UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period
ended March 31, 2004 TRANSITION
REPORT PURSUANT TO SECTION 13 OR
15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition period from to
Commission file number 1-14161
KEYSPAN CORPORATION
(Exact name of Registrant as specified in its Charter)
New York 11-3431358
-------- ----------
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
One MetroTech Center, Brooklyn, New York 11201
175 East Old Country Road, Hicksville, New York 11801
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(Address of principal executive offices) (Zip Code)
(718) 403-1000 (Brooklyn)
(631) 755-6650 (Hicksville)
---------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.[_X_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).[_X_]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class of Common Stock Outstanding at April 16, 2004
--------------------- -----------------------------
$.01 par value 160,164,056
KEYSPAN CORPORATION AND SUBSIDIARIES
INDEX
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Part I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Consolidated Balance Sheet -
March 31, 2004 and December 31, 2003 3
Consolidated Statement of Income -
Three Months Ended March 31, 2004 and 2003 5
Consolidated Statement of Cash Flows -
Three Months Ended March 31, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 30
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 57
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 61
Item 6. Exhibits and Reports on Form 8-K 61
Signatures 61
2
CONSOLIDATED BALANCE SHEET
(Unaudited)
- ---------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) March 31, 2004 December 31, 2003
- ---------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 256,940 $ 205,751
Accounts receivable 1,384,598 1,029,459
Unbilled revenue 460,460 505,633
Allowance for uncollectible accounts (91,016) (79,184)
Gas in storage, at average cost 154,072 488,521
Material and supplies, at average cost 118,772 121,415
Other 69,519 115,304
---------------------------- ---------------------
2,353,345 2,386,899
---------------------------- ---------------------
Investments and Other 256,372 248,565
Property
Gas 6,590,421 6,522,251
Electric 2,671,594 2,636,537
Other 429,716 425,576
Accumulated depreciation (2,655,711) (2,610,876)
Gas exploration and production, at cost 3,157,026 3,088,242
Accumulated depletion (1,229,368) (1,167,427)
---------------------------- ---------------------
8,963,678 8,894,303
---------------------------- ---------------------
Deferred Charges
Regulatory assets 554,563 578,383
Goodwill and other intangible assets 1,810,161 1,809,712
Other 741,613 722,320
---------------------------- ---------------------
3,106,337 3,110,415
---------------------------- ---------------------
Total Assets $ 14,679,732 $ 14,640,182
============================ =====================
See accompanying Notes to the Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEET
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) March 31, 2004 December 31, 2003
- ------------------------------------------------------------------------------------------------------------------
LIABILITIES AND CAPITALIZATION
Current Liabilities
Current redemption of long-term debt $ 1,471 $ 1,471
Accounts payable and other liabilities 950,861 1,141,597
Commercial paper 294,150 481,900
Dividends payable 72,070 72,289
Taxes accrued 197,686 46,580
Customer deposits 41,028 40,370
Interest accrued 102,967 64,609
-------------------------- ------------------------
1,660,233 1,848,816
-------------------------- ------------------------
Deferred Credits and Other Liabilities
Regulatory liabilities:
Miscellaneous liabilities 93,110 104,034
Removal cost recovered 462,585 450,034
Deferred income tax 1,250,672 1,278,341
Postretirement benefits and other reserves 1,060,525 961,962
Other 162,713 121,790
-------------------------- ------------------------
3,029,605 2,916,161
-------------------------- ------------------------
Commitments and Contingencies (See Note 6) - -
Capitalization
Common stock 3,492,116 3,487,645
Retained earnings 796,410 621,430
Other comprehensive income (89,309) (59,932)
Treasury stock (366,691) (378,487)
-------------------------- ------------------------
Total common shareholders' equity 3,832,526 3,670,656
Preferred stock 83,433 83,568
Long-term debt 5,537,456 5,611,432
-------------------------- ------------------------
Total Capitalization 9,453,415 9,365,656
-------------------------- ------------------------
Minority Interest in Subsidiary Companies 536,479 509,549
-------------------------- ------------------------
Total Liabilities and Capitalization $ 14,679,732 $ 14,640,182
========================== ========================
See accompanying Notes to the Consolidated Financial Statements.
4
CONSOLIDATED STATEMENT OF INCOME
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003
- ------------------------------------------------------------------------------------------------------------------
Revenues
Gas Distribution $ 1,927,779 $ 1,832,701
Electric Services 359,136 397,700
Energy Services 129,059 129,065
Gas Exploration and Production 152,419 127,847
Energy Investments 27,180 25,212
----------------------------------------------
Total Revenues 2,595,573 2,512,525
----------------------------------------------
Operating Expenses
Purchased gas for resale 1,226,573 1,196,165
Fuel and purchased power 101,612 97,522
Operations and maintenance 492,466 498,189
Depreciation, depletion and amortization 171,684 144,971
Operating taxes 122,279 124,713
----------------------------------------------
Total Operating Expenses 2,114,614 2,061,560
----------------------------------------------
Income from equity investments 5,717 5,729
----------------------------------------------
Operating Income 486,676 456,694
----------------------------------------------
Other Income and (Deductions)
Interest charges (84,066) (68,939)
Gain on sale of subsidiary stock - 19,020
Cost of debt redemption - (18,194)
Minority interest (20,293) (18,054)
Other 2,761 15,397
----------------------------------------------
Total Other Income and (Deductions) (101,598) (70,770)
----------------------------------------------
Income Taxes
Current 147,702 129,575
Deferred (10,320) 13,258
----------------------------------------------
Total Income Taxes 137,382 142,833
----------------------------------------------
Earnings Before Effect of Change in Accounting Principle 247,696 243,091
Cummulative Effect of Change in Accounting Principle - 174
----------------------------------------------
Net Income 247,696 243,265
Preferred stock dividend requirements 1,461 1,461
----------------------------------------------
Earnings for Common Stock $ 246,235 $ 241,804
==============================================
Basic Earnings Per Share:
Before Change in Accounting Principle,
less preferred stock dividends $ 1.54 $ 1.54
Change in Accounting Principle - -
----------------------------------------------
Basic Earnings Per Share $ 1.54 $ 1.54
==============================================
Diluted Earnings Per Share
Before Change in Accounting Principle,
less preferred stock dividends $ 1.53 $ 1.53
Change in Accounting Principle - -
----------------------------------------------
Diluted Earnings Per Share $ 1.53 $ 1.53
==============================================
Average Common Shares Outstanding (000) 159,892 156,886
Average Common Shares Outstanding - Diluted (000) 161,164 158,045
See accompanying Notes to the Consolidated Financial Statements.
5
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
- ---------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- ---------------------------------------------------------------------------------------------------------
Operating Activities
Net income $ 247,696 $ 243,265
Adjustments to reconcile net income to net
cash provided by (used in) operating activities
Depreciation, depletion and amortization 171,684 144,971
Deferred income tax (10,320) 13,258
Income from equity investments (5,717) (5,729)
Dividends from equity investments 104 -
Amortization of interest rate swap (2,448) (2,500)
(Gain) on disposal of subsidiary stock - (19,020)
Minority interest 20,293 18,054
Changes in assets and liabilities
Accounts receivable (298,134) (520,062)
Materials and supplies, fuel oil and gas in storage 337,092 201,789
Accounts payable and other liabilities (190,736) 146,311
Taxes accrued 151,106 203,411
Interest accrued 38,357 8,324
Captive insurance 43,214 -
Other 76,895 64,755
----------------------------------------
Net Cash Provided by Operating Activities 579,086 496,827
----------------------------------------
Investing Activities
Construction expenditures (220,224) (220,779)
Cost of removal (6,204) (6,938)
Proceeds from monetization of Houston Exploration - 79,200
Proceeds from sale of property 13,138 -
----------------------------------------
Net Cash Used in Investing Activities (213,290) (148,517)
----------------------------------------
Financing Activities
Treasury stock issued 11,796 26,307
Equity issuance - 473,573
Issuance of long-term debt 20,000 39,161
Payment of long-term debt (94,853) (72,565)
Payment of commercial paper (187,750) (238,365)
Redemption of promissory notes - (447,005)
Preferred stock dividends paid (1,461) (1,461)
Common stock dividends paid (71,474) (63,557)
Other 9,135 9,047
----------------------------------------
Net Cash Used in Financing Activities (314,607) (274,865)
----------------------------------------
Net Increase in Cash and Cash Equivalents $ 51,189 $ 73,445
Cash and Cash Equivalents at Beginning of Period 205,751 170,617
----------------------------------------
Cash and Cash Equivalents at End of Period $ 256,940 $ 244,062
========================================
Cash equivalents are short-term marketable securities purchased with
maturities of three months or less that were carried at cost which
approximates fair value.
See accompanying Notes to the Consolidated Financial Statements.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
KeySpan Corporation (referred to in the Notes to the Financial Statements as
"KeySpan," "we," "us" and "our") is a registered holding company under the
Public Utility Holding Company Act of 1935, as amended ("PUHCA"). KeySpan
operates six regulated utilities that distribute natural gas to approximately
2.5 million customers in New York City, Long Island, Massachusetts and New
Hampshire, making KeySpan the fifth largest gas distribution company in the
United States and the largest in the Northeast. We also own and operate electric
generating plants in Nassau and Suffolk Counties on Long Island and in Queens
County in New York City and are the largest electric generation operator in New
York State. Under contractual arrangements, we provide power, electric
transmission and distribution services, billing and other customer services for
approximately one million electric customers of the Long Island Power Authority
("LIPA"). KeySpan's other subsidiaries are involved in gas and oil exploration
and production; underground gas storage; liquefied natural gas storage; retail
electric marketing; appliance service; plumbing; heating, ventilation and air
conditioning and other mechanical services; large energy-system ownership,
installation and management; engineering and consulting services; and fiber
optic services. We also invest and participate in the development of natural gas
pipelines, electric generation and other energy-related projects, domestically
and internationally. (See Note 2 "Business Segments" for additional information
on each operating segment.)
