Let's Get Physical: Hard Assets, Balanced
Portfolios
Add Stability in Uncertain Times Energy Houston article, Vol. 4, No. 2, 2002
Article by
Duane C. Radtke
President and Chief Executive Officer
Unless you're Stephen King or Anne Rice, it would
be hard to imagine a year more shocking and unsettling than 2001. Unprecedented
terrorist attacks on American soil, war, economic recession, an about-face on
energy prices, a slumping stock market, and last but not least, the collapse
of Enron.
The demise of the nation's pre-eminent energy
trader is the industry's equivalent of the sinking of the Titanic. Enron's decision
to forego physical assets in favor of intellectual capital and marketing savvy
earned it a reputation for innovation, exceptional growth, and heady risk-taking
in deregulating energy markets. Ultimately, that strategy collapsed because
it wasn't driven by "real" growth.
Prior to this collapse, many New Economy gurus
and pundits had praised this "asset lite" business model, asserting
it was more profitable to own information about energy than the energy itself.
Companies like Dominion, which chose full integration as the path to creating
sustainable value, were labeled "Old Economy" and criticized for "hoarding
the value chain," by one prominent Silicon Valley venture capitalist.
New Economy thinking aside, a strong argument
can be made for being a player across the entire production and delivery chain
- from the wellhead to the customer. An integrated portfolio that combines a
solid base of hard assets with trading and marketing skills has the advantage
of balance and diversity - qualities that can help shore up earnings during
troubled times.
A brief look at Dominion's evolution illustrates
this strategy in action.
Previously, Dominion was largely a garden-variety,
regulated electric utility serving 2 million customers in Virginia and North
Carolina.
With deregulation unfolding, the first order
of business became clear: find a convergence partner in the natural gas business
to provide the scale, scope and skills needed to seize new market opportunities.
Enter Consolidated Natural Gas Co. of Pittsburgh.
Like Dominion, CNG's assets were focused in the nation's most energy-intensive
region - the Midwest, Mid-Atlantic and Northeast corridor - home to 50 million
homes and businesses and 40 percent of America's demand for energy.
Relative to the rest of the country, this region
also had maintained its deregulation momentum. More that a dozen states in the
northeastern quadrant of the U.S. have sensible plans in place for deregulating
their electricity markets.
The transforming merger with CNG provided the
integration and balance needed to produce and transport either gas or electricity.
Having both forms of energy improves the ability to achieve stable earnings
growth and manage the price risks inherent in a volatile industry. And in Dominion's
case, it also doubled our retail sales platform.
The recent acquisition of Louis Dreyfus Natural
Gas and its absorption into Dominion E&P is a natural fit for us - economically,
strategically and geographically. The current pullback in gas prices provided
a rare opportunity to increase our reserve base by about 60 percent -at a reasonable
price. The company's assets are high quality, geographically concentrated, and
well managed.
We believe there's at least 2 trillion cubic
feet equivalent of additional, low-risk potential reserves on Louis Dreyfus'
existing leasehold acreage that can be drilled over the next decade. That builds
on our existing, low-risk development properties - all of which are deliverable
to our focus region in the northeast quadrant of the U.S.
Diversification is another strategic benefit
of the deal. In addition to our large, existing deepwater program in the Gulf
of Mexico, we now have a significant long-life onshore gas base.
As firm believers in having physical assets to
back up trading sales, expanding these assets gives us a bigger platform for
our gas trading operations - which are expected to increase in volume by about
25 percent a year over the next few years.
Physical assets in the right place is one of
the pillars of an integrated portfolio. It frees a company from being captive
to a specific weather system, a specific service area, or even a specific form
of energy.
With natural gas in the ground, optionality improves
markedly. You can sell it into the market, store it to sell later if market
conditions warrant, burn it to produce electricity, or move it through the transmission
system. That kind of flexibility provides valuable competitive and financial
advantages.
It also allows for energy arbitrage - over region, over commodity, and even
over time. And as deregulation unfolds, opportunities to align customer and
shareholder interests will grow - interests which were often in conflict under
old-school regulation.
Besides iron in the ground, another pillar of
an integrated strategy is solid knowledge of energy markets. Skilled gas and
electric traders are vital to a company's ability to manage price risks and
improve earnings going forward.
In addition to physical assets and knowledge
of energy markets, a strong and expandable retail base can provide another important
way to stabilize earnings.
