Dominion Power 2002 Annual Report Download - page 56

Management’s Discussion and Analysis of Financial Condition
and Results of Operations, Continued
Future Acquisitions
Because Dominion’s industry is rapidly changing, there are
many opportunities for acquisitions of assets, as well as for busi-
ness combinations. Dominion investigates any opportunity that
may increase shareholder value and build on existing businesses,
with an objective to enter into transactions that would be
immediately accretive to earnings per share. Dominion has par-
ticipated in the past—and its security holders may assume that
at any time Dominion may be participating—in bidding or
other negotiations for such transactions. Such participation may
or may not result in a transaction for Dominion. However, any
such transaction that does take place may involve consideration
in the form of cash, debt or equity securities. It may also involve
payment of a premium over book or market values. Such trans-
actions or payments could affect the market prices and rates for
Dominion’s securities.
Market Rate Sensitive Instruments and
Risk Management
Dominion’s financial instruments, commodity contracts and
related derivative instruments are exposed to potential losses
due to adverse changes in interest rates, commodity prices and
equity security prices as described below. Interest rate risk gen-
erally is related to Dominion’s outstanding debt and financial
services activities. Commodity price risk is present in Domin-
ion’s electric operations, gas production and procurement
operations, and energy marketing and trading operations due
to the exposure to market shifts for prices received and paid for
natural gas, electricity and other commodities. Dominion uses
derivative instruments to manage price risk exposures for these
operations. Dominion is exposed to equity price risk through
various portfolios of equity securities.
Dominion’s sensitivity analysis estimates the potential loss
of future earnings or fair value from market risk sensitive instru-
ments over a selected time period due to a 10 percent unfavor-
able change in interest rates and commodity prices.
Commodity Price Risk—Trading Activities
As part of its strategy to market energy and to manage related
risks, Dominion manages a portfolio of commodity-based deriv-
ative instruments held for trading purposes. These contracts are
sensitive to changes in the prices of natural gas, electricity and
certain other commodities. Dominion uses established policies
and procedures to manage the risks associated with these price
fluctuations and uses derivative instruments, such as futures,
forwards, swaps and options, to mitigate risk by creating offset-
ting market positions. In addition, Dominion seeks to use its
generation capacity, when not needed to serve customers in its
service territory, to satisfy commitments to sell energy.
A hypothetical 10 percent unfavorable change in commod-
ity prices would have resulted in a decrease of approximately $41
million and $12 million in the fair value of its commodity con-
tracts held for trading purposes as of December 31, 2002 and
2001, respectively.
Commodity Price Risk—Non-Trading Activities
Dominion manages the price risk associated with purchases
and sales of natural gas, oil and electricity by using derivative
commodity instruments including futures, forwards, options
and swaps. For sensitivity analysis purposes, the fair value of
Dominion’s non-trading derivative commodity instruments is
determined based on models that consider the market prices
of commodities in future periods, the volatility of the market
prices in each period, as well as the time value factors of the
derivative instruments. Market prices and volatility are princi-
pally determined based on quoted prices on the futures
exchange. A hypothetical 10 percent unfavorable change in
market prices of Dominion’s non-trading derivative commodity
instruments would have resulted in a decrease in fair value of
approximately $331 million and $155 million as of December
31, 2002 and December 31, 2001, respectively.
The impact of a change in energy commodity prices on
Dominion’s non-trading derivative commodity instruments at a
point in time is not necessarily representative of the results that
will be realized when such contracts are ultimately settled. Net
losses from derivative commodity instruments used for hedging
purposes, to the extent realized, are generally offset by recogni-
tion of the hedged transaction, such as revenue from sales.
Interest Rate Risk
Dominion manages its interest rate risk exposure predomi-
nantly by maintaining a balance of fixed and variable rate debt.
Dominion also enters into interest rate sensitive derivatives,
including interest rate swaps and interest rate lock agreements.
In addition, Dominion, through subsidiaries, retains ownership
of mortgage investments, including subordinated bonds and
interest-only residual assets retained at securitization of mort-
gage loans originated and purchased. For financial instruments
outstanding at December 31, 2002, a hypothetical 10 percent
increase in market interest rates would decrease annual
earnings by approximately $4 million. A hypothetical 10 per-
cent increase in market interest rates, as determined at Decem-
ber 31, 2001, would have resulted in a decrease in annual
earnings of approximately $10 million. In addition, Note 13
to the Consolidated Financial Statements discussed investments
in retained interests from prior securitizations.
54 Dominion ’02 Annual Report