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Rising Supply Should Keep Natural Gas Prices in Check

Avi Feinberg

Avi Feinberg: Hi. I am Avi Feinberg, equity analyst with Morningstar, covering oil and gas pipelines. I'm at the Morningstar Management Behind the Moat Conference, and I am very pleased to be joined today by Patrick Reddy, the CFO of Spectra Energy.

Patrick Reddy: Thanks, Avi. Glad to be here.

Feinberg: Thanks, Pat. One thing that we really like about Spectra is your high-quality footprint. You have assets in many of the key emerging shale plays, be it the Marcellus, the Eagle Ford, the Horn River, and the Montney up in British Columbia. There are a lot of opportunities here and you've talked about spending $1 billion-plus per year to develop these opportunities. Can you talk a little bit more about that and what opportunities you are most excited about?

Reddy: Certainly. Well, the shale plays really are driving a lot of the supply push as we call it. One thing I would mention in passing is that, even with the economy being kind of lackluster and unemployment being at historically high rates, we are still seeing growth in the throughput on our pipeline systems where we are setting new peak day records during the winter. So, people are finding new ways to use natural gas. Our pipelines are full.

On the supply side, something that's really interesting in the last couple of years, the shale gas has become economical to produce through horizontal drilling techniques and hydraulic fracturing, which people have probably read about. That supply is available now. The interesting thing to me is that, the shale formations are really where the old conventional gas was. So, not surprisingly we have pipelines, we have gathering and processing, we have storage facilities that are near most of the new shale areas because that's where the conventional gas was. And we were there to take that during the last several decades.

So, in terms of areas that we are excited about, gosh, it's a long list. Up in British Columbia, there are two formations where we have increasing production; one is in the Horn River, which is in far north British Columbia; the other is in the Montney unconventional formation, and we are building a new plant in the Dawson area in two phases, investing about $200 million there and investing a total of about $1.5 billion in British Columbia between now and the end of 2013.

Down in the lower 48 states, we have our joint venture with Conoco DCP Midstream. They have a number of new processing plants that they are building, but are also constructing or about to construct two new natural gas liquids pipelines to relieve bottlenecks that currently exist between a collection point called Conway in Kansas and Mont Belvieu on the Gulf Coast. These natural gas liquids are used by petrochemical plants to make things like plastic. So, the NGLs have to get where the petrochemical plants are, and in our country they are mostly on the Gulf Coast. So, we are building two new pipelines to bring natural gas liquids from the Permian, from the Mid-Continent and from the Eagle Ford down to Mont Belvieu, where the producers get better prices for their product.

With that joint venture that I talked about, DCP Midstream, we've got $4 billion of projects in execution between now and 2013 and another $2 billion of potential projects. I would remind folks though that in that partnership, the funding of those investments comes from the partnership and from their master limited partnership, called DPM. That's its ticker symbol. We don't put cash into that business; they pay dividends to us.

Feinberg: Great. I noticed recently that Spectra just increased the dividend by about 8% during  the last quarter. Looking forward, you talked a little about earnings growth. Can you talk about the combination of earnings and dividend growth that you are targeting going forward and also the safety behind that dividend?

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Reddy: Certainly. We know for our investor base that having a transparent, predictable record of increasing your earnings and your dividend is very important so that we are predictable and there are no surprises. We want people to say, "Oh, Spectra, 8% dividend increase every year. We know them."

But to do that, our stated dividend policy over time and on average is to pay out up to 65% of our earnings. We are not yet there at this point. We are at about 60%, even with our 8% increase.

As we look at our three-year financial plan, we are confident that we ought to be able to sustain $0.08-type increases during the next few years out through 2013 and 2014, and that's about as far as my crystal ball goes. But it'd be our objective to pay out in that proportion from our earnings, and the only governor on that is that we want to be sure that our dividend is covered entirely by the fee-based earnings that we generate and not be dependent on increasing commodity prices in the future to pay that dividend. We compare ourselves to peers; we look at the Alerian Index for the MLPs. Our 8% increase is certainly higher than the average for that group. So we think we compare favorably.

Feinberg: Finally, maybe we could talk just kind of big picture. Clearly, there's a lot of macroeconomic uncertainty lately. Investors are worried about the eurozone, the Middle East, and slow growth in developed countries. At the same, there's no denying that natural gas and especially NGL fundamentals have been very strong in recent years. Pricing is great today still. Looking forward, how do you guys look at those fundamentals for both gas and NGLs, and how would that affect Spectra?

Reddy: Well, I think something's that happened during the last two to two-and-a-half years is recognition that natural gas is going to play a fundamental roll in meeting the energy needs of the country. A few years ago, all the talk was about renewables; solar and wind and other forms of energy that weren't fossil fuel-based and we certainly are very supportive of the new technology and phasing in more and more renewable and green energy as its available and as its cost-effective and competitive.

But most of the analyses you look at says that it's probably 50 years out before the renewable sources can put much of a dent in our energy needs. And after the problems in Japan with their nuclear reactor, it's probably unlikely that we're going to see many new nuclear plants built in the foreseeable future, and they have long-lead times. So, you keep coming back to natural gas as the premium fuel and the cleanest fossil-based fuel. So, we have that going for us.

The other thing is that with all the new supplies coming from the shale formations, we think that supply will keep up with demand growth in the country as the economy recovers and when it recovers. The one thing, though, that's been kind of counterintuitive for me is that even with the economy being in the doldrums and having high unemployment rates, as I mentioned earlier, we're setting new peak-day records every year for usage on our system. About three fourths of the gas we move on our big pipeline to the Northeast is consumed by distribution companies, your local gas company. They've basically signed up for capacity on our system based on their peak-day requirement, and that's meant that we've had increasing needs every year to expand our system.

So, we think that natural gas is going to trade in a range, maybe of $4-$6 over time, and that you probably won't see gas get much above that, given all the new production that's taking place. At the same time, there are increasing uses for natural gas as power plants that burn coal or fuel oil eventually convert to natural gas usage because it's cleaner-burning. Even though the population or the economy may not be growing quickly, there's the need to convert for environmental reasons. Investments are being made and those power generators are talking with us now about the role that we can play in helping them to convert.

On the natural gas liquids side, we've seen a lot of support for the price for our gallon in the range of about $1.20-$1.25, and we are the largest producer and seller of natural gas liquids in the country. Our folks that are responsible for that are optimistic that we'll see natural gas liquids hold up. Another thing that's a new development in this country is that the petrochemical companies are talking about building new capacity in the Gulf, and you wouldn't have heard that going back 18 months or two years ago. That's a new phenomenon. We're exporting propane to South America and to Canada, so we have new outlets for natural gas products. So we're very bullish about the future for natural gas and the role that we can play in helping to bring the gas from the supply bases to market.

Feinberg: Well, Pat, I want to thank you again for coming out to talk about Spectra's wide economic moat and to talk about your growth opportunities.

Reddy: You're very welcome. We're not hiding behind that moat.

Feinberg: No, absolutely not. I'm Avi Feinberg from Morningstar and thanks for watching.