FW: Gas Supply Outsourcing ("Asset Management") Issues

FYI - - Below is an email that I sent Frank as a follow-up to a discussion he and I had regarding the subject matter. The focus was primairly external factors that are negatively impacting the liklihood of these deals, with only cursory mention of internal issues. I thought it might be helpful as part of our discussion at 4:00 PM today.
Ed

-----Original Message-----
From: McMichael Jr., Ed
Sent: Wednesday, July 11, 2001 5:46 PM
To: Vickers, Frank W.
Subject: Gas Supply Outsourcing ("Asset Management") Issues

Frank, below are my initial thoughts. If I come up with others I will forward them along. Please review and then let's discuss. Feel free to forward this to anyone you wish.
Regards,
Ed

1. Stranded Costs are no longer a risk.
Gas LDC unbundling has slowed or stopped. Hence, the previously perceived market risk (i.e. stranded costs) is no longer present.

2. Gas Cost disallowance risk is diminished.
Even with extraordinarily high prices this winter and most every LDC buying monthly index gas, there was virtually no PUC gas cost disallowance. It was a political 'hot potato" for a few months, but any previously perceived price risk is diminished. In many states, LDCs are now being encouraged by their PUCs to start using a portfolio approach, incorporating fixed price, caps and collars to dampen commodity price volatility. Such initiatives is certainly not consistent with an exit of the merchant function.

3. Minimizes the importance of the VP of Gas Supply.
Many LDCs have created Gas Cost Incentives and/or Transport Demand Cost Incentives to generate shareholder value. The previously "pass through" aspect of the LDC gas supply function has given way to a situation where the VP of Gas Supply for most LDCs now have some profit potential. These profits are usually necessary for the LDC to achieve its regulated rate of return, but in some cases are incremental. Hence, in many cases these individuals have become more "valuable" to their organizations.

4. Loss of "core competency."
Most LDCs have created groups and empowered people to "manage" their commodity and service contracts for profit (as discussed above). As such, eliminating these jobs and redeploying and/or terminating employees is viewed as a risk. The risk is that they would potentially loose these skill sets that they think they have developed over the past several years, which many now view as one of their "core competencies."

5. Ego factor
Along with the "core competency" issue above, many LDC executives do not want to admit that Enron can manage their assets better that they can do it themselves. Further, many view Enron as a competitor in cases where they have set up a "wholesale" trading business on the backs of their ratepayers. Some examples include AGL/VNG, KeySpan (BUG/LILCO), NUI, NJ Natural, and PSEG.

6. Many LDCs have standardized outsourcing.
Many LDCs, especially those who do not have Gas Cost Incentive mechanisms, have been doing seasonal (Nov-Mar or Apr-Oct or one year) RFP type partial or full outsourcing for several years. These LDCs use these arrangements to either make money or appease their PUC and ratepayer advocate by illustrating that they are optimizing their assets and/or reducing gas costs. However, to either mitigate the need to seek PUC approval or minimize the risk of gas cost disallowance, these standardized deals limit opportunity and/or add risk in a number of ways:
(a) RFP deals go to the highest bidder, most of which have little/no internal controls/discipline and are frequently dominated by origination (not trading).
(b) The deals are in an RFP format where new ideas and original thought is typically shared with competitors.
© LDCs often demand structures that allow them to retain most/all of the optionality, thereby reducing/eliminating the ability to mark income (i.e. accrual only).
(d) Load following deals (which most all of these deals are) for only one (1) season increase the likelihood of a warmer/colder than normal season.
(e) The start up costs (e.g.. dedicated people, web site, special accounting, special reporting, etc.) have to be recovered over a short time frame.

7. Industry consolidation
Several LDC mergers have occurred over the past two or three years. In many cases, these mergers were done for "synergistic" reasons and frequently with LDCs that are served by one or more of the same pipelines. It is safe to say that most have ascribed some acquisition value to and/or used asset optimization in an attempt to gain PUC approval of the merger. In many of these situations, the LDCs try to consolidate gas supply across the companies and have frequently pushed to have such functions considered an "unregulated" part of their business. Some of these mergers include KeySpan (BUG, LILCO and the Boston Gas/Essex/Colonial), Southern Union (PG Energy, ProvGas and Valley Gas), Energy East (NYSEG, Southern Connecticut, Connecticut Natural), ConEdison (Orange & Rockland), NUI (Elizabethtown, Virginia Gas Company, City Gas of Florida, North Carolina & other smaller ones) and Atlanta Gas Light (AGL, Chattanooga and Virginia Natural Gas).