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Spectra's Footprint Results in Wide Moat

Jason Stevens

Jason Stevens: Hello, my name is Jason Stevens and I'm the director of energy research here at Morningstar. With me here today is Pat Reddy, CFO of Spectra Energy, and I thought we would welcome and thank you for joining us.

I thought what we could do first is talk about what gives Spectra its wide economic moat. What do you do to maintain that moat and how do you face competitive challenges?

Pat Reddy: OK, Jason. Well, thank you for including us today. Like any industry, you have to have your own economic moat or advantage, and in our case, it's our footprint. It's where our pipelines, our storage, our processing plants are located. We serve four of the five fastest-growing end use markets. On the supply side, our asset happen to be in the most prolific shale formations today that are being produced, especially those that have what we call wet gas or natural gas liquids content, that make them more advantageous for their producers to produce.

Then the second thing that provides an economic advantage is the growing use of natural gas and the substitution of gas for coal, for example, which is giving longevity to our buildout in our infrastructure. The other thing about our footprint, the economic advantage that comes from it, is that in a sense it's much more economical to build off of an existing footprint and price your services incrementally than it is for a brand-new build to just show up in an area and create something fresh. And so that's the primary advantage that we have.

Stevens: That makes a lot of sense, and when I look at Spectra, one of the key decisions you face is how to allocate capital.

Reddy: Yes.

Stevens: Where do you see the greatest opportunities, given your footprint in assets, to build off of that and continue to grow?

Reddy: Well, interestingly for a company our size, we're really not balance sheet or capital constrained. It's really more a function of activity constraints. How many projects can you take on and do well? For example, since we became an independent company in 2007 through the end of last year, we'd completed 50 significant projects, all above our cost of capital, and of course today, with capital cost so low, hurdle rates have come down, but we're able to earn substantially more than our cost of capital on all the projects that we've undertaken. So it's really a good position to be in.

But in terms of allocating capital we're seeing--we're in four business segments: distribution, gas transmission and storage, gas processing, and then midstream. In three of our business areas, we're seeing prolonged growth and it's all around the drilling that's taking place in the new shale formations. In our business, once the wells are drilled, we're what's called a must-run business; the gas has to be processed to be pipeline quality, the natural gas liquids have to be removed. And so once the wells are drilled, which isn't our business, we're involved in processing, we're involved in the long-term transmission, we're involved in storage, and we're seeing growth across all three of our segments.

Stevens: That makes sense. I'd like to come right back to the shale gas map and how that is impacting your business from a supply push perspective. But can I talk real quickly, ask about those 50 projects you've completed to date?

Reddy: Yes.

Stevens: What do you guys do that's distinctive in the industry to manage those projects? It's so important to deliver projects on time, on budget.

Reddy: Absolutely.

Stevens: How do you manage that, given different cycles of cost inflation and labor shortages, et cetera?

Reddy: Well, there's different ways to do it. Starting at the beginning is that, we've got a long history of infrastructure build in the company. Our backbone pipeline assets were built back in the 1940s, so we've got decades of experience. But not to pat ourselves too much on the back, we've developed a real expertise around project management. It's a strong group that we have, with a discipline around, on the front end, capital allocation and then on scheduling and build. Then part of it is building in adequate contingency in your budgets based on experience.

Part of it is how you contract for the construction. You can, depending on--there are trade-offs between cost, obviously, and risk sharing, and sometimes you can do some risk sharing with your customers. An innovative example of that is our big New Jersey and New York project. It's only a 16-mile build, but it's into Manhattan and under the Hudson River, so the budget's $1.2 billion and we have some cost sharing with our customers, where if we come in under budget, we discount the rate; if we come in say 10% over, we have some sharing.

Stevens: Got you. That gives you some insulation against any kind of overrun on such a delicate project.

Reddy: That's right. That's exactly right.

Stevens: Yeah, that's terrific. It really would protect returns. Let's talk about that shale gas push. Your asset footprint is pretty beautiful. It connects most of the shale regions to the main demand source in the winter months. When you think about what's happening with gas production and low prices, does price sensitivity for gas on your pipelines matter at all?

Reddy: Well, it matters in the sense that we're an intermediary. We're a little bit like FedEx. We get paid a fee to deliver the gas. We don't take title, so we don't own the gas in our pipeline and storage business. So the important part for us is to continue to grow our investment, grow our earnings, because we're fundamentally a dividend-paying entity. But the pace of growth then is determined by the economics to our producers and to our consumers. As long as the prices of gas and natural gas liquids are attractive in combination, the drilling will continue. We'll need to build incremental pipe, we'll need to build incremental processing plants.

We are the largest processor of gas liquids in North America and the second-largest processor of natural gas. So our growth is dependent on the health of the producers and the growing market share and it's not--the irony for me is that even in a difficult time for the country's economy, we're still seeing very high rates of increase in natural gas usage. Part of that is substitution. For example, in electric generation, natural gas is displacing coal because of environmental and emission considerations, not because the demand for electricity at this point in time is growing substantially. It's really more of a substitution game. At the same time, natural gas is a feedstock. The current price level is very attractive for the petrochemical industry, for steelmakers, for fertilizer manufacturers, and so they're gearing up and expanding and that's what's taking place.

Stevens: So long term we see this secular demand increase for gas?

Reddy: Yes.

Stevens: When I look at your footprint, particularly if we think about coal to gas, it's very attractive just given the location of where existing power demand is and coal plants and the need to replace similar levels of power generation in the same transmission zones.

Reddy: We're looking at about a 20% increase in throughput on our biggest pipeline into Northeast, which serves Boston, Philadelphia, and New York. That's because, when you think about, it's not surprising that the pipelines are in a footprint where the population centers are as we've industrialized. The power plants are near the pipelines, and so one kind of feeds the other and the pipelines access the gas basins. Not coincidentally, the shale gas is pretty much where the conventional gas was, it's just at a different elevation. So, our footprint that really can't be duplicated today--from the Gulf to the Northeast--really is the competitive advantage.

Stevens: I think that that really bears repeating. It's that irreplicable footprint that gives you that significant competitive advantage. One thing I'd like to ask along that line and just to wrap up is, you are the largest gas processor and you have a pretty significant exposure to the spread between natural gas and natural gas liquids prices. Can you talk a moment about what the structural advantages for Spectra are--of being involved in that commodity-sensitive business in addition to what we would think of as a more structurally advantaged long-haul transportation business?

Reddy: Absolutely. You might think that since 80% of our business is fee-based and/or regulated and 20% commodity-sensitive, why would you--as fundamentally a dividend-paying company that wants to grow from your fee-based earnings, why would you have this commodity-sensitive business? The reason is that we've got a long history; we're very good at it. The returns tends to be very high in the processing business relative to regulated transmission, let's say. The cash flow is good. So, even in a year like 2009, when oil prices pulled back substantially, we still got very high cash dividends from our partnership.

And then the other thing is that in that business we also have a footprint advantage. Today, we have 62 processing plants that just happen to be in the wettest shale formations--the Permian, the Eagle Ford, the Mid-Continent, et cetera. Maybe an illustration of that in that business is that in the Eagle Ford area we've got six plants today that are interconnected. If one plant's down for plant maintenance or one's down for an unplanned upset, we still have the reliability that we can sell to our producer, that we can take your production and not have to call you and ask you to shut it in, as opposed to a competitor who might charge the same rate but only have one plant. So it's back to footprint and scale.

Stevens: Yeah, very good. Well, Pat, thank you very much for your time and I sure enjoy hearing more about Spectra Energy.

Reddy: Thank you, Jason.

Stevens: You bet.