National Fuel Gas Company (NFG) Q1 2008 Earnings Report, Transcript and Summary

Good day ladies and gentlemen and welcome to the First Quarter 2008 National Fuel Gas Company Earnings Conference Call. My name is Francis and I'll be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. [Operator Instructions] As a reminder, this conference is being recorded for a replay purpose. I would now like to turn the presentation over to your host for today’s call Jim Welch, Director of Investor Relations. Please proceed.

Thank you Francis and good morning every one. Thank you for joining us on today's conference call for a discussion of last evenings’ earnings release. With us on the call from National Fuel Gas Company our Dave Smith, President and Chief Operating Officer, Ron Tanski, Treasurer and Principal Financial Officer. And joining us from Seneca Resources Corporation is Matt Cabell, President. At the end of the prepared remarks, we will open the discussion to questions. Also, since this call is being publicly broadcast, we remind you that today's teleconference discussion will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. While National Fuels expectation, believes and projection are made in good faith and are believed to have a reasonable basis, actual results may differ materially. These statements speak only as of the date on which they are made and you may refer to last evening's earnings release for a listing of certain specific risk factors. With that, we will begin with Dave Smith.

Thank you, Jim. And good morning to everyone. Phil Ackerman was scheduled to speak first this morning, but unfortunately he was delayed in the Chicago airport and he is unable to be here. First quarter net income, the consolidated $0.82 per share was yet another record for the company. All of our major operating segments reported improved operating results. We are certainly pleased with that performance. More importantly, fundamentally, National Fuel is in terrific shape. Our balance sheet is strong, our earnings are at record levels, and we expect to continue to grow the dividend. These achievements are a testament to the strength of our balanced diversified and integrated business model. Over the years, we have assembled the portfolio of real assets that are worth more together than they are apart. We have stood by that strategy in the past and we will continue to stand by that strategy in the future. From the wellhead to the burner tip, the building blocks are in place for us to continue to grow the company and to increase shareholder value not only in the short term, but over the long term. We are also pleased to have settled the proxy contest with our largest shareholder, New Mountain. At the end of the day, we both recognized the tremendous potential in our Appalachian acreage. While we may differ on how to best exploit that asset and we may differ with respect to certain other proposals, we believe that a cooperative effort will better serve our shareholders, our customers, and our employees. Turning now to the segments. Exploration and Production continues to be the immediate driver of earnings growth. The aggressive development of our Appalachian acreage remains a top priority and we're pleased with the pace of our drilling in that region. Seneca's Appalachian production for the quarter, which for the first time surpassed 2 Bcf, is up 35% over the prior year's quarter. We are on track to drill the 280 Upper Devonian wells we have planned for this year and expect to drill between 330 and 350 wells in 2009. While that's more than double the level we drilled just last year, we are exploring opportunities within the balance of our development strategy to increase the pace of our drilling activity even further in future years. With regard to the exploration of the Marcellus Shale that underlines most of our vast Appalachian acreage, we, with our partner EOG continue to make progress and remain very optimistic about the future of that play. It has the potential to provide continued earnings growth for many years. In the Gulf, Seneca's new and more focused approach and our recent discovery at High Island 24L, gives us reasons to be cautiously optimistic. We will continue to pursue similar opportunities. Nevertheless, as we have indicated in the past, we intend to keep a watchful eye on those operations and are in the process of finalizing performance targets for that division. Simply put, if we don't meet our objectives, which we will review with the Board later this month, we're going to consider a sale of those assets. Matt will provide additional details on all of Seneca's operations. In the Pipeline and Storage segment, during the fall construction season, we completed over 18 miles of the Empire Connector Project, including numerous road crossings and a major directional drills under the Keuka Lake Outlet. Construction will recommence when the weather permits likely in the early spring. To date, we’ve spent just about $45 million on the project and expect to spend another $132 million over the remainder of fiscal 2008 and into early fiscal 2009. Despite the widespread escalation and pipeline construction costs and the scarcity of pipeline contractors, we remain on time for November 1st, 2008 in-service date and on budget. Looking beyond the connector, we continue to pursue our proposed West to East Project. That would provide for a new capacity from the Rockies Express and for increasing Appalachian production to Leidy and to interconnections with Millennium and Empire at Corning. We are working with an outside engineering firm to optimize the routing of their proposed line, utilizing largely existing rights away and to refine our cost estimates. Interest from perspective shippers has been strong and hopefully nice spread. We will begin negotiating precedent [ph] agreements with anchor shippers. As we said in the past, we believe that the development of additional storage capacity will help set our West to East Project par from the many similar projects being pursued in the region. To that end, one project the Supply Corporation is pursuing is an expansion of its [inaudible] storage facilities. Reservoir analysis suggests that these facilities could provide approximately 7 Bcf of incremental storage capacity without the need for any additional base gas. We are now in the process of assessing the service facilities that will be needed to make the expansion a reality. Once that's complete, we will hold an open season for that capacity, probably if all goes well in conjunction with the west to east open season. In summary, National Fuel's short and long-term prospects have never been better. The continued and accelerated development of our Appalachian acreage and the completion of the Empire Connector project. As planned, it will be a significant source of immediate earnings growth. The Marcellus Shale and our additional pipeline and storage expansion opportunities provide significant longer-term growth opportunities. And as always, we are working to manage and improve our existing operations by, for example, implementing our revenue decoupling mechanisms in our New York utility and Ron will provide more detail on decoupling and on our New York rate case. With that, I thank you for your attention. And I will now turn the call over to Matt.

