The University of Texas School of Law

Presented:
11th Annual Gas And Power Institute

August 23-24, 2012

Houston, Texas

Alternative Financing Structures within

Commodities Arrangements

Craig Enochs
Kevin Page
Samir Najam

Jackson Walker L.L.P.

1401 McKinney Street, Suite 1900
Houston, Texas 77010
www.jw.com

Craig Enochs
cenochs@jw.com
(713) 752-4315

Kevin Page
kpage@jw.com
(713) 752-4227

Samir Najam
snajam@jw.com
(713) 752.4354

Continuing Legal Education 512-475-6700 www.utcle.org

I. INTRODUCTION: THE GROWING NEED FOR ALTERNATIVE CREDIT
STRUCTURES

It was not long ago that credit provisions were merely an afterthought in wholesale
commodity and derivative transactions. In the mid-1990s, the Base Contract for Short-Term
Sale and Purchase of Natural Gas published by the Gas Industry Standards Board (the GISB)
simply contained a one-paragraph adequate assurance provision, and many parties would enter
into a Master Agreement published by the International Swaps and Derivatives Association (an
ISDA) without the benefit of collateral margining protections afforded under an ISDA Credit
Support Annex.

This relaxed attitude toward credit began to change in the late 1990s in response to
various defaults by key industry players that occurred during such period. As a result, parties
began to more closely scrutinize credit terms in commodity trading agreements and require a
minimum level of credit support from counterparties to mitigate exposure, usually in the form of
a parent guaranty supplemented by threshold margining via cash or letters of credit. While these
structures offered trading counterparties some protection, a string of bankruptcies in the
commodity industry in the early to mid-2000s tested the commodity industrys reliance on
guaranties as a form of dependable credit support. A number of guarantors issued guaranties that
exceeded the applicable guarantors net worth, and in particular, the Enron bankruptcy
demonstrated that a guarantor frequently was insolvent if its subsidiary trading company was
insolvent. Market participants learned firsthand that guaranties did not always sufficiently
protect against credit risks associated with a defaulting counterparty.

Since that time, as the commodity industry has lurched back and forth between company
bankruptcies, the 2008 financial crisis and related credit downgrades of banks and commodity
trading entities, companies have increasingly struggled to address two important credit-related
issues:

(i) the inability to post collateral to trading counterparties under physical and
financial commodity transactions; and

(ii) the inability to access credit markets in order to fund existing or new commodity
operations and increase the value of the trading company.

As the cost of available credit continues to rise and managing trade exposure arguably
has never been more imperative than in the current marketplace, commodity trading companies
have been driven to re-analyze how they manage collateral flows and secure much-needed
capital to fund operations. The purpose of this paper is to provide a high-level overview of two
alternative transaction structures utilized by commodity market participants to address such
needs: (i) first lien credit structures; and (ii) prepaid commodity swap transactions.

II. FIRST LIEN STRUCTURES

A. Overview

To the extent a commodity market participant previously has entered into a credit facility
but has little or no available credit to separately collateralize commodity trading operations

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imperative to its business, a first lien credit structure may be useful. It is common in a secured
transaction for a debtor to provide a lender with a lien on and security interest in an asset in order
to secure the debtors payment and performance obligations. However, in the commodity
trading context, a First Lien Credit Structure specifically describes a form of credit support in
which a debtor (the Debtor), under an existing credit and security agreement (the Credit
Agreement) relating to project-financed debt on a tangible asset (the Asset), provides a
trading counterparty (a Hedge Counterparty) with a first lien on and security interest in such
Asset or other collateral set forth in the Credit Agreement (the Asset and any such other
collateral being the Collateral) to support the Debtors obligations under the relevant trading
agreement.

First Lien Credit Structures are particularly useful when lenders under the Credit
Agreement (the Lenders) are concerned about the repayment of the project debt due to
potential market movements in a commodity related to the Asset. Frequent users of this credit
tool are power plant owners who sell power generated by the Asset to Hedge Counterparties and
owners of minerals in the ground who seek to hedge certain percentages of mineral production.

