NATIONAL FUEL GAS CO annual report, FY2011

Business context and reporting period

National Fuel Gas Company filed this Form 10-K for the fiscal year ended September 30, 2011 (not a standalone fourth-quarter filing). It operates regulated gas utility and pipeline/storage businesses, oil and gas exploration and production, and energy marketing. Its utility serves approximately 731,600 customers in western New York and northwestern Pennsylvania. The company’s strategy emphasized Marcellus Shale development and Appalachian pipeline and gathering infrastructure.

Financial performance and liquidity

• Reported net income increased $32.5 million; continuing-operations income rose $39.3 million. A $31.4 million after-tax gain from selling the Seneca Energy and Model City investments was a major nonrecurring contributor.
• Segment earnings: Exploration and Production $124.2 million (up from $112.5 million); Utility $63.2 million (up from $62.5 million); Pipeline and Storage $31.5 million (down from $36.7 million); Energy Marketing $8.8 million (essentially unchanged). All Other earnings included the investment-sale gain.
• Revenue grew modestly and operating income was nearly flat. The filing does not provide a single consolidated margin figure in the supplied text.
• Cash from operations increased, chiefly due to higher receipts from oil and gas production and tax refunds versus tax payments in the prior year. Investing used $717.7 million; financing used $276.4 million. Cash and temporary investments fell to $80.4 million from $397.2 million.
• At September 30, 2011, long-term debt was $1.049 billion, including $150 million classified as current and due in November 2011; $40 million of commercial paper was outstanding. Shareholders’ equity was $1.892 billion. The company reported a 0.37 debt-to-capitalization ratio under its credit facility, against a 0.65 maximum.
• Liquidity sources included a $300 million committed credit facility, fully available at year-end, and $385 million of revocable uncommitted bank lines. Management said liquidity was adequate for known needs. It expected to refinance the $150 million maturity and planned additional long-term debt and greater short-term borrowing in fiscal 2012.

Fourth-quarter context: For the quarter ended September 30, 2011, revenue was $286.0 million, operating income $75.2 million, continuing-operations and net income $37.4 million, and diluted EPS $0.45. The comparable 2010 quarter reported revenue of $286.4 million, continuing-operations income of $32.4 million, net income of $38.4 million (including discontinued operations), and diluted EPS of $0.46.

Material changes versus the prior year

• Exploration and Production revenue rose to $519.0 million from $438.0 million, mainly from sharply higher Appalachian/Marcellus production. Gas production increased to 50.5 Bcf from 30.3 Bcf; oil production declined to 2.86 million barrels from 3.22 million. Average gas price after hedging fell to $5.39/Mcf from $6.04, while average oil price after hedging rose to $81.13/barrel from $75.25.
• Utility earnings increased slightly amid higher throughput from colder weather and customer usage; the New York weather-normalization mechanism reduced 2011 earnings by approximately $1.0 million.
• Pipeline and Storage revenue declined $3.8 million and earnings fell $5.2 million. Shippers favored lower-priced routes and supply points over Niagara-area gas; higher costs also weighed on results.
• Capital spending accelerated: total expenditures for long-lived assets were $854.2 million versus $501.4 million, including $648.8 million in Exploration and Production and $129.2 million in Pipeline and Storage.
• Long-term debt declined by $200 million after repayment of 7.5% notes; cash balances also fell substantially as investment spending increased.

Outlook, risks and unusual items

• Estimated capital expenditures were $1.163 billion for FY 2012, $1.116 billion for FY 2013, and $1.395 billion for FY 2014. FY 2012 Exploration and Production spending was estimated at $858.5 million, including approximately $808.5 million in Appalachia; the company anticipated drilling 100–125 net Marcellus horizontal wells. These plans depend in part on commodity prices, production, financing and project execution.
• Pipeline projects include Northern Access (320,000 Dth/day, service expected November 2012; estimated cost $62 million), Line N expansions, and Empire’s Tioga County Extension (350,000 Dth/day; estimated cost $49 million). The company also described a proposed West-to-East project estimated at $290 million, subject to development and regulatory milestones.
• Management cited potential federal or state regulation of hydraulic fracturing, permitting delays or restrictions, oil and gas price volatility, reserve-estimation uncertainty, and risk of a full-cost ceiling impairment. The September 2011 ceiling exceeded oil and gas property book value by about $366.1 million, but that cushion is sensitive to commodity prices and reserve estimates.
• Pipeline and storage results are exposed to changing regional gas-price differentials and contract renewals. Supply Corporation filed a FERC rate case in October 2011 seeking increased rates; proposed rates could be subject to refund and final determination.
• A Pennsylvania title dispute (Butler) could create uncertainty over ownership of Marcellus gas interests. The company said it believed the longstanding Dunham Rule would ultimately be upheld.
• Environmental clean-up liabilities were estimated at $17.2–$21.4 million; $17.2 million was accrued, with recovery expected through rates. Other ordinary-course litigation and regulatory matters were not expected to materially impair financial condition, although they could affect earnings or cash flows when resolved.
• Pension contributions were $53.6 million in 2011, with $40–$50 million expected in 2012; VEBA and 401(h) contributions were $25.2 million in 2011, with $15–$25 million expected in 2012. Market returns and actuarial assumptions may raise future costs or funding needs.
• The company sold its Gulf of Mexico offshore properties and a West Coast property in 2011, and sold its Seneca Energy and Model City investments for $59.4 million, recognizing a $50.9 million pretax gain. The Gulf sale generated $55.4 million net proceeds and no gain or loss under the full-cost accounting method.
• PwC gave an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective as of September 30, 2011.

Key facts for investors to verify

1. How much of FY 2011 earnings growth is repeatable after excluding the $31.4 million after-tax investment-sale gain, and how underlying segment earnings trend.
2. Whether Marcellus drilling, production growth, unit costs and conversion of proved undeveloped reserves support the large planned capital program and reserve estimates.
3. How the FY 2012–2014 investment program will be financed, including debt issuance, cash generation, refinancing of the November 2011 maturity, and covenant headroom.
4. Progress, customer commitments, costs and regulatory approvals for Northern Access, Line N, Tioga County Extension and West-to-East projects, together with pipeline contract renewals and the FERC rate case.
5. Potential effects of hydraulic-fracturing rules, Pennsylvania mineral-title litigation, environmental obligations, pension assumptions and gas-price movements on cash flow and earnings.