Option Strategies - Natural Gas Trading Opportunities

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Natural Gas Trade Opportunities

• We expect near-term downside for utilities names exposed to natural gas prices - EXC, D, TXU, and NRG. However, we are fundamentally bullish on these names over the medium term, on the basis of tightening U.S. power markets and Q406 shareholder events.

• We suggest two derivatives strategies that efficiently express this fundamental view with different risk-reward characteristics.

• Purchasing Oct puts and Jan call spreads lets investors gain from any near-term lows and provides participation to any upside in the fourth quarter and early next year.

• An alternative strategy involving higher risk would buy Oct puts and 1x2 call spreads expiring in January. This reduces the initial premium and provides greater leverage, but leaves investors short the upside beyond the interim target price.

September 18, 2006

Derivatives Strategy Ryan Renicker, CFA

1.212.526.9425 [email protected]

Devapriya Mallick 1.212.526.5429

[email protected]

Power & Utilities

Daniel Ford, CFA 1.212.526.0836

[email protected]

Gregg Orrill 1.212.526.0865

[email protected]

Equity Derivatives Strategy | Natural Gas Trade Opportunities

September 18, 2006 2

Investment Conclusion

We expect near-term downside for utilities names exposed to natural gas prices - EXC, D, TXU, and NRG. However, we are fundamentally bullish over the medium term based on expected catalysts. We explore two derivatives strategies for expressing this view using relatively cheap options on these names. The first strategy is to buy Oct puts and Jan 07 call spreads. A higher risk alternative is purchasing Oct puts and Jan 1x2 call spreads, with the higher strike close to the interim target.

Fundamental View – Daniel Ford/Gregg Orrill

Our fundamental view is that these 4 companies are advantaged by tightening U.S. power markets coupled with shareholder events in Q4'06 that should propel them at least halfway to our 12 month price targets by January. These catalysts include:

EXC: a 12/12 analyst meeting where we expect a dividend hike, share repurchase and 2007/2008 EPS guidance. Our 12 month target is $71 is premised upon applying a 15% premium to the integrated utilities group, or 14.3x our $4.97 estimate for ‘08. However, our interim target is $65 which reflects ½ of the potential upside to our 12 month target.

D: completion of strategic business review, potential structural changes announced. Our 12 month D price target of $79 reflects an integrated multiple of 11.2x our 2008 EPS estimate of $7.12. However, our interim target is $78 which reflects ½ of the potential upside to our 12 month target. Our long-term rating on D is a 2-Equal weight as we are skeptical on the timeliness of recognizing the strategic upside of the assets, however, we believe that within the derivatives context detailed herein, particularly due to the near-term weakness in gas prices, there is a buying opportunity.

TXU: the likely air permit for a major power plant in Texas in mid-October followed by development company debt and equity financing in Q4'06. Our 12 month TXU price target is $69, however, our interim target is $65 which reflects ½ of the potential upside to our 12 month target.

More specifically, our 12 month target is premised upon the average of three valuation methodologies, which are: 14.9x the Utility business and 17.7x the Energy Business plus a value of the retail business of $1,178 per customer which yeilds $63; 7.4x '07E EBITDA of $5.4B less $12.4B in debt which is $63; and a free cash yield of 7.9% on $2.8B in '07 which is $80.

NRG: investor meeting on 10/17 to review a generation development program. Our 12 month target is $59, however, our interim target is $53 which reflects ½ of the potential upside to our 12 month target.

More specifically, our 12 month target for NRG reflects the average of four valuation methodologies following and $2/share of NOLs NPV including: IPP average 7.5x 2008 EBITDA of $1.72B less $5.9B of net debt and 144M diluted shares; free cash yield of 10.5% on $846M or $56; asset based values of $53 and Open EBITDA average of $2.35B 2008 EBITDA of 6.6x less $6.0B of net debt.

Near-term this fundamental view is challenged by collapsing natural gas prices due to unprecedented storage levels, coupled with lack of supply disruptions (hurricanes) and normal seasonal declines in usage. In similar past periods these stocks have tracked gas down and corrected 10-15% notably in 10/05 and 5/06. We believe this trough could last until winter heating season begins to ramp-up in November.



Figure 1: Nat Gas Trade Milestones

Figure 2: Average Implied Vol for EXC, D, TXU andNRG Interim

Current RecoveryStock 9/18/06 Downside Positive Catalysts TargetD $76.87 $72-$68 Strategic review announcements $78EXC $58.73 $57-$54 Dividend hike, stock buyback, '07/'08 guidance $65NRG $48.08 $46-$43 10/17 investor meeting in TX. $53TXU $62.29 $59-$57 Air permit for TX plant and devco financing. $65

16%

18%

20%

22%

24%

26%

28%

30%

Jan-0

6

Feb-0

6

Mar-0

6

Apr-0

6

May-0

6

Jun-0

6Ju

l-06

Aug-

06

Sep-06

Avg 3m Implied Vol

Avg 1m Implied Vol

Source: Bloomberg, Lehman Brothers Source: Lehman Brothers, OptionMetrics

Based upon past patterns, we posit that the stocks could see lows of $59-$57 for TXU, $46-$43 for NRG, $57-$54 for EXC, and $72-$68 for D.

Figure 1 summarizes the potential key catalysts along with the expected downside and recovery target for each of these stocks.

We would begin buying these stocks at the high end of the correction range and aggressively purchase at the bottom end. Our point of view is backed by a long-term view of gas and power prices outlined in "Just the Beginning" 8/21/06.

Implied Vols Still Fairly Low

Implied volatility for Utilities names has been rising concurrently with the sell-off over the last two weeks. Figure 2 shows that average implied vols for these 4 stocks have been on the ascent over this period. However, these options are still trading cheap relative to their vols since the beginning of the year. In the event of a near-term trough being attained, volatility could rise even further, hence biasing us towards long option strategies.

