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Tax Clarity Brings Muni Prepaid Supply Deal Redux

A 12-year, $650 million prepaid gas supply deal between a group of 19 municipal utilities in the South and JP Morgan Securities, as well as other deals like it, could herald the return after a long hiatus of the prepaid supply deal, financed with municipal bonds.

Tennessee-based aggregator Municipal Energy Acquisition Corp. (MEAC) and JP Morgan Ventures just struck the deal for 50-80% of the member utilities' supply needs in Tennessee, Kentucky, Alabama, Mississippi and Louisiana. Atmos Energy Marketing is acting as asset manager for the deal, which will supply gas over Tennessee Gas Pipeline, Texas Gas, Gulf South, Columbia Gulf, Texas Eastern and Southern Natural Gas.

This is the second prepaid deal for MEAC, the first having been done in the late 1990s; and it's the second for Atmos Energy Marketing, Rob Ellis, Atmos senior vice president, told NGI.

Back in the late 1990s prepaid gas supply deals were quite popular among municipal gas utilities. The transactions allowed the munis to secure supply and lock in prices in long-term contracts financed with municipal bonds (see Daily GPI, May 4, 1999; Dec. 23, 1998; April 1, 1998). However, the Internal Revenue Service launched an inquiry into whether such transactions should receive tax-exempt status.

"The IRS came out with a statement in an unrelated rulemaking that said, 'we're not sure munis should be allowed to use prepays, and if we do look at it we're going to look at it retroactively,'" Dave Schryver, executive vice president of the American Public Gas Association, told NGI. "And that more or less froze the prepay market."

Then in 2003 the IRS ruled that prepays financed with municipal bonds could enjoy tax-exempt status. However, any municipal completing such a transaction was subject to a rule that said 90% of any gas purchased under such a contract must go to its customers; that is, it could not be re-sold elsewhere should the utility find that its demand dropped due to weather or the exit of a large customer, explained Schryver. Municipals breaking the rule could be subject to taxes and penalties, and the uncertainty squelched most interest in prepay deals.

Then last year the Energy Policy Act of 2005 (EPAct 2005) created a safe harbor for municipal utilities by setting the bar at 90% of gas used over a five-calendar-year test period.

"I think the reason you're seeing activity [in these deals] now is the language in the Energy Policy Act freed people up to act without that level of uncertainty that existed before EPAct," Schryver said. "The legislation has given [municipal] systems some degree of certainty.

Another joint action agency helping to resurrect the muni bond-financed prepaid deal is the Public Energy Authority of Kentucky (PEAK), an aggregator with nine members of which Gerald Ballinger is president and general manager.

Ballinger told NGI that PEAK closed a 10-year prepaid deal June 15 with BP Energy that is worth $1.03 billion. PEAK also had done a similar deal back in 1998 with Unocal (now Chevron) and Marathon. That transaction runs out Dec. 31, 2008. The latest deal picks up for the supply that is rolling off and also accommodates the demand of new members as well as demand growth on member company systems, Ballinger said. Most of the municipals are served by Texas Gas Transmission.

It's not an accident that PEAK's counterparties have been producers. Ballinger said the group favors suppliers that have equity production with which to fulfill their contracts because of the added supply security afforded. For municipals and their agencies that strike prepaid supply deals, the security of gas supply seems to be the primary driver for the transactions.

Ballinger said PEAK's bonds sold "very quickly" in the favorable bond market that existed back in June. He said PEAK wasn't trying to time the gas or bond markets but rather chose to contract for supply as needed.

"You can't really time the market," said Atmos Energy's Rob Ellis. "You just have to put the transaction together and hope that the market cooperates with you in the interim and if not, then you put it on the back burner and you wait until the market conditions improve."

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