1. BASIS OF PRESENTATION
In our opinion, the accompanying unaudited Consolidated Financial Statements
contain all adjustments necessary to present fairly KeySpan's financial position
as of March 31, 2004, and the results of operations for the three months ended
March 31, 2004 and March 31, 2003, as well as cash flows for the three months
ended March 31, 2004 and March 31, 2003. The accompanying financial statements
should be read in conjunction with the consolidated financial statements and
notes included in KeySpan's Annual Report on Form 10K for the year ended
December 31, 2003. The December 31, 2003 financial statement information has
been derived from the 2003 audited financial statements. Income from interim
periods may not be indicative of future results. Certain reclassifications were
made to conform prior period financial statements to the current period
financial statement presentation.
Basic earnings per share ("EPS") is calculated by dividing earnings available
for common stock by the weighted average number of shares of common stock
outstanding during the period. No dilution for any potentially dilutive
securities is included. Diluted EPS assumes the conversion of all potentially
dilutive securities and is calculated by dividing earnings available for common
stock, as adjusted, by the sum of the weighted average number of shares of
common stock outstanding plus all potentially dilutive securities.
We have approximately 3.6 million common stock options outstanding at March 31,
2004, that were not included in the calculation of diluted EPS since the
exercise price associated with these options was greater than the average market
price of our common stock.
7
Under the requirements of Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share" our basic and diluted EPS are as follows:
- ---------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003
- ---------------------------------------------------------------------------------------------------------
Earnings for common stock $ 246,235 $ 241,804
Interest savings on convertible preferred stock 129 133
Houston Exploration dilution (81) (87)
- ---------------------------------------------------------------------------------------------------------
Earnings for common stock - adjusted $ 246,283 $ 241,850
- ---------------------------------------------------------------------------------------------------------
Weighted average shares outstanding (000) 159,892 156,886
Add dilutive securities:
Options 1,050 931
Convertible preferred stock 222 228
- ---------------------------------------------------------------------------------------------------------
Total weighted average shares outstanding - assuming dilution 161,164 158,045
- ---------------------------------------------------------------------------------------------------------
Basic earnings per share $ 1.54 $ 1.54
- ---------------------------------------------------------------------------------------------------------
Diluted earnings per share $ 1.53 $ 1.53
- ---------------------------------------------------------------------------------------------------------
2. BUSINESS SEGMENTS
We have four reportable segments: Gas Distribution, Electric Services, Energy
Services and Energy Investments.
The Gas Distribution segment consists of six gas distribution subsidiaries.
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution services to
customers in the New York City Boroughs of Brooklyn, Queens and Staten Island.
KeySpan Energy Delivery Long Island ("KEDLI") provides gas distribution services
to customers in the Long Island Counties of Nassau and Suffolk and the Rockaway
Peninsula of Queens County. The remaining gas distribution subsidiaries, Boston
Gas Company, Colonial Gas Company, Essex Gas Company and EnergyNorth Natural
Gas, Inc., collectively referred to as KeySpan Energy Delivery New England
("KEDNE"), provide gas distribution service to customers in Massachusetts and
New Hampshire.
The Electric Services segment consists of subsidiaries that: operate the
electric transmission and distribution system owned by LIPA; own and provide
capacity to and produce energy for LIPA from our generating facilities located
on Long Island; and manage fuel supplies for LIPA to fuel our Long Island
generating facilities. These services are provided in accordance with long-term
service contracts having remaining terms that range from three to eleven years
and power purchase agreements for 23 years. The Electric Services segment also
includes subsidiaries that own, lease and operate the 2,450 megawatt ("MW")
Ravenswood electric generation facility ("Ravenswood facility"), located in
Queens, New York, which includes the recently completed 250 MW combined cycle
electric generating facility located at the Ravenswood site (see below). All of
the energy, capacity and ancillary services related to the Ravenswood facility
is sold to the New York Independent System Operator ("NYISO") energy markets.
The Electric Services segment also provides retail marketing of electricity to
commercial customers.
8
We are currently in the process of structuring a leveraged lease financing for
the new 250 megawatt electric generating facility located at the existing
Ravenswood site, and are seeking to close this transaction in May to coincide
with the commencement of full commercial operation of the new facility. At the
closing, the new facility will be acquired by the lessor from our subsidiary,
KeySpan Ravenswood, LLC, and simultaneously leased back to it. All obligations
of our subsidiary under the lease will be unconditionally guaranteed by KeySpan.
We anticipate that this lease transaction will generate cash proceeds equivalent
to the fair market value of the facility, as determined by a third-party
appraiser. It is expected that the cash proceeds from this transaction will be
used to redeem outstanding commercial paper. This lease transaction is intended
to qualify as an operating lease under SFAS 98 "Accounting for Leases:
Sale/Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real
Estate; Definition of the Lease Term; an Initial Direct Costs of Direct
Financing Leases, an amendment of FASB Statements No.13, 66, 91 and a rescission
of FASB Statement No. 26 and Technical Bulletin No. 79-11." The lease will have
an initial term of 36 years and operating lease expense is anticipated to be
between $15 million to $17 million per year. Lease payments will fluctuate from
year to year, but are substantially paid over the first 16 years.
The Energy Services segment includes companies that provide energy-related and a
minimal amount of fiber optic services to customers primarily located within the
Northeastern United States, with concentrations in the New York City
metropolitan area, including New Jersey and Connecticut, as well as Rhode
Island, Pennsylvania, Massachusetts and New Hampshire, through the following
lines of business: (i) Home Energy Services, which provides residential and
small commercial customers with service and maintenance of energy systems and
appliances; and (ii) Business Solutions, which provides plumbing, heating,
ventilation, air conditioning and mechanical services, as well as operation and
maintenance, design, engineering and consulting services to commercial and
industrial customers.
The Energy Investments segment consists of our gas exploration and production
investments, as well as certain other domestic and international energy-related
investments. Our gas exploration and production subsidiaries are engaged in gas
and oil exploration and production, and the development and acquisition of
domestic natural gas and oil properties. These investments consist of our 55%
equity interest in The Houston Exploration Company ("Houston Exploration"), an
independent natural gas and oil exploration company, as well as KeySpan
Exploration and Production, LLC, our wholly owned subsidiary engaged in a joint
venture with Houston Exploration.
Subsidiaries in this segment also hold a 20% equity interest in the Iroquois Gas
Transmission System LP, a pipeline that transports Canadian gas supply to
markets in the Northeastern United States and a 50% interest in the Premier
Transmission Pipeline in Northern Ireland. At March 31, 2004, we had an
approximate 61% investment in certain midstream natural gas assets in Western
Canada through KeySpan Energy Canada Partnership ("KeySpan Canada"). With the
exception of KeySpan Canada, which is consolidated in our financial statements,
these subsidiaries are accounted for under the equity method.
9
On April 1, 2004, The KeySpan Facilities Income Fund (the "Fund") issued 15.617
million units at a price of $12.60 per unit for gross total proceeds of
approximately CDN$196.8 million. The proceeds of the offering were used to
acquire an additional 35.91% interest in the business of KeySpan Canada from
KeySpan. KeySpan received net proceeds of approximately CDN$186.3 million (or
approximately US$140 million), after commissions and expenses. The Fund's
ownership in KeySpan Canada has now increased from 39.1% to approximately 75%.
KeySpan's ownership of KeySpan Canada is now approximately 25%. KeySpan expects
to record a pre-tax gain of approximately $20 million on this transaction, which
will be reflected in its earnings in the second quarter of 2004. The proceeds
from the transaction will be used to redeem outstanding debt.
The accounting policies of the segments are the same as those used for the
preparation of the Consolidated Financial Statements. The segments are strategic
business units that are managed separately because of their different operating
and regulatory environments. Operating results of our segments are evaluated by
management on an operating income basis. At March 31, 2004, the total assets of
each reportable segment have not changed materially from those levels reported
at December 31, 2003. However, in the first quarter of 2004 we reclassified the
operating results of our electric marketing subsidiary from the Energy Services
segment to the Electric Services segment. As a result we restated the financial
results for the first quarter of 2003. The reportable segment information is as
follows:
- ------------------------------------------------------------------------------------------------------------------------------------
Energy Investments
-------------------------
Gas
Exploration
Gas Electric Energy and Other
(InThousands of Dollars) Distribution Services Services Production Investments Eliminations Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2004
Unaffiliated revenue 1,927,779 359,136 129,059 152,419 27,180 - 2,595,573
Intersegment revenue - - 3,436 - 1,265 (4,701) -
Operating Income 379,653 47,200 (18,474) 62,108 12,922 3,267 486,676
Three Months Ended March 31, 2003
Unaffiliated revenue 1,832,701 397,700 129,065 127,847 25,212 - 2,512,525
Intersegment revenue - 25 1,426 - 1,252 (2,703) -
Operating Income 364,937 39,644 (9,122) 55,590 10,124 (4,479) 456,694
- -----------------------------------------------------------------------------------------------------------------------------------
Eliminating items include intercompany interest income and expense, the
elimination of certain intercompany accounts, as well as activities of our
corporate and administrative areas.
