DBRS Maintains Pacific Northern Gas Ratings Under Review with Negative Implications

DBRS continues to maintain Pacific Northern Gas Ltd’s (PNG or the Company) ratings Under Review with Negative Implications. The last rating action was driven by Methanex’s announcement to close its Kitimat, British Columbia, methanol plant permanently due to the negative impact of rising natural gas prices, the prevalence of dual-heating source customers, and the increasing volatility of natural gas prices. At that time, DBRS stated that it would base its rating decision on the outcome of the regulatory decision regarding the treatment of the loss of Methanex, as well as the longer-term commodity cost impact on the Company’s customer base and expected future earnings.

Prior to the termination of the Methanex contract, Methanex accounted for approximately 62% of PNG’s throughput volume and approximately 22% of net revenue ($10.4 million lost margin in 2006). The termination of the contract provided PNG with a one-time payment of $23.3 million in 2006, which is being amortized over the life of the former contract until October 2009. In the August 2006 Revenue Requirement decision, the British Columbia Utilities Commission (BCUC) permitted PNG full cost recovery of $4.8 million (representing the difference between lost margin and a portion of the termination payment realized as income for 2006). Even though PNG had intended its 2006 rate application to be subject to a negotiated settlement process, issues raised by its key intervenor, the BC Old Age Pensioners Organization (BCOAPO) led to a full written process. The BCOAPO argued that its key issue in the proceeding was whether the Utilities Commission Act (BC) required the BCUC to allocate all of the revenue shortfall arising from the closure of the Methanex Kitimat plant to ratepayers. The BCUC determined that PNG was entitled to recover its costs of service by increasing rates to cover the revenue shortfall, and that the increase in rates would not result in an over-recovery for PNG. DBRS views this decision as positive, as it confirmed that once the cost of providing service has been established (including the rate of return) the Commission is required by law to fix rates that are sufficient to enable the utility to recover all of those costs.

Based on the 2006 decision, DBRS would expect that the BCUC will set rates that will allow PNG to fully recover its costs of service, albeit spread over smaller customer volumes for 2010, when the Methanex amortization is completed in 2009. While PNG is entitled under current law to full cost recovery, there remains a risk that PNG may apply for rates which result in less than full cost recovery if necessary to remain competitive with substitute energy sources. On the positive side, however, though the termination of the Methanex contract led to a significant reduction in transportation volumes in 2006, the Company’s residential and commercial base remained stable year over year.

The competitiveness of natural gas as a fuel source remains a concern for PNG in the current environment, and the Company has experienced some switching of its small industrial customers to wood waste. However, wood waste as a source of fuel remains labour intensive and is not expected to be a significant threat in the residential sector and commercial sectors where electricity is the main alternative energy source. Electricity rates are also expected to rise in the near term according to BC Hydro’s Service Plan for 2007/08 to 2009/10. The Company has also recently experienced modest increase in its residential base after several years of slow decline, with potential growth in the service area also expected. DBRS notes that material switching could occur if natural gas prices were to spike.

PNG’s financial profile and credit metrics were reasonably stable and strong in 2006 due to the amortization of the Methanex payment. It is important that the Company maintains a reasonably strong and stable financial profile to offset its business risk. EBIT interest coverage, adjusted debt-to-capital and cash flow-to-adjusted debt were 2.61 times, 50% and 12.5%, respectively, compared to 2.59 times, 53.4% and 16.8% in 2005. PNG is in the development stage of constructing a 470-km pipeline from Kitimat to Summit Lake (KSL Project), through a 50/50 partnership with Kitimat LNG, at an estimated cost of $900 million to $1.2 billion. PNG’s cash flow from operations and cash flow metrics were impacted by $3 million of KSL Project development costs. PNG will continue to expense its share of the development costs until suitable commercial agreements are in place. In the event that this does not happen by the end of 2007, the Company has stated that it will scale down development expenditures.

DBRS has gained some comfort regarding the issues that led to the Company originally being placed under review. However, PNG currently has a bank credit facility, which matures this summer, that limits its financial flexibility. To the extent that PNG reaches an agreement on a restructured credit facility with the appropriate level of flexibility, DBRS would expect to confirm the ratings at BBB (low) and Pfd-3 (low), both with Negative trends. In the event the bank facility is not satisfactorily restructured, both ratings would likely be downgraded. If confirmed at the current rating levels with Negative trends, DBRS would look to resolve the trend within the next twelve months, with DBRS’s review focusing on a number of items, including PNG maintaining a reasonably stable and strong financial profile, economic stability in its service areas, a stable customer base (including PNG’s two large industrial customers, West Fraser Timber Co. Ltd. and Alcan Inc.) and whether suitable commercial arrangements have been made to allow the KSL Project to proceed.

Note:
All figures are in Canadian dollars unless otherwise noted.