The Lenders allow the Debtor to provide a first lien on the Collateral as credit support to
Hedge Counterparties when the products offered by the Hedge Counterparty reduce price risk or
are otherwise necessary to the operation and financial viability of the Asset. To the extent that
the Debtor purchases inputs from Hedge Counterparty that are necessary to run the Facility, such
trading positions reduce the risk that the Asset will be unable to produce the relevant commodity.
Similarly, if the Debtor sells the Facilitys output to the Hedge Counterparty, then such
relationship mitigates the risk that Debtor will be unable to find a purchaser for the commodity at
a price sufficient to repay the project debt.

As for the Hedge Counterparty, the first lien on and security interest in the Collateral
provides it with (i) equal priority of payment with the Lenders upon any liquidation of the
Collateral and (ii) some of the protections afforded to holders of a perfected security interest in
the Collateral.

B. Types of First Lien Credit Structures

First Lien Credit Structures can either stand alone as collateral in a transaction or
supplement other forms of collateral, and they generally are used as credit tools in three distinct
scenarios: (i) the first lien can wholly replace any other collateral obligations of Debtor under a
trading agreement (a Replacement Structure); (ii) the Hedge Counterparty can assign a value
to the first lien, establishing a fixed credit threshold limit for Debtor under a trading agreement,
such that Debtor only provides additional collateral if Hedge Counterpartys exposure exceeds
such threshold (a Threshold Structure); or (iii) the first lien can cover Hedge Counterpartys
credit risk over and above the value of other collateral provided by Debtor (a Tail Risk
Structure).

In general, Debtors preference is to employ a Replacement Structure because under such

an arrangement, Debtor is not required to outlay any cash or provide a letter of credit or
guaranty, making this structure cheaper for Debtor to implement than any other form of
collateral. However, given that Hedge Counterparty receives no collateral to secure Debtors

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obligations under a Replacement Structure other than the value of the first lien, this structure is
the least preferable option to Hedge Counterparty due to the risk that its exposure will exceed the
value of the first lien. In addition, a Hedge Counterparty may be hesitant to enter into a
Replacement Structure because it prefers to limit the amount of illiquid collateral held in its
credit portfolio.

If a Hedge Counterparty is unwilling to accept a Replacement Structure, Debtors

second-best option is to enter into a Tail Risk Structure. With a Tail Risk Structure, Debtor must
initially post collateral, and its first lien covers all Hedge Counterparty exposure above such
amount. This allows Debtors collateral obligations to be fixed despite any subsequent market
movements altering Hedge Counterpartys exposure during the term of a transaction. From a
Hedge Counterpartys perspective, the Tail Risk Structure is also second-best option because it
initially receives some collateral as security for Debtors obligations in addition to the
protections of the First Lien Credit Structure. Hedge Counterpartys risk arises only when it
incurs exposure in excess of Debtors posted collateral, at which point its sole credit protection
for such exposure is the value of the first lien. As such, Hedge Counterparty may incur
significant market risk if its exposure under a transaction greatly exceeds both Debtors posted
collateral and the value of Hedge Counterpartys first lien.

Finally, Debtor can agree to implement its least favorable option, a Threshold Structure.
Under a Threshold Structure, Debtor is not required to initially provide any collateral to Hedge
Counterparty. However, to the extent that Hedge Counterpartys exposure exceeds Debtors
threshold, Debtor must post collateral based on fluctuating market movements altering Hedge
Counterpartys exposure; thus Debtors collateral obligations are not fixed under a Threshold
Structure but instead are subject to fluctuating market prices that increase Debtors risk. From a
Hedge Counterpartys perspective, a Threshold Structure generally is favored because it not only
accounts for the value of Debtors first lien (as determined by Hedge Counterparty), but it also
protects Hedge Counterparty against market risk by requiring Debtor to post collateral equal to
Hedge Counterpartys exposure over and above Debtors threshold.

C. Advantages of First Lien Credit Structures

For Debtors, a First Lien Credit Structure provides numerous advantages, including the
following:

(i) It eliminates or reduces the need to provide additional collateral during the term
of a transaction and avoids the expense of such additional collateral.

(ii) For Debtors with difficulty providing readily available liquid collateral, it
provides a credit support option when few or no other collateral is available.

(iii) More equity may be available under the Credit Agreement than would be
available under any other collateral facility, providing the Debtor to provide more
collateral with a First Lien Credit Structure than with any other credit support
option.

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 (iv) A first lien does not require constant truing up of posted collateral (to the extent
of the value placed on the First Lien Credit Structure), thereby reducing the
administrative costs of calculating exposure and posting or receiving collateral.