Thanks Dave. Good morning everyone. The fiscal '08 first quarter was good one for Seneca, with U.S. production up 7% versus the first quarter last year and successful exploration and development drilling in all three divisions. I am going to discuss the details of each division's performance in a moment. But first, I would like to review the strategic changes that we have made over the past year and touch upon where we are headed. First of all we have allocated a much greater share of our capital spending to our low risk development drilling programs both in Appalachia and in California. We significantly increased our Appalachian drilling in 2007 and this year our East division will get the largest share of our E&P Capital Expenditures. In addition, in California, we have implemented new drilling programs that will, for the first time in years, add new long life oil reserves to our California properties. Second, we have sold our underperforming assets, specifically Canada. The Canadian division had not performed as expected and we felt that it would be difficult to add reserves and production at an acceptable cost. And finally, we have adopted a more focused approach to exploration within the Gulf of Mexico, an approach that we feel can be successful and add value. Capital expenditures will be less than they have been historically. But, with a more focused approach, we can build a more consistent program. In fact this approach is already paying off, as I will explain later. In addition, we have begun divesting some marginal assets in the Gulf Coast division and we will continue to do so as we identify properties that do not fit our program going forward. With these strategic changes, Seneca's performance should improve substantially and in fact, the impacts of these changes are already evident in our outstanding first quarter results and in our recent drilling success. Over the next several years, you will see an increasing emphasis on low risk drilling and Appalachia in particular. I expect finding and development cost to improve and East division production to grow significantly. So let me start on the details with an update of Appalachian. While our 2007 drilling program is beginning to be reflected in our production numbers. During the first quarter, our East division production averaged over 23 million cubic feet equivalent per day, the highest level in Seneca's recent history and 37% over the same period a year ago. Our '07 development program resulted in 360% reserve replacement of our proved developed reserves and including puds, 530% replacement of our total East division proved reserves, far superior to the majority to our peers. We currently have four rigs running in Appalachian and our drill program is ahead of where we were at this time last year. In addition, we continue to ramp up our exploration of the Marcellus Shale with one horizontal well currently being tested, a second horizontal well drilled, but abandoned due to mechanical problems, and a third horizontal well drilling as we speak. We expect to have the first Marcellus horizontal well online within the next few weeks at a rate of 350 to 400 Mcf per day. The well is currently shut in for pressure build up test to evaluate the possibility of a near well bore reservoir restriction that would explain the lower than expected rate. We expect to reach TD in the third horizontal well next week and that well will be completed in early March. All of these initial exploration wells are paid for 100% by our partner EOG. We maintain an override on any production from these initial exploration wells and we plan to participate at a 50% working interest once we believe commerciality is established or when development drilling begins. And finally in Appalachia, we are now in a position to disclose the results of Netherland Sewell’s analysis of perspective resources for our traditional shallow gas play. You may recall that Netherland Sewell’s estimate of 3P reserves was 220 Bcfe. As we pointed out in our October 11th press release, Netherland Sewell would only classify acreage as proved probable or possible. It