P N M R E S O U R C E S • 2 0 0 3 A n n u a l R e p o r t t o S h a r e h o l d e r s 38 39 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table shows the net fair value of mark-to-market energy contracts included in the balance sheet (In thousands): DECEMBER 31, 2003 2002 Mark-to-Market Energy Contracts: Current asset $ 2,098)% $ 4,531)% Long-term asset 1,359)% 267)% TOTAL MARK-TO-MARKET ASSETS 3,457 )% 4,798)% Current liability (1,941)% (5,725)% Long-term liability (1,083)% –)% TOTAL MARK-TO-MARKET LIABILITIES (3,024) % (5,725)% NET FAIR VALUE OF MARK-TO-MARKET ENERGY CONTRACTS $ 433 )% $ (927)% The mark-to-market energy portfolio positions represent net assets at December 31, 2003 and represent net liabilities at December 31, 2002 after netting all applicable open purchase and sale contracts.  The market prices used to value PNM’s mark-to-market energy portfolio are based on closing exchange prices and broker quotations. As of December 31, 2003 and December 31, 2002, PNM did not have any outstanding contracts that were valued using methods other than quoted prices. The Company did not change its methods for valuing its mark-to-market energy portfolio in 2003 as compared to 2002. The following table provides detail of changes in the Company’s mark-to-market energy portfolio net asset or liability balance sheet position from one period to the next (In thousands): The following table provides the maturity of the net assets/(liabilities) of the Company, giving an indication of when these mark-to-market amounts will settle and generate/(use) cash. The following values were determined using broker quotes (In thousands): As of December 31, 2003, a decrease in market pricing of PNM’s mark-to-market energy portfolio by 10% would have resulted in a decrease in net earnings of less than 1%. Conversely, an increase in market pricing of this portfolio by 10% would have resulted in an increase in net earnings of less than 1%. TWELVE MONTHS ENDED DECEMBER 31, 2003 2002 Sources of Fair Value Gain/(Loss) Fair value at beginning of year $ (927)% $ (30,440)% Amount realized on contracts delivered during period (2,113)% 26,336)% Changes in fair value 3,473)% 3,177)% NET FAIR VALUE AT END OF PERIOD $ 433)% $ (927)% NET CHANGE RECORDED AS MARK-TO-MARKET $ 1,360)% $ 29,513)% FAIR VALUE AT DECEMBER 31, 2003 LESS THAN 1 YEAR 1-3 YEARS TOTAL Maturities $ 157)% $ 276)% $ 433)% The Company assesses the risk of these long-term contracts and wholesale sales activities using the VAR method to maintain the Company’s total exposure within management-prescribed limits. The Company utilizes the variance/covariance model of VAR, which is a probabilistic model that measures the risk of loss to earnings in market sensitive instruments. The variance/covariance model relies on statistical relationships to analyze how changes in different markets can affect a portfolio of instruments with different characteristics and market exposure. VAR models are relatively sophisticated. The quantitative risk information, however, is limited by the parameters established in creating the model. The instruments being evaluated may trigger a potential loss in excess of calculated amounts if changes in commodity prices exceed the confidence level of the model used. The VAR methodology employs the following critical parameters: volatility estimates, market values of open positions, appropriate market-oriented holding periods and seasonally adjusted correlation estimates. The Company’s portfolio VAR calculation considers the Company’s forward position for the preceding eighteen months. The mark-to-market VAR is calculated through the contract periods. The Company uses a holding period of three days as the estimate of the length of time that will be needed to liquidate the positions. The volatility and the correlation estimates measure the impact of adverse price movements both at an individual position level as well as at the total portfolio level. The two-tailed confidence level established is 99%. For example, if VAR is calculated at $10.0 million, it is estimated at a 99% confidence level that if prices move against PNM’s positions, the Company’s pre-tax gain or loss in liquidating the portfolio would not exceed $10.0 million in the three days that it would take to liquidate the portfolio.  The Company's VAR is regularly monitored by the Company's RMC. The RMC has put in place procedures to ensure that increases in VAR are reviewed and, if deemed necessary, acted upon to reduce exposures. The VAR represents an estimate of the potential gains or losses that could be recognized on PNM’s wholesale power marketing portfolios given current volatility in the market, and is not necessarily indicative of actual results that may occur, since actual future gains and losses will differ from those estimated. Actual gains and losses may differ due to actual fluctuations in market rates, operating exposures, and the timing thereof, as well as changes to PNM’s wholesale power marketing portfolios during the year. The Company accounts for the sale of electric generation in excess of its retail needs or the purchase of power for retail needs as normal purchases and sales under SFAS 133. Transactions that do not meet the normal purchase or sale exception or the definition of a hedge under SFAS 133 are accounted for as energy marketing contracts and comprise PNM’s mark-to-market portfolio. The VAR for the mark-to-market portfolio was $56 thousand at December 31, 2003. The Company also calculates a portfolio VAR for the preceding 18 months, which in addition to its mark-to-market portfolio includes all contracts designated as normal sales and purchases, hedges, and its estimated excess generation assets. This excess is determined using average peak forecasts for the respective block of power in the forward market. The Company’s portfolio VAR was $9.2 million at December 31, 2003. The following table shows the high, average and low market risk as measured by VAR on the Company’s mark-to-market portfolio (In thousands): TWELVE MONTHS ENDED DECEMBER 31, 2003 HIGH AVERAGE LOW PERIOD END Three day holding period, 99% two-tailed confidence level $ 727)% $ 122)% $ 1)% $ 56)% One day holding period, 99% two-tailed confidence level $ 420)% $ 70)% $ –)% $ 32)% Ten day holding period, 95% two-tailed confidence level $ 1,012)% $ 170)% $ 1)% $ 78)%