Southern Union Company (SUG)

TOP CONTRIBUTORS

Avinash Gandhi

Southern Union Company is a holding company involved in the natural gas business. The company's services include moving gas from the well to the pipeline, building and contracting pipelines, purifying and compressing the gas, storing it, and distributing it through its utilities businesses.

Southern Union's largest segment, Transportation and Storage, operates 14,900 miles of pipeline from the Gulf Coast to the Midwest and Florida, as well as a LNG receiving terminal in Louisiana. The company bought a larger stake in the privately-owned pipeline company Florida Gas in 2006, betting that the migration of baby boomers to the state would cause demand for natural gas in the region to rise, bringing in higher revenues. The regulated nature of the gas industry makes it much easier for a pipeline company to grow through acquisitions, and Southern Union faces challenges from MLPs that have easier access to funding. MLPs are income-tax exempt and have multiple partners to fund development, so they can spend more on inputs and capital to achieve the same overall rates of return as corporations. This lets them strongarm single corporations out of lucrative pipeline purchases and gas transportation contracts.

Southern Union plans on using the MLP framework to its advantage, however, by spinning off its only non-regulated business, the Gathering and Processing segment. These plans are not concrete, however, because the instability of current financial markets make it unlikely that the company will find partners before the economy settles down. Until that happens, the company will use its gas utilities in Missouri and Massachusetts to bring in a steady cash flow (made all the more steady by Missouri's flat-monthly-rate regulatory system) in order to fund the expansion of other segments.

Business and Financials

Southern Union operates three main segments:

• Transportation and Storage: This segment owns and operates pipelines used to move natural gas around the U.S.; the company has about 14,900 miles of pipeline split between two subsidiaries: Panhandle and Florida Gas. Panhandle operates 9,900 miles of pipeline from Texas, Oklahoma, Colorado, the Gulf Coast, and the Gulf of Mexico to markets in the Midwest, while Florida gas operates 5,000 miles of pipeline from the Gulf Coast to Florida.^[2] This segment also operates a liquified natural gas (LNG) receiving terminal in Louisiana. This is a regulated business.
• Gathering and Processing: Gathering is the movement of natural gas from the well to the transportation pipeline or liquification hub. Processing is essentially taking straight-from-the-earth gas and making it cleanly burnable. Southern Union's gathering and processing operations occur in Texas and New Mexico. ConocoPhillips contributes 16% of this segment's revenue.
• Distribution: Southern Union's gas distribution segment encompasses its gas utilities businesses in Missouri and Massachusetts. Between Missouri Gas Energy and New England Gas Company, Southern Union's Distribution segment has over 550,000 customers.^[3] This is a regulated business.

Trends and Forces

Government Regulation of Gas Pipelines and Distribution Gives the Company Little Control over its Margins

Southern Union faces two different utilities regulation schemes because it operates in two different states. As states tightly regulate utilities prices, SUG must appeal to state lawmakers for rate increases. In Missouri, the company charges a flat monthly fee to its residential customers, while its remaining customers in Missouri and all those in Massachusetts are charged a flat service rate every month plus a fee based on the amount of gas the customer uses. Missouri's residential billing scheme benefits the company by reducing seasonal revenue fluctuations; most utilities see revenue rise in winter months, when gas is being used in residential heating systems, and fall in summer, when electricity is used to power air conditioners. The Missouri residential system reduces these fluctuations, as well as the negative effects that unseasonal weather (e.g. warm winters) would have on the company. SUG has not filed for a rate increase in either Missouri or Massachusetts since 2006 and 2007, respectively. Both cases were settled by regulators in 2007.

The national government works with the states to monitor utilities, regulating transmissions rates while the states set electric and gas distribution rates. These rules are designed to ensure both profitability for companies and accessibility for consumers, but often hold back utilities companies, like SUG, from achieving potential revenues and profitability by preventing them from charging delivery rates that the level of demand would really allow. Regulation can also cause the company's margins to be volatile, as lobbying the government is the only way the company can control its prices. Unfortunately, natural gas costs fluctuate very rapidly, but it takes a long time for SUG's lobbyists to convince state and regional regulators to raise the price ceiling. For the most part, regulators will only raise rates if the company can show that something, whether rising costs or inflationary pressure, is causing their margins to shrink to unfair levels.