Because of the nature of our Electric Services business, electric revenues are
derived from two large customers - the NYISO and LIPA. Electric Services
revenues from these customers of $345.6 million and $334.4 million for the three
months ended March 31, 2004 and 2003 represent approximately 13% of our
consolidated revenues in both periods.
10
3. COMPREHENSIVE INCOME
The table below indicates the components of comprehensive income:
- ------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
Net Income $ 247,696 $ 243,265
- ------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax
Net losses (gains) on derivative instruments 11,029 2,354
Foreign currency translation adjustments (1,896) 9,753
Unrealized gains (losses) on marketable securities 513 (3,156)
Settlement of derivative premiums 3,437 -
Unrealized losses on derivative financial instruments (42,458) (14,749)
- ------------------------------------------------------------------------------------------------------------------------
Other comprehensive loss, net of tax (29,375) (5,798)
- ------------------------------------------------------------------------------------------------------------------------
Comprehensive Income $ 218,321 $ 237,467
- ------------------------------------------------------------------------------------------------------------------------
Related tax (benefit) expense
Net losses (gains) on derivative instruments 5,939 1,267
Foreign currency translation adjustments (1,021) 5,252
Unrealized gains (losses) on marketable securities 274 (1,699)
Settlement of derivative premiums 1,851 -
Unrealized losses on derivative financial instruments (22,862) (7,942)
- ------------------------------------------------------------------------------------------------------------------------
Total Tax (Benefit) Expense $ (15,819) $ (3,122)
- ------------------------------------------------------------------------------------------------------------------------
4. HEDGING AND DERIVATIVE FINANCIAL INSTRUMENTS
Financially-Settled Commodity Derivative Instruments - Hedging Activities: From
time to time, KeySpan subsidiaries have utilized derivative financial
instruments, such as futures, options and swaps, for the purpose of hedging the
cash flow variability associated with changes in commodity prices. KeySpan is
exposed to commodity price risk primarily with regard to its gas exploration and
production activities and its electric generating facilities. Derivative
financial instruments are employed by Houston Exploration to hedge cash flow
variability associated with forecasted sales of natural gas. The Ravenswood
facility uses derivative financial instruments to hedge the cash flow
variability associated with the purchase of natural gas and oil that will be
consumed during the generation of electricity. The Ravenswood facility also
hedges the cash flow variability associated with a portion of on-peak electric
energy sales.
The majority of these derivative financial instruments are cash flow hedges that
qualify for hedge accounting under SFAS 133 "Accounting for Derivative
Instruments and Hedging Activities," as amended by SFAS 149 "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities," collectively
SFAS 133, and are not considered held for trading purposes as defined by current
accounting literature. Accordingly, we carry the fair market value of our
derivative instruments on the Consolidated Balance Sheet as either a current or
deferred asset or liability, as appropriate, and defer the effective portion of
unrealized gains or losses in accumulated other comprehensive income. Gains and
losses are reclassified from accumulated other comprehensive income to the
Consolidated Statement of Income in the period the hedged transaction effects
earnings. Gains and losses are reflected as a component of either revenue or
fuel and purchased power depending on the hedged transaction. Hedge
ineffectiveness results from changes during the period in the price
differentials between the index price of the derivative contract and the index
price at the point of sale for the cash flow that is being hedged, and is
recorded directly to earnings.
11
Houston Exploration has utilized collars and purchased put options, as well as
over-the-counter ("OTC") swaps, to hedge the cash flow variability associated
with forecasted sales of a portion of its natural gas production. At March 31,
2004, Houston Exploration has hedge positions in place for approximately 70% of
its estimated 2004 gas production, with an effective floor price of $4.26 and an
effective ceiling price of $5.85. Further, Houston Exploration has hedge
positions in place for approximately 60% of its estimated 2005 gas production,
with an effective floor price of $4.57 and an effective ceiling price of $5.46.
Houston Exploration uses standard New York Mercantile Exchange ("NYMEX") futures
prices to value its swap positions and, in addition, uses published volatility
in its Black-Scholes calculation for outstanding options. The maximum length of
time over which Houston Exploration has hedged such cash flow variability is
through December 2005. The fair market value of these derivative instruments at
March 31, 2004 was a liability of $83.8 million. The estimated amount of losses
associated with such derivative instruments that are reported in other
comprehensive income and that are expected to be reclassified into earnings over
the next twelve months is $63.5 million, or approximately $41 million after-tax.
For the first three months of 2004, Houston Exploration recorded an unrealized
loss of $1.0 million ($0.7 million net of tax) representing the ineffective
portion of its derivative instruments.
With respect to price exposure associated with fuel purchases for the Ravenswood
facility, KeySpan employs standard NYMEX natural gas futures contracts to hedge
the cash flow variability for a portion of forecasted purchases of natural gas.
KeySpan also employs the use of financially-settled oil swap contracts to hedge
the cash flow variability for a portion of forecasted purchases of fuel oil that
will be consumed at the Ravenswood facility. The maximum length of time over
which we have hedged cash flow variability associated with forecasted purchases
of natural gas and fuel oil is through September 2005. We use standard NYMEX
futures prices to value the gas futures contracts and market quoted forward
prices to value oil swap contracts. The fair market value of these derivative
instruments at March 31, 2004 was an asset of $0.3 million. A substantial
portion of these derivative instruments, which are reported in other
comprehensive income, are expected to be reclassified into earnings over the
next twelve months.
We have also engaged in the use of cash-settled swap instruments to hedge the
cash flow variability associated with a portion of forecasted peak electric
energy sales from the Ravenswood facility. Our hedging strategy is to hedge
approximately 50% of forecasted on-peak summer season electric energy sales and
a portion of forecasted peak electric energy sales for the remainder of the
year. The maximum length of time over which we have hedged cash flow variability
is through December 2005. We use market quoted forward prices to value these
outstanding derivatives. The fair market value of these derivative instruments
at March 31, 2004 was a liability of $1.1 million. The estimated amount of
losses associated with such derivative instruments that are reported in other
comprehensive income and that are expected to be reclassified into earnings over
the next twelve months is $0.6 million, or approximately $0.4 million after-tax.
12
The table below summarizes the fair value of each category of derivative
instrument outstanding at March 31, 2004 and its related line item on the
Consolidated Balance Sheet. Fair value is the amount at which derivative
instruments could be exchanged in a current transaction between willing parties,
other than in a forced liquidation sale.
- --------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) March 31, 2004 December 31, 2003
- --------------------------------------------------------------------------------------------------------
Gas Contracts:
Other current assets $ 47 $ 3,458
Accounts payable and other liabilities (63,535) (35,592)
Other deferred liabilities (20,302) (4,734)
Oil Contracts:
Other current assets 257 -
Other deferred charges 6 385
Electric Contracts:
Accounts payable and other liabilities (572) -
Other deferred liabilities (477) 259
- --------------------------------------------------------------------------------------------------------
$ (84,576) $ (36,224)
- --------------------------------------------------------------------------------------------------------
Financially-Settled Commodity Derivative Instruments that Do Not Qualify for
Hedge Accounting: KeySpan subsidiaries also employ a limited number of financial
derivatives that do not qualify for hedge accounting treatment under SFAS 133.
In 2003, we sold a "swaption" to hedge the cash flow variability associated with
50 MW of forecasted 2004 summer electric energy sales from the Ravenswood
facility. The swaption is an option that gives the counterparty the right, but
not the obligation, to enter into a swap transaction with KeySpan in the future
at a given strike price. This swaption can be converted into a swap, at the
election of the counterparty and has an expiration date of June 1, 2004. The
premium payment KeySpan received was recorded as a current liability on the
Consolidated Balance Sheet. The premium generally will be recorded into income
at the time the swaption is either exercised or expires. An internally developed
option-pricing model is used to value the swaption and at March 31, 2004, the
fair value of the swaption was immaterial.
Firm Gas Sales Derivative Instruments - Regulated Utilities: We use derivative
financial instruments to reduce the cash flow variability associated with the
purchase price for a portion of future natural gas purchases associated with our
Gas Distribution operations. Our strategy is to minimize fluctuations in firm
gas sales prices to our regulated firm gas sales customers in our New York and
New England service territories. The accounting for these derivative instruments
is subject to SFAS 71 "Accounting for the Effects of Certain Types of
Regulation." Therefore, changes in the fair value of these derivatives have been
recorded as a regulatory asset or regulatory liability on the Consolidated
Balance Sheet. Gains or losses on the settlement of these contracts are
initially deferred and then refunded to or collected from our firm gas sales
customers consistent with regulatory requirements. At March 31, 2004, these
derivatives had a net fair market value of $18.4 million and are reflected as a
regulatory liability on the Consolidated Balance Sheet.
13
Physically-Settled Commodity Derivative Instruments: SFAS 133 establishes
criteria that must be satisfied in order for option contracts, forward contracts
with optionality features, or contracts that combine a forward contract and a
purchase option contract to be exempted as normal purchases and sales. Based
upon a continuing review of our physical gas contracts, we determined that
certain contracts for the physical purchase of natural gas associated with our
regulated gas utilities are not exempt as normal purchases from the requirements
of SFAS 133. Since these contracts are for the purchase of natural gas sold to
regulated firm gas sales customers, the accounting for these contracts is
subject to SFAS 71. Therefore, changes in the market value of these contracts
have been recorded as a regulatory asset or regulatory liability on the
Consolidated Balance Sheet. At March 31, 2004 these contracts had a net negative
fair market value of $5.3 million, and are reflected as a $6.0 million
regulatory asset and $0.7 million regulatory liability on the Consolidated
Balance Sheet.