From a Hedge Counterpartys perspective, a First Lien Credit Structure also provides
many advantages, including the following:

(i) It confers a pari passu right of payment and a security interest in a tangible Asset.

(ii) It aligns the Hedge Counterpartys interests in the Collateral with the Lenders
interests under the credit facility, which results in (i) an increased likelihood that
other creditors of the Debtor will advocate for the Debtor to take action that is
favorable to the Hedge Counterpartys interests; and (ii) reduced oversight
expense for the Hedge Counterparty to the extent the Lenders take action
necessary to preserve and/or realize upon the Collateral without Hedge
Counterpartys active participation.

(iii) It generally presents right-way risk. The concept of right-way risk recognizes
that as the price of the input or product increases (thus potentially increasing a
Hedge Counterpartys exposure to the risk that the Debtor will not perform), the
value of the Asset also increases.

(iv) Unlike most other forms of collateral (such as guaranties or letters of credit), a
first lien is a property interest and the Hedge Counterparty owns more than simply
a third-partys promise to pay.

D. Disadvantages of First Lien Credit Structures

Although a First Lien Credit Structure is advantageous to Debtors in the above-

mentioned ways, this alternative credit structure also has the following drawbacks for Debtors:

(i) In many cases a Hedge Counterparty will require additional Collateral be

provided along with the first lien, thereby eliminating much of the administrative
benefit provided by the use of only a first lien as collateral.

(ii) Given that first liens are fairly illiquid and contingent upon the terms of a Credit
Agreement and the actions of the Lenders, they may not be as highly valued as
more liquid forms of collateral.

(iii) Although a Hedge Counterparty may purport to accept a First Lien as the sole
form of Collateral, the Hedge Counterparty may apply very conservative risk
limits and parameters on the commercial terms of transactions secured by the first
lien that may or may not be disclosed to the Debtor. If these limits are disclosed,
the Hedge Counterparty may be willing to lift these limits only if forms of
Collateral other than the first lien are posted for transactions that fall outside the
transaction limits.

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 (iv) Granting a first lien puts Assets at risk that may not otherwise be at risk when
using other forms of Collateral, thereby increasing the risk to the Debtor of its
own default.

(v) When negotiating over the use of a first lien as Collateral, a Hedge Counterparty
may demand price concessions in the commodity contract in exchange for
accepting the first lien.

From the Hedge Counterpartys perspective, there are certain tradeoffs that must be
accepted when a transaction is secured by a First Lien Credit Structure:

(i) First liens are relatively illiquid, thus the process of foreclosing on the Asset can
take more time and be more expensive than realizing on other forms of Collateral.

(ii) Additionally, because a first lien is relatively illiquid, the amount of time between
a Debtors default and the payment of funds pursuant to a first lien can be lengthy.

(iii) A Hedge Counterparty has more control under other forms of Collateral that it
does with a first lien because, under a First Lien Structure, a Hedge Counterparty
can only exercise its rights to the Collateral pursuant to the terms, conditions and
procedures set forth in the Credit Agreement. Under such an agreement, a Hedge
Counterparty shares in the first lien with the Lenders and thus must work through
a democratic process that typically requires at least a majority of debt holders to
agree to foreclose before any action can be taken against the Asset secured by the
first lien.

(iv) First liens by their nature are not fungible. Unlike with cash and transferable
letters of credit, a Hedge Counterparty holding a first lien on an Asset will
generally be unable to rehypothecate such first lien to a third party in order to
secure Hedge Counterpartys obligations to such third party. As a result, a Hedge
Counterpartys capital costs associated with its credit support obligations across
its portfolio may be greater when it accepts a first lien than when it accepts a more
fungible form of Collateral.

(v) Credit Agreements are complex, lengthy and not standardized, often requiring
extensive legal review to understand the risks and obligations therein, which adds
to the monetary cost and time required to negotiate the credit arrangements for a
transaction.

E. Other Issues to Consider When Using First Lien Credit Structures

In addition to the above-mentioned advantages and disadvantages commodity trading

counterparties face when using a First Lien Credit Structure, there are other matters to consider
when deciding to use this alternative credit tool:

i. Voting Rights Under the Credit Agreement

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 A Hedge Counterparty accepting a first lien needs to be aware of voting rights as set fort
in the Credit Agreement, which typically directly translates to its ability to control the Collateral.

