There is lots of room to grow for the long-term, pre-paid natural gas supply deals that municipal utilities are lining up with increasing frequency, although the current credit crunch could slow the growth for the rest of 2007, a panel of financial and gas industry speakers told participants last Wednesday at the LDC Forum Rockies & West conference in Los Angeles.
Since 2003 after an Internal Revenue Service (IRS) ruling cleared the legality of the tax treatment on the deals, 26 major pre-pays (24 for gas) have been done, accounting for $21 billion in long-term gas supplies. Some 16% of the municipal utility sector's gas needs currently are filled by pre-paid contracts.
"There is significant room for more transactions," said Ken Shulklapper, a vice president in the commodities marketing group at JPMorgan, which estimates that there is currently $10-15 billion in new pre-paid gas deals waiting to get done in the municipal utility sector -- either through public sector financing units or by the utilities themselves. A third way is through cooperatives or aggregates of munis, such as MuniGas, a Texas-based organization created to do pre-pays whose executive director, Robert Murphy, spoke on the panel at the LDC Forum.
Shulklapper said JP Morgan analyzed three recent muni gas pre-paid deals to assess the impact from the recent credit crunch caused by the sub-prime mortgage market meltdown. "What we found was that investors are seeing more risk in the bonds [tied to the pre-pay gas deals], and as a result they are demanding bigger returns in the bonds. That changes the economics of the deals." He said since third-quarter earnings reports began coming in last month with larger write-downs, the crunch is a definite factor again, he said.
"It changes the economics of the deals -- municipalities will raise the terms of what they're looking for, and it can change what the suppliers are looking for. But the bottom line is that longer term, higher prices offer greater savings as do longer terms for the contracts."
Another example of the subprime mortgage problems splashing the pre-pay gas sector came Thursday when Standard & Poor's Ratings Services (S&P) changed the outlook from stable to negative on the $668.5 million deal by the Northern California Gas Authority to get long-term pre-paid supplies for the municipal utility in Sacramento, CA. Morgan Stanley is the gas supplier, and it just reported that revenues fell by $3.7 billion in the two-month period ended Oct. 31 because of a decline in value of its subprime mortgage-related exposure, S&P said.
From a major supplier's point of view, Donald Black, a managing director with BP Energy's North American gas and power financial products operations, said he expects muni pre-pay deals to be "a big part of the 2008 natural gas landscape." Greater numbers of municipal utilities, and smaller ones, will begin participating, and there will be few, if any, "mega-deals until the capital markets settle down."
"Size is not your friend right now, and I would look for the maximum deals to be in the $1-1.5 billion range, with 20-year terms," said Black, adding that there will be more opportunities for financial hedging as more muni volumes are committed to index-set priced pre-paid deals for long-term periods. Ultimately, there will be more competition for providing more of what he called "one-stop shops" with firms that can provide both the physical commodity and financial capabilities for the munis and their financing arms.
Chris Foster, a former Enron Corp. trader, laid out the generic model for how pre-paid deals work, citing the many steps and parties that make the transactions extremely complicated, but nevertheless, as he stressed, pre-paid contracts are completely legal from IRS's standpoint, per its rulings in 2002.
Foster listed seven key elements of the pre-pays:
From Murphy's MuniGas perspective, recent pre-paid deals have been "generally good" as the publicly stated savings have grown along with the longer terms of the deals, stretching up to 30 years. "Many more deals are being pitched," he said. 'Much of the focus is on savings potential; however, sometimes conflicting fundamental mandates must be addressed."
For public-sector utilities, the mandates are three: ensuring reliable physical supplies from dependable suppliers at specified times and places; managing all-in costs of the total supplies; and finally, prudently satisfying both near- and long-term, firm and swing requirements, Murphy said.
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