will be reduced due to inherent credit mitigation of oil price risk
    • Amortisation payments will be reduced in low crude price environment
    Principal Linked to Oil Price Issuer: Client Principal Amount: USD 300,000,000 Effective Date: March 2006 Maturity Date: 5 years after Effective Date Interest Rate: 3M USD LIBOR + 75 bppa Tranches: XXX quarterly linear amortisation payments Amortisation Payment: Standard Amortisation + Oil Amortisation Standard Amortisation: USD 15,000,000 Oil Amortisation: Volume x { Max [Oil Price - $78/bbl, 0] - Max [Oil Price - $100/bbl, 0] - Max [$55/bbl – Oil Price, 0] + Max [$40/bbl – Oil Price, 0] } Volume: 100,000 bbl per quarterly Coupon Period Oil Price: Quarterly average of PLATTS mid prices for Dated Brent crude oil * Assumes Client standard funding at 100 bppa 10 Securing Oil Revenues Principal Linked to Oil Price Illustration of Amortisation vs. Oil Price Indicative Terms and Conditions / Sample $12 $13 $14 $15 $16 $17 25 30 36 41 46 51 57 62 67 72 78 83 88 Oil ($/bbl) Amortisation Payment ($MM) 25 35 45 55 65 75 85 95 Oil Amortisation Payments Standard Payment Oil Price
  • 15. 11 Protection Range and Opportunity Cost versus historical and forward The strategy offers effective protection from falling oil price, limited to the difference between the Put Strikes The opportunity cost of the strategy is limited to the Call Spread ____________________ Source: Bloomberg Protection and Risk Range refer to an Asian Single Settlement Four-Way Strategy maturing 31 st December 2009 Lower Amortisation Payment Higher Amortisation Payment Call Spread Put Spread 0 10 20 30 40 50 60 70 80 90 100 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 $/bbl Securing Oil Revenues
  • 16. Stabilising Revenues 12 Traditional hedging by buying puts or selling forward can be a delicate decision if the market goes against the hedge In retrospect, any put premium lost will often be seen as money wasted… putting the decision makers at “political risk” AAA oil bonds achieve the same objectives as the puts, without incurring any political risk Securing Oil Revenues
    • Fiscal Policy and Stabilization Funds can be complementation do NOT solve the problem entirely
    • Risk Management via Oil Price Insurance (Put Option) is the most conservative
      • Protect against lower prices
      • Retain upside to higher prices
    • Risk Management via Oil Forward Sales does not benefit from upside
    • Risk management via Over-The-Counter (OTC) derivatives, such as buying put options, selling forwards, or selling call options, may not be an efficient nor suitable approach for governments
    • AAA oil bonds provide AAA insurance, better suited for governments
    Solving the Problem of Revenue Stability…
  • 17.
    • AAA Oil Bonds are highly conservative investments, that simultaneously combine the benefits of stabilization mechanisms and hedging of oil price risk
    • Current historically high oil forward prices provide a short term OPPORTUNITY to oil producing countries… but also a long term THREAT on how to manage falling revenues if oil price drops
    • The bullish outlook in the immediate-near term, should not blind policy makers of the opportunities and threats arising from current long-term prices
    • AAA Oil Bonds provide significant improvements versus traditional Over the Counter Derivatives or Money Markets
    Investing in Oil Indexed Notes 13 Securing Oil Revenues $/bbl 3 year Oil Bond vs Fixed Income Current Crude oil Price AAA Oil Bonds Optimise Revenue Management Favourable Market – High Oil Forwards AAA Oil Bonds
  • 18. 14 The PV of the interest available is around 13% of the notional, which given current put options prices allows to purchase 11 million barrels of $40/bbl puts spread over the next 3 years The AAA bond will return 100% at maturity, and protects $440 Million of oil revenues over the next 5 years Issuer: African Development Bank (AAA/Aaa) Issue Size: [USD 1 Bio] Maturity Date: [3 years] from Issue Date Issue Price: 100% in USD Redemption: 100% in USD Coupon: An amount in USD, payable ANNUALLY , equal to the maximum of zero or the difference between the Floor Level and the Final Price, per the Oil Volume Protected Max [ 0 , Oil Floor – Oil Final ] x Oil Volume Protected Oil Floor: [40 USD/bbl] Oil Final : Daily average of IPE Brent over year prior to each Settlement Date Oil Volume Protected: [3.65] million bbl per annum (total 11 million bbl over 3 years) Fees: None Dealer/Underwriter: Merrill Lynch International Listing: Unlisted Program: Global Debt Issuance Facility Format: Permanent Global Note 3 Year AAA Oil Bond, 40 $/bbl Floor, 100% Principal Protected Basis: IPE Brent: 62.96 $/bbl, assuming 3 Year AAA Oil Bond, strike 35 $/bbl, 100% Principal Protection Securing Oil Revenues Indicative Termsheet
  • 19. 15 Three-Way Zero Cost Strategy - Oil Derivatives
    • The Three-Way Zero Cost strategy enables Producer to achieve price protection on crude oil while partially participating in rising oil prices. Producer can finance the purchase of a Put Option by selling a Call Spread. The structure limits the opportunity cost of the hedge to the difference between the Higher and Lower Call Strike
    • At maturity, assuming cash settlement:
      • If the oil price is less than the Put Strike, then Producer receives the difference between the Put Strike Price and the prevailing oil price
      • If the oil price is higher than the Put Strike and less than the Lower Call Strike, neither party makes a payment
      • If the oil price is greater than the Lower Call Strike and less than the Higher Call Strike, then Producer pays the difference between the prevailing oil price and the Lower Call Strike
      • If the oil price is greater than the Higher Call Strike, then Producer pays the difference between the Higher Call Strike and the Lower Call Strike
    • The Three-Way Strategy can be implemented in Asian and Quanto forms
    • Producer receives compensation when the oil price drops below the Put Strike
    • Producer’s payment occurs only if the oil price is above the Lower Call Strike and is limited to the difference between the Higher and Lower Call Strikes
    • Structure is zero premium
    • Producer has the flexibility of customising maturity, Put Strike and Call Strikes, as well as the notional
    Securing Oil Revenues Benefits & Considerations Description Graphical Illustration Downside Protection Higher Call Strike Lower Call Strike Put Strike Realised Price Oil Price Forgone Appreciation
  • 20. 16 Three-Way Zero Cost Strategy – Potential Exposure The Three-Way strategy offers effective protection from large market shocks The risk is limited to the range of the Call Spread and is at much higher levels than both long-term oil prices and current analyst predictions ____________________ Source: Bloomberg Protection and Risk Range refer to an Asian Single Settlement Three-Way Strategy maturing 31 st December 2009 Securing Oil Revenues Call Spread Protection Range Opportunity Cost Put Strike
  • 21. 17 Indicative Prices Securing Oil Revenues Fixed Price Swap on IPE Brent Three-Way Zero Cost Strategy on IPE Brent
  • 22. 3. Securing Revenues from Energy Distribution
  • 23.