Although both the Lenders and Hedge Counterparties generally possess some form of
voting rights, their respective rights may not be equal. The matters on which a Hedge
Counterparty may vote and the weight of the Hedge Counterpartys vote in determining the
matter often vary depending on the specific terms of each Credit Agreement and the issue at
hand. Voting rights under First Lien Credit Structures are often allocated between the Lenders
and Hedge Counterparties based on the ratio of a relevant entitys current credit exposure
compared to the cumulative debt outstanding under the Credit Agreement. Using this formula, a
Hedge Counterparty will be unlikely to ever have a level of exposure reasonably equal to the
debt held by the Lenders for most of the term of the loan held by the Lenders (although the
parties voting rights continually change throughout the life of the credit facility because as the
Debtor pays down its debt under the Credit Agreement, the exposure of the Lenders in turn
decreases). Thus Hedge Counterparties must work directly with Lenders (and potentially, other
Hedge Counterparties) to achieve desired results. As such, a Hedge Counterparty entering into a
commodity trading agreement secured by a First Lien Credit Structure faces additional dynamics
and potential challenges not encountered by counterparties to trading agreements secured by
other forms of collateral.

ii. Payment of Credit Facility in Full

Another consideration of a Hedge Counterparty in a First Lien Credit Structure is how its
lien and security interest in the Collateral is treated once the credit facility is paid in full. As
discussed herein, a Hedge Counterpartys Collateral rights tend to derive directly from the Credit
Agreement. The Hedge Counterparty may want to specify that the decision to release its lien
pursuant to the Credit Agreement cannot be made unilaterally by the Lenders without the Hedge
Counterpartys consent or without the Debtor first providing alternative forms of Collateral to
secure its commodity trading obligations to Hedge Counterparty.

iii. Documentation of First Lien Issues in Trading Agreements

Both Debtor and Hedge Counterparty must carefully contemplate the drafting of trading
agreements to accommodate first lien issues. For example, if the Credit Agreement terminates or
is no longer in full force and effect, a Hedge Counterparty may want to specify in the trading
agreement secured by the first lien that if Debtors obligations cease to be subject to a first lien
and security interest in the Collateral or cease to rank in equal priority of payment with the
Lenders upon liquidation of the Collateral, then an event of default or termination event
immediately occurs under such trading agreement. Another remedy used in such situations
requires the Debtor to provide additional Collateral or risk an event of default under the
agreement. Of these two remedies, the requirement that additional Collateral be posted is
preferable for the Hedge Counterparty because it provides the Hedge Counterparty with
Collateral to realize upon for payment of Debtors obligations if the trading agreement
terminates and Debtor fails to pay amounts it owes thereunder.

To the extent that the parties have entered into a margining arrangement and Hedge
Counterparty has granted Debtor a collateral threshold based on the value of the First Lien Credit

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Structure, Hedge Counterparty may want to articulate that such threshold is reduced to zero if the
first lien ceases to exist, therefore requiring the Debtor to provide alternative forms of Collateral
to secure its obligations under the trading agreement.

Additionally, a Hedge Counterparty may prefer to include representations, warranties

and/or covenants in trading agreements to clearly articulate that a Hedge Counterparty is holding
a first lien and security interest in the Collateral to support the Debtors obligations under the
agreement. Other representations which may protect Hedge Counterparty relate to Debtors
authorization and/or ability to provide the first lien in accordance with the Credit Agreements
terms and Debtors compliance with any representations, warranties and/or covenants otherwise
contained in the Credit Agreement itself.

Finally, Debtor and Hedge Counterparty should analyze their rights under the Credit
Agreement to make sure they are consistent with any rights set forth under the trading
agreement. For example, if the Credit Agreement provides that the Debtors assets (including its
rights under various trading agreements) may be encumbered or transferred under certain
circumstances, then any transfer provisions in the trading agreement should acknowledge and be
subordinate to such rights under the Credit Agreement notwithstanding any conflicting terms in
the trading agreement.