Interest Rate Derivative Instruments: In May 2003, we entered into interest rate
swap agreements in which we swapped $250 million of 7.25% fixed rate debt to
floating rate debt. Under the terms of the agreements, we received the fixed
coupon rate associated with these bonds and paid our swap counterparties a
variable interest rate based on LIBOR, that was reset on a semi-annual basis.
These swaps were designated as fair-value hedges and qualified for "short-cut"
hedge accounting treatment under SFAS 133. During the three months ended March
31, 2004, we paid our counterparty an average interest rate of 6.44%, and as a
result, we realized interest savings of $0.5 million. The fair market value of
this derivative was $2 million at March 31, 2004.
On April 7, 2004 we terminated these swap agreements and received $1.2 million
from our swap counterparties, of which $0.7 million represented accrued swap
interest. The difference between the termination settlement amount and the
amount of accrued interest, $0.5 million, will be recorded as a reduction to
interest expense over the remaining life of the bond.
Weather Derivatives: The utility tariffs associated with KEDNE's operations do
not contain weather normalization adjustments. As a result, fluctuations from
normal weather may have a significant positive or negative effect on the results
of these operations. In October 2003, we entered into heating-degree day call
and put options to mitigate the effect of fluctuations from normal weather on
KEDNE's financial position and cash flows for the 2003/2004 winter heating
season - November 2003 through March 2004. With respect to sold call options,
KeySpan was required to make a payment of $27,500 per heating degree day to its
counterparties when actual weather experienced during this time frame was above
4,440 heating degree days, which equates to approximately 2% colder than normal
weather, based on the most recent 20-year average for normal weather. The
maximum amount KeySpan was required to pay on its sold call options was $5.5
million. With respect to purchased put options, KeySpan would have received a
$27,500 per heating degree day payment from its counterparties when actual
weather was below 4,266 heating degree days, or approximately 2% warmer than
normal. The maximum amount KeySpan would have received on its purchased put
options was $11 million. The net premium cost for these options was $0.4
million. We account for these derivatives pursuant to the requirements of EITF
99-2, "Accounting for Weather Derivatives." In this regard, such instruments are
accounted for using the "intrinsic value method" as set forth in such guidance.
During the first quarter of 2004, weather, as measured in heating degree-days,
was 9.4% colder than normal and, as a result, $4.1 million was recorded as a
reduction to revenues.
14
Derivative contracts are primarily used to manage exposure to market risk
arising from changes in commodity prices and interest rates. In the event of
non-performance by a counterparty to a derivative contract, the desired impact
may not be achieved. The risk of counterparty non-performance is generally
considered a credit risk and is actively managed by assessing each counterparty
credit profile and negotiating appropriate levels of collateral and credit
support. We believe that our credit risk related to the above mentioned
derivative financial instruments is no greater than the risk associated with the
primary contracts which they hedge and that the elimination of a portion of the
price risk reduces volatility in our reported results of operations, financial
position and cash flows and lowers overall business risk.
5. RECENT ACCOUNTING PRONOUNCEMENTS
In March 2004, the Financial Accounting Standards Board ("FASB") issued, as a
proposal, FASB Staff Position ("FSP") 106-b "Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003." When issued in final, this guidance will supersede
FSP 106-1 issued in 2003 and will clarify the accounting and disclosure
requirements for employers with postretirement benefit plans that have been or
will be affected by the passage of the Medicare Prescription Drug Improvement
and Modernization Act of 2003 ("the Act"). The Act introduces two new features
to Medicare that an employer needs to consider in measuring its obligation and
net periodic postretirement benefit costs. The effective date for the new
requirements is the first interim or annual period beginning after June 15, 2004
or for KeySpan's purposes the third quarter of 2004.
KeySpan's retiree health benefit plan currently includes a prescription drug
benefit that is provided to retired employees. It is anticipated that
implementation of the new requirements will have a positive impact on KeySpan's
results of operations and cash flows, although the magnitude of the impact can
not be determined with any degree of certainty at this time.
6. FINANCIAL GUARANTEES AND CONTINGENCIES
Variable Interest Entity: KeySpan has an arrangement with a variable interest
entity through which we lease a portion of the Ravenswood facility. We acquired
the Ravenswood facility, then a 2,200-megawatt electric generating facility
located in Queens, New York, in part, through a variable interest entity from
The Consolidated Edison Company of New York, Inc. ("Consolidated Edison") on
June 18, 1999 for approximately $597 million. In order to reduce the initial
cash requirements, we entered into a lease arrangement ("Master Lease") with a
variable interest, unaffiliated financing entity that acquired a portion of the
facility, or three steam generating units, directly from Consolidated Edison and
leased it to our subsidiary. The variable interest unaffiliated financing entity
acquired the property for $425 million, financed with debt of $412.3 million
(97% of capitalization) and equity of $12.7 million (3% of capitalization).
KeySpan has no ownership interests in the units or the variable interest entity.
KeySpan has guaranteed all payment and performance obligations of our subsidiary
under the Master Lease. Monthly lease payments substantially equal the monthly
interest expense on such debt securities.
15
The initial term of the Master Lease expires on June 20, 2004 and may be
extended until June 20, 2009. In June 2004, we have the right to: (i) either
purchase the facility for the original acquisition cost of $425 million, plus
the present value of the lease payments that would otherwise have been paid
through June 2009; (ii) terminate the Master Lease and dispose of the facility;
or (iii) otherwise extend the Master Lease to 2009. At this time, KeySpan
intends to extend the Master Lease through 2009. In June 2009, when the Master
Lease terminates, we may purchase the facility in an amount equal to the
original acquisition cost, subject to adjustment, or surrender the facility to
the lessor. If we elect not to purchase the property, the Ravenswood facility
will be sold by the lessor. We have guaranteed to the lessor 84% of the residual
value of the original cost of the property.
We have classified the Master Lease as $412.3 million long-term debt on the
Consolidated Balance Sheet based on our current status as primary beneficiary.
Further, we have an asset on the Consolidated Balance Sheet for an amount
substantially equal to the fair market value of the leased assets at the
inception of the lease, less depreciation since that date, or approximately $385
million. Under the terms of our credit facility, the Master Lease has been
considered debt in the ratio of debt-to-total capitalization since the inception
of the lease. If our subsidiary that leases the Ravenswood facility were not
able to fulfill its payment obligations with respect to the Master Lease
payments, then the maximum amount KeySpan would be exposed to under its current
guarantees would be $425 million, plus the present value of the remaining lease
payments through June 20, 2009.
Asset Retirement Obligations: In 2003, KeySpan adopted SFAS 143, "Accounting for
Asset Retirement Obligations." SFAS 143 required us to record a liability and
corresponding asset representing the present value of legal obligations
associated with the retirement of tangible, long-lived assets. At March 31,
2004, the present value of our future asset retirement obligation ("ARO") was
approximately $88.6 million, primarily related to our investment in Houston
Exploration.
KeySpan's largest asset base is its gas transmission and distribution system. A
legal obligation exists due to certain safety requirements at final abandonment.
In addition, a legal obligation may be construed to exist with respect to
KeySpan's liquefied natural gas ("LNG") storage tanks due to clean up
responsibilities upon cessation of use. However, mass assets such as storage,
transmission and distribution assets are believed to operate in perpetuity and,
therefore, have indeterminate cash flow estimates. Since that exposure is in
perpetuity and cannot be measured, no liability will be recorded pursuant to
SFAS 143. KeySpan's ARO will be re-evaluated in future periods until sufficient
information exists to determine a reasonable estimate of fair value.
16
Environmental Matters
New York Sites: Within the State of New York we have identified 43 historical
manufactured gas plant ("MGP") sites and related facilities, which were owned or
operated by KeySpan subsidiaries or such companies' predecessors.
We have identified 28 of these sites as being associated with the historical
operations of KEDNY. One site has been fully remediated. The remaining sites
will be investigated and, if necessary, remediated under the terms and
conditions of Administrative Orders on Consent ("ACO") or Voluntary Cleanup
Agreements ("VCA"). Expenditures incurred to date by us with respect to KEDNY
MGP-related activities total $42.6 million.
The remaining 15 sites have been identified as being associated with the
historical operations of KEDLI. Expenditures incurred to date by us with respect
to KEDLI MGP-related activities total $33.9 million. One site has been fully
investigated and requires no further action. The remaining sites will be
investigated and, if necessary, remediated under the conditions of ACOs or VCAs
We presently estimate the remaining cost of our KEDNY and KEDLI MGP-related
environmental remediation activities will be $220.6 million, which amount has
been accrued by us as a reasonable estimate of probable cost for known sites.
Expenditures incurred to date by us with respect to these MGP-related activities
total $76.5 million.
With respect to remediation costs, the KEDNY and KEDLI rate plans generally
provide for the recovery of investigation and remediation costs in rates charged
to gas distribution customers. At March 31, 2004, we have reflected a regulatory
asset of $240.8 million for our KEDNY/KEDLI MGP sites. In accordance with New
York State Public Service Commission ("NYPSC") policy, KeySpan records a
reduction to regulatory liabilities as costs are incurred for environmental
clean-up activities. At March 31, 2004, these previously deferred regulatory
liabilities totaled $53 million. In October 2003, KEDNY and KEDLI filed a joint
petition with the NYPSC seeking rate treatment for additional environmental
costs that may be incurred in the future.
We are also responsible for environmental obligations associated with the
Ravenswood facility, purchased from Consolidated Edison in 1999, including
remediation activities associated with its historical operations and those of
the MGP facilities that formerly operated at the site. We are not responsible
for liabilities arising from disposal of waste at off-site locations prior to
the acquisition closing and any monetary fines arising from Consolidated
Edison's pre-closing conduct. We presently estimate the remaining environmental
clean up activities for this site will be $3.3 million, which amount has been
accrued by us. Expenditures incurred to date total $1.7 million.