was relatively close to wells with reliable production data. Therefore, the majority our acreage was outside of the 3P area. Since then Netherland Sewell has completed their estimate of perspective resources and provided statistical range of 400 Bcfe to 1.0 Tcfe with the most likely value of 670 Bcfe. One final comment on Appalachia. I think it is important for everyone to understand that although it may appear that New Mountain Vantage and National Fuel have differing views of our Appalachian position and the appropriate development strategy. Fundamentally we are well aligned. We both recognize that in the current gas price environment our Appalachian position has great potential and much opportunity for future growth. Appalachia will continue to be the focus of our E&P efforts for many years and it is expected to provide substantial earnings and shareholder value. Now let's move to the Gulf of Mexico. Our first quarter production averaged 41 million cubic feet equivalent per day or up 8% from the previous quarter. The Highland 24L field came online in late October and is currently producing approximately 70 million cubic feet per day and 600 barrels of condensate per day. Seneca hold a 35% working interest. Also, our fiscal 2008, Gulf of Mexico exploration program is off to a great start with our first well finding over 100 feet of net pay in the first target. We are now partially through the second target, and appear to have found additional pay. Seneca holds a 29% working interest. We've now drilled three consecutive exploration discovery wells in the Gulf of Mexico. We have also spud a new exploratory well in Highland Block 23L, only a couple of miles from our Highland 24L field. As I said in my opening comments, our new focused approach is clearly paying off. With this new strategy, our goals will be related to finding and development cost rather than growth or reserve replacement. We will spend less in the Gulf and over time the division will become a smaller share of our producing portfolio. However, we expect this smaller more focused effort to have a competitive finding and development cost and a rate of return that is comparable to the other two divisions. Moving on to California, in California, we have reached 8,700 barrels of oil equivalent per day, up 6% versus last year's first quarter. We increased our steam generation capacity at Midway-Sunset by 33% last summer. And the effect of increased steam injection is now apparent. Also of note, we've recently drilled five wells for the Maverick Sand at Midway-Sunset. And the first two wells are now producing at a combined rate of 150 barrels of oil per day. Just this morning, I received a report on the third well and it appears that it will add another 60 barrels of oil per day. Once all five wells have been completed and are on production, we will decide whether we will drill additional wells later this year. This is a new producing horizon for us at Midway-Sunset and the program could add between 200,000 barrels and 800,000 barrels of new reserves to our California base. Historically in California, we are focused on efficient low-cost operations. In fact, Barry and the West division team have managed to keep lifting cost nearly flat for years and well below industry average. Our capital was been spent on steam generation capacity and the drilling of puds and acceleration wells. What we are now adding to the mix are new reserve adding drill programs such as the Maverick that I just mentioned. Although, long-term production growth is unlikely in California, we hope to keep production relatively flat for at least several more years and a very slow decline thereafter. Again, it's been a great quarter for Seneca. We contributed net income from continuing operations of $0.39 per share to the company's consolidated earnings. Our production is up substantially and our exploration and development programs are off to an excellent start. We have high expectations for this fiscal year and beyond as we continue to implement the new initiatives that I've reviewed this morning. And now, I'll turn it over to Ron.