III. PREPAID SWAP TRANSACTIONS

A. Overview

To the extent a commodity trading participant has little or no access to capital markets
because the cost of credit is too expensive or it is otherwise unable to secure financing from
traditional lending sources, a prepaid commodity swap transaction may be able to provide
necessary funding for the participant to invest in business inputs and operations (a Prepaid
Swap Structure). Under a Prepaid Swap Structure, the entity in need of funding (the Swap
Debtor) generally will enter into an ISDA Master Agreement and Schedule (the Swap Trading
Agreement) with a financial entity or, alternatively, the commodity trading affiliate of a
financial entity (the Swap Lender). As part of the Swap Trading Agreement, the parties enter
into a commodity swap transaction (a Swap Transaction) whereby each month during the term
of the transaction:

(i) the Swap Debtor pays a floating amount equal to the product of (A) a notional
quantity of the relevant commodity to be produced by the Swap Debtor in its
business operations during such month (the Swap Quantity), and (B) a monthly
index price applicable to such commodity (the Index Price); and

(ii) the Swap Lender pays a fixed amount equal to the product of (A) the Swap
Quantity; and (B) a fixed price of $0.00.

At the time the parties enter into the Swap Transaction, the Swap Lender makes an initial, lump-
sum payment to the Swap Debtor equal to the net present value of (i) a negotiated per-unit fixed
price for the relevant commodity under the Swap Transaction, multiplied by (ii) the cumulative
Swap Quantity to be settled during the entire term of the Swap Transaction (such calculation
being the Prepayment). Upon receiving the Prepayment, the Swap Debtor uses such funds to

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invest in inputs for commodity production, thus increasing the value of the Swap Debtors
business. In exchange for making the Prepayment and entering into the Swap Transaction, the
Swap Lender receives a first lien on and security interest in the commodity being produced by
the Swap Debtor, usually effectuated by a lien on the Swap Debtors relevant mineral interests in
the commodity or a lien on the Swap Debtors payment receivables tied to physical commodity
sales to third parties. An example of a financially-settled Prepaid Swap Structure is set forth on
Exhibit A attached hereto.

Importantly, the Swap Quantity involved in the Swap Transaction generally is only a
percentage of the Swap Debtors total anticipated commodity production. As a result, the
amount of the Prepayment owed by Swap Lender (and, in turn, the value of the overall Swap
Transaction) funds only a portion of the Swap Debtors start-up costs and expenses necessary for
commodity operations. From a practical perspective, a limited Swap Quantity serves two key
functions. First, it recognizes the fact that a Swap Lender is more willing to make a Prepayment
for the limited purpose of getting the Swap Debtors commodity production viable in the short-
term instead of providing a more expensive, riskier financing of Swap Debtors long-term
operations. Second, by limiting the amount of the initial Prepayment, a conservative Swap
Quantity mitigates the Swap Lenders repayment risk to the extent overall commodity production
fails to meet anticipated levels during the term of the Swap Transaction. In other words, even if
the Swap Debtors commodity production declines below anticipated benchmarks, such limited
production still may sufficiently enable Swap Debtor to make timely payments to Swap Lender
under the Swap Transaction.

Because of the nature of the transaction, Prepaid Swap Structures are most commonly
utilized by two types of commodity market participants: (i) producers of agricultural
commodities in markets outside the United States; and (ii) producers of minerals, such as crude
oil and natural gas.

B. Use by Non-U.S. Agricultural Commodity Growers

Prepaid Swap Structures are commonly utilized by foreign producers of agricultural

commodities such as soybeans, cocoa and coffee. Agricultural commodity growers have a
significant need for upfront capital to purchase inputs to invest in their business, such as seeds,
fertilizer and irrigation systems. However, growers in undeveloped or under-developed parts of
the worldsuch as portions of South America and Africaoften do not have access to
traditional financing sources and credit markets otherwise available to U.S.-based agricultural
commodity producers. In addition, foreign agricultural commodity growers typically do not
receive funding through subsidies or other government programs commonly available to
agricultural producers within the United States. For these reasons, a Prepaid Swap Structure may
be particularly useful to agricultural commodity growers in need of start-up capital to invest in
farming operations outside of the United States.

A Prepaid Swap Structure involving a Swap Debtor-producer of agricultural commodities

may give rise to unique characteristics and issues. For example, it is common for the Swap
Lender to be an aggregator of agricultural commodities and thus require the Swap Transaction to
be settled by physical delivery of the agricultural commodity. Moreover, the commodity
aggregator Swap Lender may have entered into a back-to-back Prepaid Swap Structure with a

Page 8
commodity merchant such that payment streams and physical commodity deliveries are passed
through the deal structure, with the aggregator making a small profit margin for its role in
facilitating the transaction. An example of a physically-settled Prepaid Swap Structure is set
forth on Exhibit B attached hereto.