New England Sites: Within the Commonwealth of Massachusetts and the State of New
Hampshire, we are aware of 76 former MGP sites and related facilities within the
existing or former service territories of KEDNE.
17
Boston Gas Company, Colonial Gas Company and Essex Gas Company may have or share
responsibility under applicable environmental laws for the remediation of 66 of
these sites. A subsidiary of National Grid USA ("National Grid"), formerly New
England Electric System, has assumed responsibility for remediating 11 of these
sites, subject to a limited contribution from Boston Gas Company, and has
provided full indemnification to Boston Gas Company with respect to 8 other
sites. In addition, Boston Gas Company, Colonial Gas Company, and Essex Gas
Company have each assumed responsibility for remediating 3 sites. At this time,
it is uncertain as to whether Boston Gas Company, Colonial Gas Company or Essex
Gas Company have or share responsibility for remediating any of the other sites.
No notice of responsibility has been issued to us for any of these sites from
any governmental environmental authority.
We presently estimate the remaining cost of these Massachusetts KEDNE
MGP-related environmental cleanup activities will be $25.4 million, which amount
has been accrued by us as a reasonable estimate of probable cost for known
sites. Expenditures incurred since November 8, 2000 with respect to these
MGP-related activities total $13.9 million.
We may have or share responsibility under applicable environmental laws for the
remediation of 10 MGP sites and related facilities associated with the
historical operations of EnergyNorth. At four of these sites we have entered
into cost sharing agreements with other parties who share responsibility for
remediation of these sites. EnergyNorth also has entered into an agreement with
the United States Environmental Protection Agency ("EPA") for the contamination
from the Nashua site that was allegedly commingled with asbestos at the Nashua
River Asbestos Site, adjacent to the Nashua MGP site.
We presently estimate the remaining cost of EnergyNorth MGP-related
environmental cleanup activities will be $13.8 million, which amount has been
accrued by us as a reasonable estimate of probable cost for known sites.
Expenditures incurred since November 8, 2000, with respect to these MGP-related
activities total $8 million.
By rate orders, the Massachusetts Department of Telecommunications and Energy
("DTE") and the New Hampshire Public Utility Commission ("NHPUC") provide for
the recovery of site investigation and remediation costs and, accordingly, at
March 31, 2004, we have reflected a regulatory asset of $51.2 million for the
KEDNE MGP sites. Colonial Gas Company and Essex Gas Company are not subject to
the provisions of Statement of Financial Accounting Standard ("SFAS") 71,
"Accounting for the Effects of Certain Types of Regulation" and therefore have
recorded no regulatory asset. However, rate plans currently in effect for these
subsidiaries provide for the recovery of investigation and remediation costs.
KeySpan New England, LLC Sites: We are aware of three non-utility sites
associated with KeySpan New England, LLC, a successor company to Eastern
Enterprises, for which we may have or share environmental remediation or ongoing
maintenance responsibility. These three sites, located in Philadelphia,
Pennsylvania, New Haven, Connecticut and Everett, Massachusetts, were associated
18
with historical operations involving the production of coke and related
industrial processes. Honeywell International, Inc. and Beazer East, Inc. (both
former owners and/or operators of certain facilities at Everett ("the Everett
Facility") together with KeySpan, have entered into an ACO with the
Massachusetts Department of Environmental Protection for the investigation and
development of a remedial response plan for a portion of that site. KeySpan,
Honeywell and Beazer East have entered into a cost-sharing agreement under which
each company has agreed to pay one-third of the costs of compliance with the
consent order, while preserving any claims it may have against the other
companies for, among other things, reallocation of proportionate liability.
We presently estimate the remaining cost of our environmental cleanup activities
for the three non-utility sites will be approximately $24.3 million, which
amount has been accrued by us as a reasonable estimate of probable costs for
known sites. Expenditures incurred since November 8, 2000, with respect to these
sites total $8.5 million.
We believe that in the aggregate, the accrued liability for these MGP sites and
related facilities identified above are reasonable estimates of the probable
cost for the investigation and remediation of these sites and facilities. As
circumstances warrant, we periodically re-evaluate the accrued liabilities
associated with MGP sites and related facilities. We may be required to
investigate and, if necessary, remediate each site previously noted, or other
currently unknown former sites and related facility sites, the cost of which is
not presently determinable but may be material to our financial position,
results of operations or cash flows. Remediation costs for each site may be
materially higher than noted, depending upon remediation experience, selected
end use for each site, and actual environmental conditions encountered.
See KeySpan's Annual Report on Form 10K for the year ended December 31, 2003
Note 7 to those Consolidated Financial Statements "Contractual Obligations,
Financial Guarantees and Contingencies" for further information on environmental
matters.
Legal Matters
From time to time we are subject to various legal proceedings arising out of the
ordinary course of our business. Except as described below, or in KeySpan's
Annual Report on Form 10K for the year ended December 31, 2003, we do not
consider any of such proceedings to be material to our business or likely to
result in a material adverse effect on our results of operations, financial
condition or cash flows.
KeySpan and certain of its current and former officers and directors are
defendants in a consolidated class action lawsuit filed in the United States
District Court for the Eastern District of New York. This lawsuit alleges, among
other things, violations of Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934, as amended ("Exchange Act"), in connection with disclosures
relating to or following the acquisition of the Roy Kay companies. In October
2001, a shareholder's derivative action was commenced in the same court against
19
certain current and former officers and directors of KeySpan, alleging, among
other things, breaches of fiduciary duty, violations of the New York Business
Corporation Law and violations of Section 20(a) of the Exchange Act. On June 12,
2002, a second derivative action was commenced which asserted similar
allegations. Each of these proceedings seeks monetary damages in an unspecified
amount. On March 18, 2003, the court granted our motion to dismiss the class
action complaint. The court's order dismissed certain class allegations with
prejudice, but provided the plaintiffs a final opportunity to file an amended
complaint concerning the remaining allegations. In April 2003, plaintiffs filed
an amended complaint and in July 2003 the court denied our motion to dismiss the
amended complaint but did strike certain allegations. On November 20, 2003, the
court granted our motion for reconsideration of the July 2003 order and the
court struck additional allegations from the amended complaint which effectively
limited the potential class period. On December 19, 2003, KeySpan filed a motion
to dismiss the derivative actions. The motion is still pending. KeySpan intends
to vigorously defend each of these proceedings. However, we are unable to
predict the outcome of these proceedings or what effect, if any, such outcome
will have on our financial condition, results of operations or cash flows.
KeySpan subsidiaries, along with several other parties, have been named as
defendants in numerous proceedings filed by plaintiffs claiming various degrees
of injury from asbestos exposure at generating facilities formerly owned by Long
Island Lighting Company ("LILCO") and others. In connection with the May 1998
transaction with LIPA, costs incurred by KeySpan for liabilities for asbestos
exposure arising from the activities of the generating facilities previously
owned by LILCO are recoverable from LIPA through the Power Supply Agreement
("PSA") between LIPA and KeySpan.
KeySpan is unable to determine the outcome of the outstanding asbestos
proceedings, but does not believe that such outcome, if adverse, will have a
material effect on its financial condition, results of operation or cash flows.
KeySpan believes that its cost recovery rights under the PSA, its
indemnification rights against third parties and its insurance coverage (above
applicable deductible limits) cover its exposure for asbestos liabilities
generally.
20
Financial Guarantees
KeySpan has issued financial guarantees in the normal course of business,
primarily on behalf of its subsidiaries, to various third party creditors. At
March 31, 2004, the following amounts would have to be paid by KeySpan in the
event of non-payment by the primary obligor at the time payment is due:
- -----------------------------------------------------------------------------------------------------------------------
Nature of Guarantee (In Thousands of Dollars) Amount of Expiration
Exposure Dates
- -----------------------------------------------------------------------------------------------------------------------
Medium-Term Notes - KEDLI (i) $ 525,000 2008-2010
Industrial Development Revenue Bonds (ii) 128,000 2027
Master Lease - Ravenswood (iii) 425,000 2004
Surety Bonds (iv) 169,000 Revolving
Commodity Guarantees and Other (v) 51,000 2005
Letters of Credit (vi) 74,000 2004
- -----------------------------------------------------------------------------------------------------------------------
$ 1,372,000
- -----------------------------------------------------------------------------------------------------------------------
The following is a description of KeySpan's outstanding subsidiary guarantees:
(i) KeySpan has fully and unconditionally guaranteed $525 million to holders of
Medium-Term Notes issued by KEDLI. These notes are due to be repaid on
January 15, 2008 and February 1, 2010. KEDLI is required to comply with
certain financial covenants under the debt agreements. Currently, KEDLI is
in compliance with all covenants and management does not anticipate that
KEDLI will have any difficulty maintaining such compliance. The face value
of these notes is included in long-term debt on the Consolidated Balance
Sheet.
(ii) KeySpan has fully and unconditionally guaranteed the payment obligations of
its subsidiaries with regard to $128 million of Industrial Development
Revenue Bonds issued through the Nassau County and Suffolk County
Industrial Development Authorities for the construction of the Glenwood and
Port Jefferson electric-generation peaking plants. The face value of these
notes are included in long-term debt on the Consolidated Balance Sheet.
(iii)KeySpan has guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the $425 million Ravenswood master lease
(the "Master Lease") associated with the lease of the Ravenswood facility.
The initial term of the lease expires on June 20, 2004 and may be extended
until June 20, 2009. The Master Lease is classified as $412.3 million
long-term debt on the Consolidated Balance Sheet.