Thank you, Matt, and good morning everyone. Looking at consolidated earnings, last evening's release detailing our first quarter results was relatively straight forward with higher oil prices in our exploration and production segment that provided the largest component to the increase in this quarter's earnings compared to last year. GAAP earnings were also higher in the utility, energy marketing and Timber segments. But, with the Exploration and Production segments that was the driver behind our record earnings. On page 18 of the release, you can see that oil prices after hedging were almost $29 per barrel higher than last year, which caused the biggest boost to earnings. Higher natural gas commodity prices and increased production also contributed to the higher earnings. Average oil prices after hedging for the quarter were approximately $11 per barrel higher than the prices that had been built into our forecast and earnings guidance, while natural gas prices for the quarter were about a dime lower. The quarter of production under our belt was approximately 57% of our remaining oil production for the year hedged and approximately 53% of our remaining natural gas production for the year hedged, we are in a position to raise the earnings guidance for the entire year by $0.10 per share. I'll remind everyone again that this guidance assumes that un-hedged production in our forecast is priced out using the July 24th NYMEX strip as modified by the average price differentials that we laid out in our third quarter earnings release last August. To the extent that actual sales prices vary, our sensitivity table at page 21 of last night's release can give you an idea of the projected impact on earnings. Moving from the exploration and Production segment to the Utility segment, it was weather that was colder than last year in our New York jurisdiction plus a slight uptick in usage per account, combined with a full quarter of higher base rates in Pennsylvania that explains higher utility earnings this year compared to last year. In the New York jurisdiction, the Public Service Commission issued an order on December 21st that addressed the rate increase we request that we filed in January 2007. While the order did not have a major impact on earnings for the first quarter, there are a couple of items worth noting for the future. You may recall that when we filed our case over a year ago the total increase requested was $52 million. The approved increase ended up at $12.6 million split between a $1.8 million base rate increase and a $10.8 million rate component to cover expenses associated with our Conservation Incentive Program. As part of the rate order, the New York Commission approved the implementation of a revenue decoupling mechanism where the recovery of our operating costs and margin is decoupled from customer usage. We're now in a position to encourage our customers to conserve. Since the cost of the natural gas commodity is the largest component of our utility customer's bill, the most effective way for our customers to reduce their overall heating expense is to burn less gas. Because of the company's recovery of a majority of its operating costs had been tied directly to customer usage, we could not fully recover our operating costs if customer conservation caused our throughput to decrease. Our customers can see a substantial decrease in their bill by cutting back on their usage and with the revenue decoupling mechanism, the company stands a much better chance of recovering its operating expenses and margin through the revenue decoupling rate adjustments. While we think the Conservation Incentive Program and RDM are wins for both our customers and the company, we think the low 9.1% return on equity authorized by the commission is a bad deal for our shareholders. It's no consolation that the ROE is in line with awards to other gas utilities in the state and even 10 basis points higher than the recommended rate in Con Ed’s current electric case. The problem is that the New York Commission's ROE awards are at least 100 basis points below the average ROE provided to get utilities across the US during 2007. I think the Commission needs to review its policies to make sure the utilities in the state, can continue to attract investors and capital to maintain and develop critical infrastructure in the state. One final note about the New York Rate Order. The Commission also approved a rate design change for our residential rates where a greater proportion of our overall revenue requirement will be recovered through our minimum charge and first usage rate blocks. This will have the affect all else being equal of shifting a portion of our customer's bills from the winter to the summer. From a financial reporting perspective and for analysts model, this change will reduce our second quarter margin by approximately $8 million. That $8 million in margin will then be recovered through the third and fourth quarters. Moving from the Utility segment to the consolidated company, you can see on the balance sheet at page 11 of last night's release that we had 83,946,575 shares outstanding at the end of December. Later on today, when we file out 10-Q for the first quarter, you will note on the cover page that we report 83,526,251 shares outstanding at the end of January or a decrease of a little lower 420,000 shares. It’s safe for you to assume that the decrease was the result of share repurchases made during the market debt last month under our authorized repurchase program. And aside from that comment, I will revert to our standard protocol of saying nothing more about the repurchase details until we report on them in the second quarter 10-Q. At this point there are no other changes to our forecast or earnings projections and that covers our prepared remarks. So, I will ask the operator to open the lines for questions. Question and Answer