    • The Power Plant is exposed to the risk of higher Fuel/Coal Market Prices as revenues from electricity sales are regulated
      • Increasing regulated electricity Tariff is a highly political decision
      • purchasing cost is directly driven by market price which have proved to be very volatile
    • Regulated electricity Tariff in most countries aim providing price stability to final consumers
    • Ideally, the Power Plant would like to stabilise its Fuel/Coal purchasing cost in line with the the regulated electricity Tariff
    • Merrill Lynch proposal is to secure cost of Fuel/Coal supply at a Fixed Price level through a financial swap or a fixed price physical delivery
    Fuel/Coal Fired Power Plant with a Regulated Electricity Tariff 18 Fuel Oil Supplier Power Plant Retail Market Merrill Lynch Floating Market Price Floating Market Price Fixed Price Regulated Tariff Electricity Delivery Physical Fuel Oil Delivery Securing Revenues from Energy Distribution Description Financial Hedge Fixed Price Physical Delivery Physical Transfer Financial Transfer Basis Risk Physical Transfer Financial Transfer Basis Risk Power Plant Retail Market Merrill Lynch Fixed Price Regulated Tariff Electricity Delivery Physical Coal Delivery
  • 24. 19
    • By entering the proposed hedging strategy, the Power Plant can secure is purchasing cost over the future.
      • It helps to mitigate the risk of margin squeeze when purchasing costs increase more than the regulated Tariff
      • The Power Plant gives up potential benefit from lower purchasing cost
      • The basis risk between hedged purchasing costs and revenues from regulated tariff is low as long as price stability drives regulated electricity Tariff
    • When financing project or restructuring existing financing, Development Banks will value the hedging strategy as
        • It provides improved visibility on future cash flows generated by the power plant
        • it helps stabilising retail electricity prices avoiding political tension from Tariff increase
    • Following solutions facilitate the hedging execution
      • Guarantee from the State or from a Devlopment Bank
      • Pari-Passu with the financing banks
      • Collateral under the form of a partial pre-payment of future purchasing cost
      • Paying premium for an insurance against higher purchasing costs rather than fixing it
    Fuel/Coal Fired Power Plant with a Regulated Electricity Tariff Securing Revenues from Energy Distribution Structuring the Hedge Benefit and Considerations Risk of a margin squeeze
  • 25.
    • Merrill Lynch prohibits (a) employees from, directly or indirectly, offering a favorable research rating or specific price target, or offering to change such rating or price target, as consideration or inducement for the receipt of business or for compensation, and (b) Research Analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investor clients.
    • This proposal is confidential, for your private use only, and may not be shared with others (other than your advisors) without Merrill Lynch's written permission, except that you (and each of your employees, representatives or other agents) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the proposal and all materials of any kind (including opinions or other tax analyses) that are provided to you relating to such tax treatment and tax structure. For purposes of the preceding sentence, tax refers to U.S. federal and state tax. This proposal is for discussion purposes only. Merrill Lynch is not an expert on, and does not render opinions regarding, legal, accounting, regulatory or tax matters. You should consult with your advisors concerning these matters before undertaking the proposed transaction.
    • This information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Although the information is obtained from sources we consider reliable, we do not represent that it is accurate or complete.
    • We are acting solely in the capacity of an arm’s length counterparty and not in the capacity of your financial advisor or fiduciary.
    • Generally, all over-the-counter ("OTC") derivative transactions involve the risk of adverse or unanticipated market developments, risk of illiquidity and other risks. Unless specifically stated otherwise, any prices mentioned here are not bids or offers of Merrill Lynch to purchase or sell any securities or other financial instruments. We or persons involved in the preparation of issuance of this material, may from time to time have long or short positions in, and buy or sell, securities, futures, or options related to those mentioned herein.
    • Prior to undertaking any trade, you should consult with your own auditors and your professional tax advisers how such particular trade(s) affect you. Merrill Lynch accepts no liability for clients’ legal, regulatory, credit, tax and accounting aspects in relation to the proposed strategies. While Merrill Lynch may provide illustrations of trading strategies, this is on the understanding that Merrill Lynch is not giving any legal, regulatory, credit, tax or accounting advice to clients and no assurance or undertaking is given that the illustrated benefits can be achieved.
    • Merrill Lynch’s ability to execute the transactions described herein will be subject to approval of Merrill Lynch credit, risk and legal departments, respectively, and any associated due diligence undertaken by these groups.
    20 Disclaimer