The mechanics of a physically-settled Prepaid Swap Structure are similar to the

mechanics involved in a financially-settled Prepaid Swap Structure: (i) the parties enter into a
Swap Trading Agreement; (ii) the Swap Lender is obligated to make an initial Prepayment to
Swap Debtor based on the cumulative Swap Quantities applicable under the Swap Transaction;
and (iii) the Swap Quantity usually is only a portion of Swap Debtors total anticipated
agricultural commodity production. However, the key difference between a physically-settled
Prepaid Swap Structure and financially-settled Prepaid Swap Structure is that the Swap
Transaction at issue in a physically-settled Prepaid Swap Structure is not financially settled.
Instead, the Swap Transaction resembles a commodity forward transaction whereby each month
during the term (i) the Swap Debtor physically delivers to Swap Lender the relevant commodity
in an amount equal to the monthly Swap Quantity, and (ii) the Swap Lender pays a fixed amount
for the commodity equal to the product of (A) the monthly Swap Quantity, and (B) a fixed
commodity price of $0.00. To secure Swap Debtors obligations under the Swap Transaction,
Swap Lender generally will take a lien on and security interest in all or a portion of the Swap
Debtors agricultural commodity production.

Because physically-settled Prepaid Swap Structures typically involve foreign agricultural

commodity growers, practical issues may need to be considered in structuring the transaction.
Agricultural commodity Swap Debtors often are located in under-developed or undeveloped
countries, and international laws and customs in such countries will drive the Swap Lenders
ability to transact business with Swap Debtors. Unstable political regimes and trade customs
may dictate delivery and payment terms, and Swap Lender will want to ensure that all applicable
national and local licenses, consents and/or permits necessary for taking delivery of the relevant
commodity are obtained before performance obligations arise. The parties should consider how
the Swap Trading Agreement will sufficiently address physical delivery and payment risks
inherent to dealing with foreign laws and regulations, whether by additional representations,
force majeure and/or indemnification provisions. In addition, the Swap Lender also will need to
conduct diligence to understand how it can successfully obtain and perfect a lien on and security
interest in the Swap Debtors commodity production, as the law of secured transactions likely
will be unique to each country (and indeed, perhaps each state or region) in which the Swap
Debtors agricultural crop production is physically located.

C. Use by Producers of Crude Oil and Natural Gas

Apart from agricultural commodity growers, producers of crude oil and natural gas may
choose to enter into financially-settled Prepaid Swap Structures in order to obtain necessary
funding for drilling and operating expenditures. In such case, a producer-Swap Debtor receives a
Prepayment from a Swap Lender pursuant to the terms of a Swap Trading Agreement with the
intent that such Prepayment will be utilized by Swap Debtor in developing wells so that
consistent mineral production becomes viable. At the time the Swap Lender makes the
Prepayment, the parties enter into a Swap Transaction whereby each month during the term (i)
the Swap Debtor agrees to pay (A) an Index Price applicable to crude or natural gas (as

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applicable), multiplied by (B) the Swap Quantity applicable to such month; and (ii) the Swap
Lender agrees to pay (A) a fixed price of $0.00, multiplied by (B) the Swap Quantity applicable
to such month. The Swap Quantity generally is a mere fraction of the Swap Debtors total
anticipated oil or natural gas reserves under its lease(s), thus limiting the amount of Swap
Lenders initial Prepayment and mitigating the risk that Swap Debtor will be unable to pay Swap
Lender if oil or gas production is delayed or significantly declines. In exchange for providing
the Prepayment and entering into the Swap Transaction, Swap Lender generally will receive a
first lien on and security interest in Swap Debtors assets and mineral rights associated Swap
Debtors drilling and production activity tied to the Prepayment. An example of a financially-
settled Prepaid Swap Structure utilized by a natural gas producer is set forth on Exhibit C
attached hereto.