At Dominion, for example, we have the option
of opening access to new retail markets by building new gas pipelines - like
the proposed 260-mile Greenbrier project we're planning to build between West
Virginia and North Carolina.
When it goes into service, the Greenbrier pipeline
will supply local gas distribution companies, industrial customers, gas marketers
and new power generation facilities in the rapidly growing Piedmont region of
North Carolina.
Long story short, a vibrant retail base can offer
many untapped opportunities for significant new revenues, while at the same
time providing an effective hedge against risk.
Steady cash flow from regulated, recession-resistent
utility distribution businesses can provide a strong underpinning for earnings
growth and re-investment in faster growing business lines, such as E&P and
power generation, where potential returns are far greater.
Call it full integration, diversification, a
best-of-all-worlds machine. By any name, it's a sustainable model for building
long-term shareholder value.
Speaking of models, when it comes to forecasting natural gas prices - and electric
prices for that matter - we don't have a silver bullet that provides "the
answer." We use a bottoms up approach that starts with supply and demand.
A variety of models and tools help identify uncertainty trends and relationships,
but we always go back to basic supply and demand when forecasting gas prices
- a key modeling assumption in the E&P business.
Industry analysts and experts are bearish on
gas right now. But we view the decline in gas prices as a temporary phenomenon.
Gas prices retreated in 2001 because of four
factors that together formed a kind of "perfect storm" scenario:
An unusually mild summer that depressed demand and boosted
storage injections;
An economy that moved in slow motion;
A drop in consumption by industrial customers who responded
to high prices early in the year; and
A rush to bring additional gas to market at the expense
of needed exploration.
In typical fashion, the market overreacted to
these short-term conditions. Longer term, sustainable conditions should create
another "perfect storm" scenario - of the opposite effect just described.
In other words, the gas industry's long-term
supply and demand fundamentals should provide a lot of additional upside potential.
Our research shows natural gas demand continuing
to grow at a faster pace than supply. And unless the law of supply and demand
is repealed, this should provide strong support for gas prices going forward.
A lot of analysts are predicting a 30 Tcf market
by 2010. We're not quite that bullish. We're forecasting about 28 Tcf.
We model natural gas demand growth from the electric
sector. That's because so much of that growth is expected to come from new gas-fired
power generation.
Our estimates show that demand for gas for electric
generation will increase about 10 percent a year - from the current 3 trillion
cubic feet per year to about 8 trillion cubic feet by 2010.
By 2005, in fact, we project that demand for
gas for electric generation will surpass the demand for residential heating
load.
Combined with modest demand growth from other
sources, strong gas demand growth related to electric generation will result
in an average annual growth rate of 3.25 percent over the next 10 years.
Bottom line: If you're bullish on electricity's
future, you've got to be bullish on the future for gas as well.
Turning to the supply side, we think it's unlikely
that domestic gas production will grow more than 2 percent a year over the coming
decade - if that.
One major obstacle to increased production is
an industry-wide natural decline rate of about 20 percent a year. That decline
rate rises to 35 percent in the Gulf of Mexico, which accounts for more than
one-quarter of our domestic annual production.
For production to grow enough to meet the projected
3.25 percent annual demand growth, we as a nation would have to add about 5
trillion cfe of new reserves per year - a level the industry wasn't able to
achieve during the last decade.
To meet a 28 Tcf demand by 2010, new supply from
the Rockies and all existing liquid natural gas infrastructure, plus potential
new liquid natural gas, needs to come on line. This incremental supply will
be higher cost, and it drives our long-term view about prices.
We believe the wellhead price of natural gas
will average in the lower-to-mid $3 range over the coming decade. That doesn't
mean gas prices won't spike above or fall below this range. But fundamental
supply and demand dynamics should quickly push the price back into the lower-to-mid
$3 range.
Let's face it. We're operating here more in the
realm of art than science. Market psychology and the Farmer's Almanac weather
predictions will likely dictate the correct price within this range.
Uncertainty is not new to the E&P business
- whether we're talking about prices, volumes, supply and demand, whatever.
But because oil and gas are commodities, we'd better get used to unprecedented
market gyrations and risk exposure. They're part and parcel of the times in
which we live.
Balanced energy portfolios up and down the value
chain can be an effective weapon - at both the E&P and corporate levels
- in the ongoing pursuit of competitive advantage.