(iv) KeySpan has agreed to indemnify the issuers of various surety and
performance bonds associated with certain construction projects currently
being performed by subsidiaries within the Energy Services segment. In the
event that the operating companies in the Energy Services segment fail to
perform their obligations under contract, the injured party may demand that
the surety make payments or provide services under the bond. KeySpan would
then be obligated to reimburse the surety for any expenses or cash outlays
it incurs.
21
(v) KeySpan has guaranteed commodity-related payments for certain of its
subsidiaries. These guarantees are provided to third parties to facilitate
physical and financial transactions involved in the purchase of natural
gas, oil and other petroleum products for electric production and marketing
activities. The guarantees cover actual purchases by these subsidiaries
that are still outstanding as of March 31, 2004.
(vi) KeySpan has arranged for stand-by letters of credit to be issued to third
parties that have extended credit to certain subsidiaries. Certain vendors
require us to post letters of credit to guarantee subsidiary performance
under our contracts and to ensure payment to our subsidiary subcontractors
and vendors under those contracts. Certain of our vendors also require
letters of credit to ensure reimbursement for amounts they are disbursing
on behalf of our subsidiaries, such as to beneficiaries under our
self-funded insurance programs. Such letters of credit are generally issued
by a bank or similar financial institution. The letters of credit commit
the issuer to pay specified amounts to the holder of the letter of credit
if the holder demonstrates that we have failed to perform specified
actions. If this were to occur, KeySpan would be required to reimburse the
issuer of the letter of credit.
To date, KeySpan has not had a claim made against it for any of the above
guarantees and we have no reason to believe that our subsidiaries will
default on their current obligations. However, we cannot predict when or if
any defaults may take place or the impact any such defaults may have on our
consolidated results of operations, financial condition or cash flows.
Other Contingencies: We derive a substantial portion of our revenues in our
Electric Services segment from a series of agreements with LIPA pursuant to
which we manage LIPA's transmission and distribution system and supply the
majority of LIPA's customers' electricity needs. The agreements terminate at
various dates between May 28, 2006 and May 28, 2013, and at this time, we can
provide no assurance that any of the agreements will be renewed or extended, or
if they were to be renewed or extended, the terms and conditions thereof. In
addition, given the complexity of these agreements, disputes arise from time to
time between KeySpan and LIPA concerning the rights and obligations of each
party to make and receive payments as required pursuant to the terms of these
agreements. As a result, KeySpan is unable to determine what effect, if any, the
ultimate resolution of these disputes will have on its financial condition,
results of operations or cash flows.
7. STOCK OPTIONS
Stock options have been issued to KeySpan officers, directors and certain other
management employees and consultants as approved by the Board of Directors.
These options generally vest over a three-to-five year period and have a
ten-year exercise period. Moreover, under a separate plan, Houston Exploration
has issued stock options to its directors and key Houston Exploration employees.
22
(Beginning in 2004, KeySpan officers that serve on the Houston Exploration Board
of Directors will not receive Houston Exploration stock options.) In 2003,
KeySpan and Houston Exploration adopted the prospective method of transition of
accounting for stock option expense in accordance with SFAS 148 "Accounting for
Stock-Based Compensation - Transition and Disclosure". Accordingly, compensation
expense has been recognized by employing the fair value recognition provisions
of SFAS 123 "Accounting for Stock-Based Compensation" for grants awarded after
January 1, 2003.
KeySpan and Houston Exploration continue to apply APB Opinion 25, "Accounting
for Stock Issued to Employees," and related Interpretations in accounting for
grants awarded prior to January 1, 2003. Accordingly, no compensation cost has
been recognized for these fixed stock option plans in the Consolidated Financial
Statements since the exercise prices and market values were equal on the grant
dates. Had compensation cost for these plans been determined based on the fair
value at the grant dates for awards under the plans consistent with SFAS 123,
our net income and earnings per share would have decreased to the pro-forma
amounts indicated below:
- --------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003
- --------------------------------------------------------------------------------------------------------------------------
Earnings available for common stock:
As reported $ 246,235 $ 241,804
Add: recorded stock-based compensation expense, net of tax 1,512 857
Deduct: total stock-based compensation expense, net of tax (2,967) (2,913)
- --------------------------------------------------------------------------------------------------------------------------
Pro-forma earnings $ 244,780 $ 239,748
- --------------------------------------------------------------------------------------------------------------------------
Earnings per share:
Basic - as reported $ 1.54 $ 1.54
Basic - pro-forma $ 1.53 $ 1.53
Diluted - as reported $ 1.53 $ 1.53
Diluted - pro-forma $ 1.52 $ 1.52
- --------------------------------------------------------------------------------------------------------------------------
8. POSTRETIREMENT BENEFITS
Pension Plans: The following information represents the consolidated net
periodic pension cost for the three months ended March 31, 2004 and 2003 for our
noncontributory defined benefit pension plans which cover substantially all
employees. Benefits are based on years of service and compensation. Funding for
pensions is in accordance with requirements of federal law and regulations.
KEDLI and Boston Gas Company are subject to certain deferral accounting
requirements mandated by the New York Public Service Commission ("NYSPSC") and
the Department of Telecommunications Energy ("DTE"), respectively for pension
costs and other postretirement benefit costs. Further, KeySpan's electric
subsidiaries are subject to certain "true-up" provisions in accordance with the
LIPA service agreements.
23
The calculation of net periodic pension cost is as follows:
- ---------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- ---------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 13,079 $ 11,883
Interest cost on projected benefit obligation 36,047 34,568
Expected return on plan assets (36,521) (32,639)
Net amortization and deferral 16,917 16,737
- ---------------------------------------------------------------------------------------------------------------------
Total pension cost $ 29,522 $ 30,549
- ---------------------------------------------------------------------------------------------------------------------
Other Postretirement Benefits: The following information represents the
consolidated net periodic other postretirement benefit cost for the three months
ended March 31, 2004 and 2003 for our noncontributory defined benefit plans
covering certain health care and life insurance benefits for retired employees.
We have been funding a portion of future benefits over employees' active service
lives through Voluntary Employee Beneficiary Association ("VEBA") trusts.
Contributions to VEBA trusts are tax deductible, subject to limitations
contained in the Internal Revenue Code.
Net periodic other postretirement benefit cost included the following
components:
- ------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- ------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period 5,392 4,706
Interest cost on accumulated
postretirement benefit obligation 18,521 17,451
Expected return on plan assets (7,708) (6,883)
Net amortization and deferral 11,280 8,954
- ------------------------------------------------------------------------------------------------------------------
Other postretirement cost 27,485 24,228
- ------------------------------------------------------------------------------------------------------------------
In 2004, KeySpan is expected to contribute approximately $89 million to its
pension plans and approximately $58 million to its other postretirement benefit
plans, which are the same funding levels as reported in KeySpan's Annual Report
on Form 10K for the Year Ended December 31, 2003.
9. LONG-TERM DEBT
At March 31, 2004, KeySpan had $460 million of MEDS Equity Units outstanding at
8.75% consisting of a three-year forward purchase contract for our common stock
and a six-year note. The purchase contract commits us, three years from the date
of issuance of the MEDS Equity Units, May 2005, to issue and the investors to
purchase, a number of shares of our common stock based on a formula tied to the
market price of our common stock at that time. The 8.75% coupon is composed of
interest payments on the six-year note of 4.9% and premium payments on the
three-year equity forward contract of 3.85%. These instruments have been
recorded as long-term debt on the Consolidated Balance Sheet. Further, upon
issuance of the MEDS Equity Units, we recorded a direct charge to retained
earnings of $49.1 million, which represents the present value of the forward
contract's premium payments.
24
There were 9.2 million MEDS Equity units issued which are subject to conversion
upon execution of the three-year forward purchase contract. The number of shares
to be issued depends on the average closing price of our common stock over the
20 day trading period ending on the third trading day prior to May 16, 2005. If
the average closing price over this time frame is less than or equal to $35.30
of KeySpan's common stock, 13 million shares will be issued. If the average
closing price over this time frame is greater than or equal to $42.36, 10.9
million shares will be issued. The number of shares issued at a price between
$35.30 and $42.36 will be between 10.9 million and 13 million based upon a
sliding scale.
These securities are currently not considered convertible instruments for
purposes of applying SFAS 128 "Earnings Per Share" calculations, unless or until
such time as the market value of our common stock reaches a threshold
appreciation price ($42.36 per share) that is higher than the current per share
market value. Interest payments do, however, reduce net income and earnings per
share.
The Emerging Issues Task Force of the FASB is considering proposals related to
accounting for certain securities and financial instruments, including
securities such as the Equity Units. The current proposals being considered
include the method of accounting discussed above. Alternatively, other proposals
being considered could result in the common shares issuable pursuant to the
purchase contract to be deemed outstanding and included in the calculation of
diluted earnings per share, and could result in periodic "mark to market" of the
purchase contracts, causing periodic charges or credits to income. If this
latter approach were adopted, our basic and diluted earnings per share could
increase and decrease from quarter to quarter to reflect the lesser and greater
number of shares issuable upon satisfaction of the contract, as well as charges
or credits to income.