Fluctuating Natural Gas Prices Make Southern Union's Margins Much Less Predictable

Southern Union is not a natural gas exploration and production company, so it must purchase the natural gas it sells from other companies. Natural gas prices are extremely volatile, fluctuating between $5/cf and $10/cf several times in the past three years^[4]; though SUG tries to hedge against these fluctuations by purchasing long-term supply contracts, most E&P companies are loath to sell at fixed prices while natural gas prices are trending upwards. Furthermore, utilities regulations mean that Southern Union cannot pass rising costs onto consumers, giving the company less control of its margins.

Southern Union is Planning on Spinning its Only Non-Regulated Business into an MLP - Eventually

Southern Union's Gathering and Processing segment is its only non-regulated business. Though this is the company's smallest segment, making up only 12.4% of EBIT^[5], it has the largest growth potential. Since natural gas gathering and processing operations are not regulated, Southern Union will be able to change prices based on cost and demand. As demand for natural gas in the U.S. grows, thanks to popular concern over the environmental effects of coal-fired power plants and the maturing of American oil reserves, natural gas prices will rise and American exploration and production companies will increase production at natural gas sites in the Rockies, Appalachians, and Gulf Coast. As this occurs, demand for midstream services, like those provided by Southern Union's Gathering and Processing segment, is expected to rise (much like the demand for oilfield services has), carrying prices up with it, and giving Southern Union's revenues and margins a boost that its other segments have little hope of, given their regulated natures.

To increase the segment's potential, SUG is planning on spinning it off into an MLP. Master Limited Partnerships (MLPs) are partnerships in which Limited Partners provide capital and General Partners manage assets and operations. At the end of a given period, Limited Partners earn a set amount of money from the company's cash flow (like dividends) while the General Partner gets paid based on the performance of the MLP (like shares). MLPs benefit from paying no income taxes and from having multiple sources of capital funding; because of the lack of income tax, MLPs require a lower profit margin to realize the same overall rate of return as regular companies, while multiple sources of funding let them spend heavily while incurring less debt. They are, however, subject to certain requirements, the primary being that they must receive 90% of their cash from real estate, commodities, or natural resources.^[6] Natural gas midstream operations are considered a commodity.

Given the volatility of the current market, Southern Union is unlikely to spinoff the business until investors are more likely to join the MLP. It's unclear what the exact status of SUG will be within the MLP, but it can be assumed that since the company owns the assets now, it will be the majority owner of the General Partner share. This will give the company the ability to reap rewards based on the MLP's success, while the existence of the MLP itself will give the gathering and processing business (and SUG) the advantage of paying fewer taxes and having multiple sources of capital to fund growth.

Pipeline MLPs have Significant Advantages over SUG's Pipeline Business

Southern Union's Transportation and Storage segment is at a significant disadvantage to master limited partnerships involved in the same industry. The natural gas pipeline business is heavily regulated, as the cost of pipeline infrastructure is high enough to create natural monopolies. The time required to install new infrastructure forces transmissions companies to incur large debts, while rate regulations mean they can't pass costs on to their customers. So most pipeline operators grow through external acquisitions. MLPs receive capital from multiple sources, so they have the ability to strong-arm single operators like SUG when bidding on acquisitions or natural gas contracts. Furthermore, because they pay no income taxes, MLPs can acquire riskier or smaller pipelines because the income needed to meet their goals is lower than the income needed by a tax-paying company with the same goals.

