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S&P: High Gas Prices Put Indirect Earnings Pressure on Distributors

Near-record average annual natural gas prices this year could cause problems on several fronts for local distribution companies, Standard & Poor's Equity Research (S&P) said Thursday in a semiannual study of the gas industry. However, S&P also noted signs of substantial market recovery in the merchant energy sector and gains in other nonregulated business segments -- particularly exploration and production.

Most natural gas utilities saw positive earnings growth last year because of a strong economy, reduced interest costs, new regulatory mechanisms and gains in some of their nonregulated operations, particulaly E&P. But this year they face a few challenges because of continuing high prices.

Gas prices are projected to decline slightly in 2005 to an average of $5.75/MMBtu, the second highest average annual price ever, S&P said, despite the fact that natural gas storage levels are higher than they were during the winter of 2003-04 and at the high end of historical averages. The high cost of gas may not have a direct impact on utility cost bases, particularly if they have pass-through mechanisms, but high prices will negatively impact their gas customers, both large and small, S&P noted.

"Higher gas prices tend to be felt by LDCs indirectly -- through the possibility that regulators will refuse to reimburse some expenses or through a rise in bad debt, but most importantly through the loss of demand of customers," said S&P's Yogeesh Wagle and Vaughan Scully, co-authors of the report. A more significant threat could come from large industrial users, who have a strong incentive to switch fuels when possible, and have threatened to close or consolidate plants when not, they said. This leads to reduced gas volumes moving through the distribution network.

"If plants close, there are fewer opportunities for expanding the network to serve new customers, and declining economic activity can lead eventually to lower residential gas usage," said the authors. "Areas highly dependent on gas-intensive industries, such as chemicals or fertilizer manufacturing, are at greatest risk. While improved efficiency and addition of dual-fuel capabilities can help lessen the impact for industrial customers, these changes can be expensive and time consuming." Power generators also may not run their plants if fuel prices are too high, they added.

While the regulated distribution sector struggles, the merchant energy business is recovering well, S&P said. In fact, the merchant sector was in better financial shape at the start of 2005 despite three years of bankruptcies, criminal indictments, executive resignations and trading scandals.

"Bankruptcy filings have ended; most companies have settled charges of market manipulation; credit ratings have stabilized; asset sales, write-downs, and abandonments have died down; and profitability is returning," said Wagle.

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