10. KEYSPAN GAS EAST CORPORATION SUMMARY FINANCIAL INFORMATION
KEDLI is a wholly owned subsidiary of KeySpan. KEDLI was formed on May 7, 1998
and on May 28, 1998 acquired substantially all of the assets related to the gas
distribution business of LILCO. KEDLI established a program for the issuance,
from time to time, of up to $600 million aggregate principal amount of
Medium-Term Notes, which are fully and unconditionally guaranteed by the parent,
KeySpan Corporation. On February 1, 2000, KEDLI issued $400 million of 7.875%
Medium-Term Notes due 2010. In January 2001, KEDLI issued an additional $125
million of Medium-Term Notes at 6.9% due January 2008. The following condensed
financial statements are required to be disclosed by SEC regulations and set
forth those of KEDLI, KeySpan Corporation as guarantor of the Medium-Term Notes
and our other subsidiaries on a combined basis.
25
- ---------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2004
(In Thousands of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- --------------------------------------------------------------------------------------------------------------------------------
Revenues $ 153 $ 471,083 $ 2,124,490 $ (153) $ 2,595,573
-----------------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 291,089 935,484 - 1,226,573
Fuel and purchased power - - 101,612 - 101,612
Operations and maintenance 369 33,217 458,880 - 492,466
Intercompany expense - 1,355 (1,355) -
Depreciation and amortization - 29,841 141,843 - 171,684
Operating taxes - 19,543 102,736 - 122,279
-----------------------------------------------------------------------------------------
Total Operating Expenses 369 375,045 1,739,200 - 2,114,614
-----------------------------------------------------------------------------------------
Income from equity investments - - 5,717 - 5,717
-----------------------------------------------------------------------------------------
Operating Income (Loss) (216) 96,038 391,007 (153) 486,676
-----------------------------------------------------------------------------------------
Interest charges (53,488) (15,863) (71,475) 56,760 (84,066)
Other income and (deductions) 297,529 374 (1,960) (313,475) (17,532)
-----------------------------------------------------------------------------------------
Total Other Income and (Deductions) 244,041 (15,489) (73,435) (256,715) (101,598)
-----------------------------------------------------------------------------------------
Income Taxes (Benefit) (5,862) 22,710 120,534 - 137,382
- -
-----------------------------------------------------------------------------------------
Net Income $ 249,687 $ 57,839 $ 197,038 $ (256,868) $ 247,696
=========================================================================================
- ------------------------------------------------------------------------------------------------------------------------------------
Statement of Income
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2003
(In Thousands of Dollars) Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
- -----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 143 $ 478,345 $ 2,034,180 $ (143) $ 2,512,525
------------------------------------------------------------------------------------
Operating Expenses
Purchased gas - 287,009 909,156 - 1,196,165
Fuel and purchased power - - 97,522 - 97,522
Operations and maintenance 7,259 38,220 452,710 - 498,189
Intercompany expense 34 1,182 (1,182) (34) -
Depreciation and amortization (20) 26,920 118,071 - 144,971
Operating taxes - 24,005 100,708 - 124,713
------------------------------------------------------------------------------------
Total Operating Expenses 7,273 377,336 1,676,985 (34) 2,061,560
------------------------------------------------------------------------------------
Income from equity investments - - 5,729 - 5,729
------------------------------------------------------------------------------------
Operating Income (Loss) (7,130) 101,009 362,924 (109) 456,694
------------------------------------------------------------------------------------
Interest charges (46,477) (15,006) (52,299) 44,843 (68,939)
Other income and (deductions) 293,453 (7,217) 4,514 (292,581) (1,831)
------------------------------------------------------------------------------------
Total Other Income and (Deductions) 246,976 (22,223) (47,785) (247,738) (70,770)
------------------------------------------------------------------------------------
Income Taxes (3,419) 28,312 117,940 - 142,833
------------------------------------------------------------------------------------
Earnings before change in accounting principle 243,265 50,474 197,199 (247,847) 243,091
Cumulative change in accounting principle 174 - 174
------------------------------------------------------------------------------------
Net Income $ 243,265 $ 50,474 $ 197,373 $ (247,847) $ 243,265
====================================================================================
26
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
March 31, 2004
Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
---------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash & temporary cash investments $ 81,730 $ 59 $ 175,151 $ - $ 256,940
Accounts receivable, net 7,667 274,627 1,471,748 - 1,754,042
Other current assets 2,479 44,457 295,427 - 342,363
---------------------------------------------------------------------------------------
91,876 319,143 1,942,326 - 2,353,345
---------------------------------------------------------------------------------------
Equity Investments 4,740,262 1,043 160,609 (4,645,542) 256,372
---------------------------------------------------------------------------------------
Property
Gas - 1,919,592 4,670,829 - 6,590,421
Other - - 6,258,336 - 6,258,336
Accumulated depreciation and depletion - (316,831) (3,568,248) - (3,885,079)
---------------------------------------------------------------------------------------
- 1,602,761 7,360,917 - 8,963,678
---------------------------------------------------------------------------------------
Intercompany Accounts Receivable 2,977,170 1,212,607 (4,189,777) -
Deferred Charges 375,495 225,589 2,505,253 - 3,106,337
---------------------------------------------------------------------------------------
Total Assets $ 8,184,803 $ 2,148,536 $ 13,181,712 $ (8,835,319) $14,679,732
=======================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 49,113 $ 162,274 $ 740,946 $ - $ 952,333
Commercial paper 294,150 - - 294,150
Other current liabilities 283,634 12,275 117,841 - 413,750
---------------------------------------------------------------------------------------
626,897 174,549 858,787 - 1,660,233
---------------------------------------------------------------------------------------
Intercompany Accounts Payable - 48,291 2,556,920 (2,605,211) -
---------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax (48,188) 259,184 1,039,676 - 1,250,672
Other deferred credits and liabilities 571,504 175,547 1,031,882 - 1,778,933
---------------------------------------------------------------------------------------
523,316 434,731 2,071,558 - 3,029,605
---------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 3,901,569 840,061 3,736,438 (4,645,542) 3,832,526
Preferred stock 83,433 - - - 83,433
Long-term debt 3,049,588 650,904 3,421,530 (1,584,566) 5,537,456
---------------------------------------------------------------------------------------
Total Capitalization 7,034,590 1,490,965 7,157,968 (6,230,108) 9,453,415
---------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 536,479 - 536,479
---------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 8,184,803 $ 2,148,536 $ 13,181,712 $ (8,835,319) $14,679,732
=======================================================================================
27
- ------------------------------------------------------------------------------------------------------------------------------------
Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
December 31, 2003
Guarantor KEDLI Other Subsidiaries Eliminations Consolidated
---------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash & temporary cash investments $ 97,567 $ 1,554 $ 106,630 $ - $ 205,751
Accounts receivable, net 3,298 209,151 1,243,459 - 1,455,908
Other current assets 3,250 130,994 590,996 - 725,240
---------------------------------------------------------------------------------------
104,115 341,699 1,941,085 - 2,386,899
---------------------------------------------------------------------------------------
Investments and Other 4,475,949 1,123 153,520 (4,382,027) 248,565
---------------------------------------------------------------------------------------
Property
Gas - 1,899,375 4,622,876 - 6,522,251
Other - - 6,150,355 - 6,150,355
Accumulated depreciation and depletion - (312,204) (3,466,099) - (3,778,303)
---------------------------------------------------------------------------------------
- 1,587,171 7,307,132 - 8,894,303
---------------------------------------------------------------------------------------
Intercompany Accounts Receivable 3,105,571 - 1,274,293 (4,379,864) -
Deferred Charges 374,076 237,870 2,498,469 - 3,110,415
---------------------------------------------------------------------------------------
Total Assets $ 8,059,711 $ 2,167,863 $ 13,174,499 $ (8,761,891) $ 14,640,182
=======================================================================================
LIABILITIES AND CAPITALIZATION
Current Liabilities
Accounts payable $ 125,892 $ 165,613 $ 850,092 $ - $ 1,141,597
Commercial paper 481,900 - - - 481,900
Other current liabilities 129,168 16,125 80,026 - 225,319
---------------------------------------------------------------------------------------
736,960 181,738 930,118 - 1,848,816
---------------------------------------------------------------------------------------
Intercompany Accounts Payable - 116,197 2,679,101 (2,795,298) -
---------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred income tax (48,059) 256,882 1,069,518 - 1,278,341
Other deferred credits and liabilities 532,062 179,919 925,839 - 1,637,820
---------------------------------------------------------------------------------------
484,003 436,801 1,995,357 - 2,916,161
---------------------------------------------------------------------------------------
Capitalization
Common shareholders' equity 3,707,785 782,223 3,562,675 (4,382,027) 3,670,656
Preferred stock 83,568 - - - 83,568
Long-term debt 3,047,395 650,904 3,497,699 (1,584,566) 5,611,432
---------------------------------------------------------------------------------------
Total Capitalization 6,838,748 1,433,127 7,060,374 (5,966,593) 9,365,656
---------------------------------------------------------------------------------------
Minority Interest in Subsidiary Companies - - 509,549 - 509,549
---------------------------------------------------------------------------------------
Total Liabilities & Capitalization $ 8,059,711 $ 2,167,863 $ 13,174,499 $ (8,761,891) $ 14,640,182
=======================================================================================
28
- -------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- -------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2004
----------------------------------------------------------------------
Guarantor KEDLI Other Subsidiaries Consolidated
----------------------------------------------------------------------
Operating Activities
Net Cash Provided by Operating Activities $ 95,128 $ 91,155 $ 392,803 $ 579,086
----------------------------------------------------------------------
Investing Activities
Capital expenditures - (24,388) (195,836) (220,224)
Cost of removal - (356) (5,848) (6,204)
Proceeds from sale of property - - 13,138 13,138
----------------------------------------------------------------------
Net Cash Provided by (Used in) Investing Activities - (24,744) (188,546) (213,290)
----------------------------------------------------------------------
Financing Activities
Treasury stock issued 11,796 - - 11,796
Payment of debt, net (187,750) - (74,853) (262,603)
Common and preferred stock dividends paid (72,935) - - (72,935)
Other 9,523 - (388) 9,135
Net intercompany accounts 128,401 (67,906) (60,495) -
-
----------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities (110,965) (67,906) (135,736) (314,607)
----------------------------------------------------------------------
Net Increase in Cash and Cash Equivalents $ (15,837) $ (1,495) $ 68,521 $ 51,189
Cash and Cash Equivalents at Beginning of Period 97,567 1,554 106,630 205,751
----------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 81,730 $ 59 $ 175,151 $ 256,940
======================================================================
- ----------------------------------------------------------------------------------------------------------------------------------
Statement of Cash Flows
- ----------------------------------------------------------------------------------------------------------------------------------
Three Months Ended March 31, 2003
------------------------------------------------------------------------
Guarantor KEDLI Other Subsidiaries Consolidated
------------------------------------------------------------------------
Operating Activities
Net Cash Provided by (Used in) Operating Activities $ 239,598 $ 121,439 $ 135,790 $ 496,827
------------------------------------------------------------------------
Investing Activities
Capital expenditures - (25,941) (194,838) (220,779)
Cost of removal - (420) (6,518) (6,938)
Proceeds from monetization of Houston Exploration 79,200 - - 79,200
------------------------------------------------------------------------
Net Cash Used in Investing Activities 79,200 (26,361) (201,356) (148,517)
------------------------------------------------------------------------
Financing Activities
Treasury stock issued 26,307 - - 26,307
Equity issuance 473,573 - - 473,573
Redemption of promissory notes (447,005) - - (447,005)
Payment of debt, net (238,365) - (33,404) (271,769)
Common and preferred stock dividends paid (65,018) - - (65,018)
Other 7,153 - 1,894 9,047
Net intercompany accounts (73,193) (87,265) 160,458 -
-
------------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities (316,548) (87,265) 128,948 (274,865)
------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents $ 2,250 $ 7,813 $ 63,382 $ 73,445
Cash and Cash Equivalents at Beginning of Period 88,308 6,472 75,837 170,617
------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 90,558 $ 14,285 $ 139,219 $ 244,062
========================================================================
29
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Consolidated Review of Results
The following is a summary of transactions affecting comparative earnings and a
discussion of material changes in revenues and expenses during the three months
ended March 31, 2004, compared to the three months ended March 31, 2003.