Thank you. [Operator Instructions] And your first question comes from the line of [inaudible] Round Rock Capital. Please proceed.

Good morning everyone. David Hugley - President and General Counsel, Secretary Good morning.

A couple of questions for you. I wanted to get some clarity on the resource potential from Netherland and Sewell that does not include Marcellus potential is that correct?

Correct.

Okay. Now I am interested… we have seen some pretty good industry well results, Range [ph] put out some pretty good numbers on their resource potential. I think last week Equitable put out some big numbers as well. I am just curious when we might expect a similar disclosure from you guys and I guess a follow up to that is what are we waiting on here?

We are waiting on more well results before we are in a position to make any kind of resource potential projections. Range has got several wells producing, they are in a different positions than we are.

Okay. All right, is there a timeframe that you hope to have some of this information available to disclose to investors?

You mean a timeframe for when we plan to disclose a resource potential?

Yes.

No. No, there isn't any planned timeframe for that. I think I would tend to focus more on our drilling results and our timing of that. Obviously the more wells we get drilled and particularly if those wells are successful and generate a development program for us, the sooner we will be able to talk about what the potential might be. David Hugley - President and General Counsel, Secretary Yes, in '08 I think with respect to Range, my recollection of that is, it was like their '07 based ninth and tenth well. So they were a little bit head of us in terms of the drilling in the Marcellus but...

In terms of Equitable, I think they've only got what, one well down ? I don't even know that they fraced that well yet. David Hugley - President and General Counsel, Secretary Yes. I think Equitable takes a different approach with regard to prospective resource than we do. I think we tend to be more conservative that way.

Understand. Have you guys engaged Netherland Sewell to perform an assessment of the Marcellus at all.

No. There is really not enough data yet.

Fair enough. Thank you guys. David Hugley - President and General Counsel, Secretary Thank you.

Your next question comes from the line of Shneur Gershuni with UBS. Please proceed.

Hi, good morning guys. David Hugley - President and General Counsel, Secretary Good morning.

Couple of quick questions. I guess this is one bigger question with respect to CapEx. You noted that you might be divesting some property, just curious if you are going to be recycling that capital into the Gulf? You also mentioned with respect to pipeline historics that there is a bunch of opportunities kind of what's your expectation if all these projects get green light and what kind of CapEx are we talking about? And then with respect to Appalachia, is there enough midstream available for you at this point right now to gather what the increased drilling program and potentially the growth in the program on a go forward basis? So sort of putting it all into context on a consolidated basis, you feel that you are prepared for the amount of CapEx and kind of what kind of number are we talking about if everything gets green lighted. David Hugley - President and General Counsel, Secretary Yes with respect to the projects, Shneur, I think the... certainly the west to east is a very significant number and I know $700 million is the number out there and it might range from 650 to 750 depending on the response from the customers, depending upon the size of the play. So that's a significant number. With respect to storage enhancements it's a significant number, but we are really not at this point in a position to disclose that because we are, I think we are leaning there towards market based rates, and so I think its inappropriate to disclose CapEx with respect to that. And certainly with respect to the Marcellus shale, to the extent that we have a significant results there, we would be looking to redeploy more capital and your question with respect to the gathering systems is a very good one. I think no, there is not sufficient gathering capacity in the Appalachian region now. We have moved ahead, talked about this previously. We have moved ahead with our midstream company, the midstream company is now in the process of finalizing its first deal with respect to laying pipe and I think more importantly the structure is in place, we've done all the legal work, all the regulatory work, everything is in place with the midstream so that when and if the Marcellus Shale is what people expect it to be. We're ready and we'll be able to move very quickly to bring that gas out of that region. We see it is an incremental profit opportunity, Shneur.

Shneur and with respect to divestitures. If you look cash flow statement for the first quarter, there was really just like $1.5 million of sales of minor properties that Matt mentioned in the Gulf Coast division. I would expect that the trimming that you would see would be properties of that magnitude. So there wouldn't be a huge inflow of capital from the sale of properties and the outflow of capital with respect to increased drilling is going to really ramp up over the year but it's...

Yes. If I can just add to than, Ron, we've got a couple of other small divestitures in the Gulf Coast that are working. That mean while we've got a couple of small acquisitions in California that are working if you take the whole thing together it's about a wash.

