Questar (STR)

TOP CONTRIBUTORS

Michael Francis

Questar is a vertically integrated holding company focused on drilling for, transporting, and distributing natural gas, which accounts for some 89% of their proved reserves. The company does business largely in the Rocky Mountains and mid-continental United States, engaging in exploration and production activities, providing midstream field services (gathering and processing gas for third parties) and interstate transportation (pipeline), and operating a regulated gas utility.^[1]

Questar's utility business provides stable operating cash flow, which allows the company to finance its riskier drilling and production activities at a lower interest rate than competitors. Furthermore, the company has enjoyed the tailwinds of rising gas prices, which have driven revenue and cash generation. Nonetheless, long-term pressure from breakthroughs in potentially sustainable (and perhaps someday more affordable) alternative energy sources may put a damper on current demand levels for natural gas.

Financial and Operating Metrics

Below are relevant operating data for the company. The company has benefited from increasing oil & gas prices, though between 2005 and 2006, the company experienced the effects of a lower average selling price of natural gas, which comprised the majority of its production.

Trends & Drivers

• With a pipeline business and a regulated utility, Questar can use steady earnings to obtain low-cost funding for riskier exploration endeavors. Regulated utilities generally provide highly reliable cash flow. This allows the company to obtain interest rates on debt that are lower than competitors, which provides something of a cost advantage in drilling operations. This structure also sets the stage for exploration and production to drive growth at the parent company while the utility provides stability.

• Questar has a big stake in the Pinedale Anticline of Wyoming. Its most important drilling leasehold is expected to continue being a prolific, low-cost operation for years to come. Though it has and still faces some regulatory challenges, the company has worked successfully to allow for winter drilling, which mitigates incurring start-up costs every spring, and has appeased regulators with favorable plans to reduce emissions (and, hence, costs for themselves) and to work with other companies to reduce the usage of land surface, which should help protect the regional environment.

• Rising natural gas prices have been a major tailwind for Questar. The company is highly dependent on favorable market prices for natural gas, which tend to fluctuate significantly over time, but have risen notably of late.^[4] Over the past few years, rapidly increasing demand for energy coupled with constrained supply has led to higher prices for natural gas. This has juiced returns for Questar, while providing strong cash flow and favorable access to capital as creditors place significant weight on market prices of the company's production. Increases in the prices of oil and gas are not, however, without negative side effects. Because drilling for oil and gas becomes much more profitable when prices are on the rise, the company faces much stiffer competition for the acquisition of land or drilling rights to oil- and gas-rich properties. These properties' market values rise in proportion to the rise in the value of the commodities underneath them, which cuts into the company's possible return on investment and puts a damper on hope for rapid growth. A similar phenomenon can occur in buying or leasing drilling equipment, as prices are driven by eager competitors bidding them up in order to drill for the commodities. Furthermore, the company usually hedges the prices at which it can sell gas.^[5] By use of derivatives, the company attempts to lock in a price or a range of prices, which limits downside but also presents an opportunity cost if oil prices rise significantly over the lives of contracts.

• Hybrid and Alternative Energy Technology - Rising oil and natural gas prices and environmental consciousness have led both consumers and companies to seek out alternative sources of energy and to invest in renewable energy such as nuclear, solar, as wind technologies to heat homes and generate electricity. Global consumer demand can shift toward renewable energy sources in the long run and incentives to develop long-term solutions to the world's dependence on oil and gas become stronger due to recent environmental concerns over climate change, consumer consciousness and the entrepreneurial profit motive. And, to be sure, Congress is probably quite likely to incentive R&D and renewable energy usage through subsidies, target minimums, or other means over the next several years. While no massive legislation has taken effect, several bills have been proposed and Congress generally has renewable energy high on the to-do list.

• Government Regulation. As a gas utility, the company is subject to government regulation, including regulation on price, for instance. The company must sell energy on a rate schedule approved by government regulators, and, for instance, is only authorized to earn a return on equity just south of 12%. The future of government regulation is murky, however, given that on the one hand, regulators still wince from the recent bad experience with deregulation, but on the other hand, rising generation costs are forcing regulators and utilities alike to develop innovative methods of reducing end-user energy costs. A recently added regulation is the Renewable Portfolio Standards (RPS), which require utilities to purchase a certain portion of their energy needs from renewable sources. Many states have implemented RPS, and it is anticipated that such standards will increase in the future, likely increasing the cost base for many utilities.

Competition and Market Share

As a seller of a commodity product, the company operates in a highly competitive environment in which all firms are price-takers, selling their oil and gas production at given market prices. Firms generally compete on their ability to drill efficiently and earn high returns on investment through intelligent property acquisition and operational prowess. Questar is able to finance its operations at a lower cost of capital than many competitors due to the stable cash flow characteristics of its utility business. Furthermore, scale does matter some, as companies with greater production levels and revenue can generally cover many administrative expenses over a wider base of properties. Below, for instance, is a regression of revenue and operating margin for 14 independent oil & gas companies.

Below is a table comparing several independent oil & gas companies across several metrics.^[6] It is worth noting that the Energy Information Administration reports that there exists around 170 trillion cubic feet of natural gas proved reserves in the United States.^[7] Given this, an estimated "market share" for Questar's 1.461 trillion cubic feet gas reserves would be around 0.87%, indicative of the dispersion and fragmentation of the natural gas industry in the US.

Footnotes

1. ↑ STR 2006 10-K, "Business," pg 7
2. ↑ STR 2006 10-K, "Selected Financial Data," pg 25
3. ↑ STR 2006 10-K, "Business," pg 3
4. ↑ STR 2006 10-K, "Risk Factors," pg 8
5. ↑ STR 2006 10-K, "Business," pg 10
6. ↑ All data compiled from company annual reports and 10-K's
7. ↑ Energy Information Administration - Annual Energy Outlook 2002
8. ↑ MMcfe/day, or millions of natural gas cubic feet equivalent, is a measure of the level of production per day that converts oil into the energy-yielding natural gas equivalent using a ratio of 6 to 1 (natural gas to oil)