Population Growth in Florida Will Lead to Natural Gas Demand Growth - and Opportunities for Southern Union's Florida Gas Pipeline

Southern Union increased its share of the Florida Gas pipeline to 50% at the end of 2006.^[7] As baby boomers begin to settle into their retired lives, Florida, the stereotypical senior haven, is set to receive a massive population boost. Flordia's Demographic Estimating Conference has estimated that the state's population will grow by 7.4% - nearly 1.4 million people.^[8] A larger population means more natural gas demand for two reasons. First, gas utilities will have more people to serve, and thus more gas to deliver. Second, with population growth will come an increased electrical load, especially given the amount of air-conditioning used in the humid subtropical climate. Coal-fired power plants have become increasingly difficult to fund, thanks to the Carbon Principles implemented by Citigroup, Morgan Stanley, and JP Morgan Chase, so many Florida utilities have switched gears and started to build gas-powered generating facilities. Already, Tallahassee, the state capital, is nearly 100% natural gas powered.^[9]

Competition

Southern Union is engaged in the storage, transport, production, and refining of natural gas; its utilities business operates in Missouri and Massachusetts.

In the gas transportation industry, SUG competes with Enbridge, Questar, Oneok, TC Pipelines, and Transcanada Pipelines.

High infrastructure costs make SUG a monopolist utility in the regions it services, though government regulation keeps the company from exploiting customers with high prices. Atmos Energy is one distribution company that operates in Missouri with Southern Union.

Major gas utilities include

• AGL Resources - AGL Resources operates gas delivery services in Florida, Georgia, Maryland, New Jersey, Tennessee, and Virginia, and has close relationships with twelve different gas marketing companies.
• Atmos Energy - Atmos operates in Texas, Kentucky, Louisiana, Mississippi, Colorado, Kansas, Tennessee, Georgia, Illinois, Iowa, Missouri, and Virginia. It is not only a gas utility but also a natural gas marketing, pipeline, and storage company.
• Energen - Energen is an energy holding company that operates in a variety of businesses, from oil exploration and production to natural gas marketing and distribution. Its utilities business is the largest gas distributor in Alabama.
• Equitable Resources - Equitable Resources is a vertically integrated natural gas company that operates from the upstream to natural gas distribution. Its gas utilities operate in Pennsylvania, West Virginia, and Kentucky.
• ONEOK - ONEOK is a transport and distribution company that acts as a utility in Oklahoma, Kansas, and Texas.
• National Fuel Gas Company - NFG is a diversified natural gas company that does exploration, production, transportation, marketing, and distribution of gas; its utilities segment operates in New York and Pennsylvania.
• Sempra Energy - Sempra is a gas and electric utilities company in California that also operates power generation and gas transportation businesses.
• National Grid Transco - National Grid is a gas and utilities company that operates in the United Kingdom and the United State; in the U.S., it operates in Rhode Island and New York.

References

1. ↑ SUG 2007 10-K
2. ↑ SUG 2007 10-K, Page 4
3. ↑ Reuters Full Description: Southern Union Co SUG (NYSE)
4. ↑ Natural Gas Price Chart for 2000-2007
5. ↑ SUG 2007 10-K, Page 30
6. ↑ Investopedia: "Master Limited Partnership"
7. ↑ Southern Union Company News: "Southern Union Announces Transactions Affecting Ownership of Florida Gas and Transwestern"
8. ↑ FLORIDA DEMOGRAPHIC ESTIMATING CONFERENCE: Charts, February 18th, 2008
9. ↑ The New York Times: "Utilities Turn From Coal to Gas, Raising Risk of Price Increase"
10. ↑ ATG 2007 10-K
11. ↑ ATO 2007 10-K
12. ↑ EGN 2007 1-K
13. ↑ EQT 2007 10-K
14. ↑ NFG 2007 10-K
15. ↑ OKE 2007 10-K
16. ↑ SUG 2007 10-K
17. ↑ SRE 2007 10-K
18. ↑ Equitable Resources: Equitable Utilities: Equitable Gas
19. ↑ Reuters Full Description: National Fuel Gas Co
20. ↑ Reuters: Full Description: National Grid Transco