Okay. If I could just ask two more opinion questions, Ron with respect to the rate case, I mean with the lower ROE result of just… I thought it's a democratic Governor now in the State of New York or is it really the cost of getting the decoupling. And then with Net have you had a chance to review the differing 2P and 3P reserve reports between what you [inaudible]... what you guys have put together and kind of what were the key assumption differences in the report, was it IP rates, was it the length high curved drilling costs and so forth, just wanted to get...

Haven't seen it yet, Shneur.

Okay. Great.

And with respect to the rate case as I mentioned we're in line with the other orders across the state. We're in a era of decreased interest rates and the commissions still adheres to it's policies that are put together in its generic financing case, and we think there are some issue with that structure and with that methodology. The ALJ in the case suggested that it may be time for the commission to review its policies with respect to CAPM and DCF methodologies. But the ALJ was not in a position to do that. You suggested we take that up kind of legislatively if you will with the commission. David Hugley - President and General Counsel, Secretary Shneur, with respect to that, the Schlumberger reported and the information will be exchanging. I wouldn't want to leave the impression that it's because of the difficulties between the parties. In fact it's not, I talked an amount just earlier this week and we're now ranging the exchange of that information.

Let me add one more thing to that, Shneur. I don't think anyone has characterized their Schlumberger report as a reserves report. So I don't know that the kind of direct comparisons you're asking are necessarily going to be possible. David Hugley - President and General Counsel, Secretary And let me add to it as well, Shneur. There are confidentiality provisions in the agreement itself. So and I'm sure you have seen that agreement, but... so how much we would disclose and would be taking about is problematic and certainly subject to question.

Okay. Great. Thank you very much. I've got more questions but I'll jump back in the queue.

Your next question comes from the line of Tim Schneider [ph] with Citi. Please proceed.

Yes. Good morning guys. Just one quick follow-up on the gathering infrastructure question, actually at this point is all the gas that you guys produce coming to market or is there anything lost, just because the infrastructure requirements are a little tight right now? David Hugley - President and General Counsel, Secretary I guess a way, I would characterize it is, we were bumping the limit and we are constantly working on infrastructure issues to resolve that limit. Do we have anything significant shut-in because of capacity constraints, no.

Okay.

Yes, I think, Chris, I think part of what we would be looking for in the midstream as well is the market is constrained in areas there. Much of that gas is going into existing markets. So we would be looking to move that gas off of our system to the extent we can. And that would be part of the plan with respect to the midstream company.

Okay. Great. Then jumping over to the Gulf region for a second, you said you kind of take a look at… if performance targets are met, what is the time frame on that? David Hugley - President and General Counsel, Secretary On setting the performance targets?

Exactly, and kind of evaluating if it's been met or not and deciding whether --? David Hugley - President and General Counsel, Secretary We got a meet with the Board very soon and discuss our performance targets that we have in mind to get their approval on those targets. And what we are talking about is fiscal '08, specifically.

All right. Jumping back to Marcellus, do you guys have any indication and I know EOG is carrying the cost right now of what's the well [ph] costs are in that area yet? David Hugley - President and General Counsel, Secretary The horizontal wells, drilled, fraced, completed are on the order of $3 million. But that's exploration stage. Obviously if we got to a development stage, we would expect that cost to go down.

Okay and that's with an IP of 350 to 450, is that right? David Hugley - President and General Counsel, Secretary I wouldn't call that an IP. That's the production… sales production rate roughly that we are expecting yet. So, IP would be higher than that. But IP is probably less relevant than what you expect to sell.

Alright. That does it for me. Thank you. David Hugley - President and General Counsel, Secretary Thank you.

[Operator Instructions] And there are no other questions in the queue at this time. I would like to turn the call to Mr. Jim Welch for closing remarks.

Thank you. At this point we will conclude our call for today. We would like to once again thank everyone for being with us on this teleconference. A replay of this call will be available in about one hour on both our website and by telephone and will run through the close of business on Friday, February 15th. To access the replay online, visit our investor relations website at investor.nationalfuelgas.com. And to access by telephone, call 1-888-286-8010 and enter pass-code 59260259. This concludes our conference call for today, thank you and good bye.

Thank you all for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.