We suggest two possible options strategies with different risk-reward profiles that efficiently express our fundamental view.



Strategy I: Oct Puts vs Jan Call Spreads

• Expectations of a near-term pullback merit purchasing short-dated puts expiring in October.

• Long call spreads expiring in January give participation to any potential upside in the later part of the fourth quarter and early next year.

• We show the payoff from a strategy of buying TXU Oct 60 puts and TXU Jan 07 62.5-65 call spreads (Figure 3).

• The trade benefits from any downside below $60 as of the October expiration and gains from TXU rising to $65 by the January expiration.

• The up-front premium is $2.15, or approximately 3.5% of TXU’s closing price last night. This represents the maximum downside from the trade.

• Figure 4 shows the expiration payoff of the strategy for TXU, for different underlying prices as of the October 20th and January 19th expirations.

• Per our fundamental expectations, if TXU retreats to $57 by October 20 and rallies back to $65 by January 19, the trade stands to pay off $5.5 at expiration, over 250% of the initial premium.

Figure 3: Puts vs Call Spreads Payoff – TXU

Figure 4: Strategy I P/L for TXU Under Different Scenarios

-3

-2

-1

0

1

2

3

4

5

6

50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80

TXU Price

Stra

tegy

Pay

off

Payoff (9/18/06)Payoff (10/20/06)Payoff (1/19/07)

Benefit from pullback till Oct

50 52 54 56 58 60 62 64 66 68 7050 7.9 7.9 7.9 7.9 7.9 7.9 7.9 9.4 10.4 10.4 10.452 5.9 5.9 5.9 5.9 5.9 5.9 5.9 7.4 8.4 8.4 8.454 3.9 3.9 3.9 3.9 3.9 3.9 3.9 5.4 6.4 6.4 6.456 1.9 1.9 1.9 1.9 1.9 1.9 1.9 3.4 4.4 4.4 4.458 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 1.4 2.4 2.4 2.460 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.462 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.464 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.466 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.468 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.470 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4

TXU Price as of Jan 07 Expiration

TXU

Pric

e as

of O

ct E

xpira

tion

Maximum downside limited to premium paid

Max gain if TXU retracts in near-term and rallies before Jan

Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg



Strategy II: Oct Puts vs Jan 1x2 Call Spreads

• A higher risk alternative to the previous strategy would be to purchase 1x2 call spreads expiring in January.

• This reduces the initial premium and provides greater leverage but leaves the investor short the upside beyond the near-term target price.

• The strategy makes more sense for stocks with an upward sloping term structure of implied volatility, such as NRG.

• Figure 5 shows the payoff on different dates from a long position in NRG Oct 45 puts and NRG Jan 07 50-55 1x2 call spreads.

• The initial cost of setting up the trade is $1.5, or about 3.1% of NRG’s closing price last night.

• Figure 6 shows the suggested strikes and breakevens for the other stocks. The upper is the price above which the stock has to finish in order for the 1x2 call spreads to start losing.

Figure 5: Puts vs 1x2 Call Spreads Payoff - NRG

Figure 6: Puts vs 1x2 Call Spreads Payoff – Suggested Strikes

-10

-8

-6

-4

-2

0

2

4

6

8

10

35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65

NRG Price

Stra

tegy

Pay

off

Payoff (9/18/06)Payoff (10/20/06)Payoff (1/19/07)

1x2 call spreads start losing beyond upper breakeven

Ticker Oct Leg Jan Leg Net Premium

Lower Breakeven

(Oct 06)

Upper Breakeven

(Jan 07)

D B 75 Put B 75-80 1x2 Call Spread 1.7 74.3 81.6EXC B 60 Put B 60-65 1x2 Call Spread 3.05 58.1 71.35NRG B 45 Put B 50-55 1x2 Call Spread 1.5 44.4 58.1TXU B 60 Put B 60-65 1x2 Call Spread 0.9 59.1 66.3

Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg



Analyst Certification: We, Ryan Renicker, Daniel Ford and Gregg Orrill, hereby certify (1) that the views expressed in this research email accurately reflect our personal views about any or all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this email. To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research email accurately reflect the firm's quantitative research model (2) no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this email communication.

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Mentioned Stocks

Dominion Resources (D - USD77.16) 2-Equal weight / Negative A/D/E/J/K/L/M

Risks Which May Impede the Achievement of the Price Target: Dominion is exposed to the electricity, natural gas, and oil commodity markets which can create earnings volatility.

Other Material Conflicts: Lehman Brothers is acting as financial advisor to Equitable Resources in connection with the potential acquisition of Dominion Peoples and Dominion Hope from Dominion Resources

Exelon Corp (EXC - USD59.21) 1-Overweight / Negative D/J/L

Risks Which May Impede the Achievement of the Price Target: Risks to the outlook include wholesale commodity prices, generation development market conditions, the outcome of regulatory proceedings, rating agency actions, interest rates, and access to the capital markets.

Other Material Conflicts: Lehman Brothers is currently acting as a financial advisor to Exelon Corp. with respect to its restructuring of Commonwealth Edison.

NRG Energy (NRG - USD47.30) 1-Overweight / Negative D/F/J/L

Risks Which May Impede the Achievement of the Price Target: Key risks include power and gas prices, weather volatility, higher interest rates and wider credit spreads, and power markets regulation.

TXU Corp (TXU - USD61.45) 1-Overweight / Negative A/D/E/F/J/L

Risks Which May Impede the Achievement of the Price Target: Key risks are Texas regulation, U.S. power and gas prices, interest rates, and credit rating downgrades.



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Option Strategies - Natural Gas Trading Opportunities

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Transcript of Option Strategies - Natural Gas Trading Opportunities