When a Prepaid Swap Structure funds a mineral producers operations, a number of legal
and practical issues arise that are unique to the transaction. Broad legal and commercial
expertise is required to facilitate all facets of the deal. Commodity and derivatives counsel will
be involved documenting the Swap Trading Agreement and the Swap Transactions, and lending
counsel also may be useful to ensure that the Swap Trading Agreement includes covenants,
additional defaults and restrictions commonly found in traditional lending arrangements.
Upstream oil and natural gas counsel will work in conjunction with both parties on a number of
issues, including but not limited to (i) Swap Debtors ownership of its mineral rights involved
and other title issues, (ii) the scope of Swap Debtors authority to act under its joint operating
agreements and mineral leases and any limitations therein, (iii) an analysis of production and
reserve reports to determine the viability of anticipated oil or natural gas production in the
relevant leases; and (iv) other State and local laws governing real property rights and extraction
of minerals. Such issues are important to both parties because they generally will dictate the
amount of the Prepayment that Swap Lender is willing to provide to Swap Debtor under the
Swap Transaction, as well as the value Swap Lender assigns to its security interest in Swap
Debtors assets and mineral rights. Corporate and tax counsel also may be needed to ensure that
Swap Lenders security interest is properly documented, secured and perfected in the relevant
State where the property is located and that no State tax law issues arise associated with the
Prepayment or Swap Lenders lien on the collateral.

D. Other Possible Applications

Although agricultural commodity growers and mineral producers are common examples
of entities that utilize Prepaid Swap Structures, other players in the commodity industry also may
find the structure attractive and analyze whether it is viable option for their business.

For example, if a hedge fund purchased an electric generation facility but did not have
sufficient funding (whether through private investors or traditional lending resources) to invest in
ramp up costs and operations at the plant, the hedge fund could consider a Prepaid Swap
Structure to fund the facilitys initial expenses. In such case, the hedge fund-Swap Debtor could
enter into a Swap Trading Agreement with a Swap Lender, most likely a financial institutions
energy trading affiliate that trades physical power. After analyzing the total capacity of the plant
and its operational characteristics, the parties would negotiate a predetermined base quantity of
power in order to determine the amount of Swap Lenders initial Prepayment and the notional
quantity of power under the Swap Transaction.

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 Under the Swap Transaction, the Swap Debtor would agree to pay (A) an Index Price
applicable to power, multiplied by (B) the Swap Quantity applicable to such month; and (ii) the
Swap Lender would agree to pay (A) a fixed price of $0.00, multiplied by (B) the Swap Quantity
applicable to such month. Because Swap Debtor would owe Swap Lender an index-based
amount under the Swap Transaction, Swap Debtor could sell power generated at the facility at
the Index Price in the marketplace and flow through such payments to Swap Lender under the
Swap Transaction. In exchange for making the Prepayment and entering into the Swap
Transaction, Swap Lender could take a lien on and security interest in all or a portion of Swap
Debtors receivables associated with sales of power generated at the facility, most likely through
a security agreement and deposit account control agreement (or similar means). In such case, if
Swap Debtor failed to make payments to Swap Lender under the Swap Transaction, Swap
Lender would be able to efficiently exercise a remedy and remain protected from a credit
standpoint.

IV. CONCLUSION

Credit markets drive collateral scarcity in a reinforcing cycle. To the extent a commodity
market participant is unable to receive funding through traditional credit sources, whether
because the cost of credit is too expensive or markets are otherwise readily available, it is likely
that such market participant also has an inability to deliver traditionally-accepted forms of
collateral to secure payment obligations under its commodity trading agreements. Because credit
markets continue to fluctuate, commodity market participants will be driven to create innovative
credit solutions that specifically address (i) how to fund the market participants business
operations, and (ii) how to collateralize the market participants commodity trading obligations.
These solutions most likely will manifest in new, unique transaction structures not traditionally
considered in the commodity marketplace, as opposed to new forms of collateral supporting
traditional trading structures. Although First Lien Credit Structures and Prepaid Swap Structures
are two examples of alternative collateral structures impacting commodity trading markets, the
industry most certainly will continue to pioneer other credit structures to accommodate the
changing dynamics in todays credit landscape.

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 EXHIBIT A

Diagram of a Financially-Settled Prepaid Swap Structure:

General Overview

Exhibit A - 1
 EXHIBIT B

Diagram of a Physically-Settled Prepaid Swap Structure:

Agricultural Commodity Grower

Exhibit B - 1
 EXHIBIT C

Diagram of a Financially-Settled Prepaid Swap Structure:

Natural Gas Producer

Exhibit C - 1