Capitalized terms used in the following discussion, but not otherwise defined,
have the same meaning as when used in the Notes to the Consolidated Financial
Statements included under Item 1. References to "KeySpan," "we," "us," and "our"
mean KeySpan Corporation, together with its consolidated subsidiaries.
Operating income by segment, as well as consolidated earnings available for
common stock is set forth in the following table for the periods indicated.
- -------------------------------------------------------------------------------
(In Thousands of Dollars, Except per Share)
- -------------------------------------------------------------------------------
Quarter Ended March 31, 2004 2003
- -------------------------------------------------------------------------------
Gas Distribution $ 379,653 $ 364,937
Electric Services 47,200 39,644
Energy Services (18,474) (9,122)
Energy Investments 75,030 65,714
Eliminations and other 3,267 (4,479)
- -------------------------------------------------------------------------------
Operating Income 486,676 456,694
Interest charges (84,066) (68,939)
Other income and (deductions) (17,532) (1,831)
Income taxes 137,382 142,833
- -------------------------------------------------------------------------------
Income before cumulative effect
of a change in accounting principle 247,696 243,091
Cumulative effect of a change
in accounting principle - 174
- -------------------------------------------------------------------------------
Net Income 247,696 243,265
Preferred stock dividend requirements 1,461 1,461
- -------------------------------------------------------------------------------
Earnings for Common Stock $ 246,235 $ 241,804
- -------------------------------------------------------------------------------
Basic Earnings per Share
Income before cumulative effect
of a change in accounting principle $ 1.54 $ 1.54
Change in accounting principle - -
- -------------------------------------------------------------------------------
$ 1.54 $ 1.54
- -------------------------------------------------------------------------------
As indicated in the above table, operating income increased $30 million, or 7%,
for the quarter ended March 31, 2004, compared to the corresponding period last
year. The increase in operating income reflects higher earnings from the Gas
Distribution, Energy Investments and Electric Services segments, somewhat offset
by a decrease in earnings from the Energy Services segment. The Gas Distribution
segment benefited from oil-to-gas conversions throughout all our service
territories, as well as from a rate increase resulting from the Boston Gas
Company rate proceeding concluded last fall. In the Energy Investment segment,
30
higher gas production volumes and realized gas prices resulted in an increase in
operating income associated with gas exploration and production activities,
while the Electric Services segment benefited from generally lower operating
costs. Operating results for the Energy Services segment reflects higher
operating costs. (See the discussion under the caption "Review of Operating
Segments" for further details on each segment.)
The increase in interest expense of $15.1 million, or 22%, reflects the benefits
realized in 2003 associated with interest rate swaps. In February 2003, we
terminated an interest rate swap agreement with a notional amount of $270
million. This swap was used to hedge a portion of outstanding promissory notes
that were issued to the Long Island Power Authority ("LIPA") in connection with
the KeySpan/Long Island Lighting Company ("LILCO") business combination
completed in May 1998. In March 2003, we called approximately $447 million of
the outstanding promissory notes and recorded debt redemption charges of $18.2
million in other income and (deductions). The cash proceeds from the termination
of the interest rate hedge were $18.4 million, of which $8.1 million represented
accrued swap interest. The difference between the termination settlement amount
and the amount of accrued swap interest, $10.3 million, was recorded to earnings
(as an adjustment to interest expense) in the first quarter of 2003 and
effectively offset a portion of the redemption charges. Further, in December
2003, KeySpan implemented FASB Interpretation No. 46 ("FIN 46"), "Consolidation
of Variable Interest Entities, an Interpretation of ARB No. 51." This
Interpretation required us to, among other things, consolidate the Ravenswood
Master Lease and classify the lease obligation as long-term debt on the
Consolidated Balance Sheet based on our current status as primary beneficiary.
As a result of implementing FIN 46, beginning January 1, 2004 lease payments
have been reflected as interest expense on the Consolidated Statement of Income
resulting in an increase to interest expense of $7.5 million for the first
quarter of 2004.
Other income and (deductions) includes minority interest adjustments of $20.3
million and $18.1 million for the first quarter of 2004 and 2003, respectively,
related to our ownership interest in The Houston Exploration Company ("Houston
Exploration") our gas exploration and production subsidiary, as well as our
ownership interest in KeySpan Canada, which owns natural gas processing
facilities in western Canada. On April 1, 2004 KeySpan completed the sale of an
additional 36% interest in KeySpan Canada. KeySpan's ownership interest in
KeySpan Canada is now 25%. (See Note 2 to the Consolidated Financial Statements
"Business Segments" for additional details.)
In addition to the debt redemption charges noted above, other income and
(deductions) for the first quarter of 2003 also includes a gain of $19.0 million
reflecting the monetization of a portion of our ownership interest in Houston
Exploration. In February 2003, we reduced our ownership interest in Houston
Exploration from 66% to approximately 55% following the repurchase, by Houston
Exploration, of three million shares of common stock owned by KeySpan. Income
taxes were not provided on this transaction, since the transaction was
structured as a return of capital. Further, during the first quarter of 2003
Houston Exploration recorded a $10.6 million severance tax refund for severance
taxes paid in 2002 and earlier periods, which has also been reflected in other
income and (deductions).
31
Income tax expense for the first quarter of 2004 generally reflects the level of
pre-tax income and a $6.0 million benefit to income taxes resulting from a
revised appraisal associated with property that was disposed of in 2003.
Earnings available for common stock for the three months ended March 31, 2004,
increased by $4.4 million, or 2%, compared to the same period last year.
Earnings per share, however, remained the same as last year since average common
shares outstanding for the quarter ended March 31, 2004 increased by 2%,
reflecting the re-issuance of shares held in treasury pursuant to dividend
reinvestment and employee benefit plans. This increase in average common shares
outstanding reduced first quarter 2004 earnings per share by $0.03 compared to
the corresponding period in 2003.
Consistent with our prior earnings guidance, KeySpan's consolidated earnings for
2004 are forecasted to be in the range of $2.55 to $2.75 per share, excluding
special items. Earnings from continuing core operations (defined for this
purpose as all continuing operations other than exploration and production, less
preferred stock dividends) are forecasted to be in the range of $2.20 to $2.30
per share, while earnings from exploration and production operations are
forecasted to be in the range of $0.35 to $0.45 per share.
Consolidated earnings are seasonal in nature due to the significant contribution
to earnings of the gas distribution operations. As a result, we expect to earn
most of our annual earnings in the first and fourth quarters of the fiscal year.
Review of Operating Segments
- ----------------------------
In response to new disclosure regulations adopted by the Securities and Exchange
Commission as part of its implementation of the Sarbanes-Oxley Act of 2002 -
specifically Regulation G which became effective March 2003 - we report all of
KeySpan's segment results on an Operating Income basis. Management believes that
this Generally Accepted Accounting Principle (GAAP) based measure provides a
reasonable indication of KeySpan's underlying performance associated with its
operations. The following is a discussion of financial results achieved by
KeySpan's operating segments presented on an operating income basis.
Gas Distribution
KeySpan Energy Delivery New York ("KEDNY") provides gas distribution service to
customers in the New York City Boroughs of Brooklyn, Staten Island and a portion
of Queens, and KeySpan Energy Delivery Long Island ("KEDLI") provides gas
distribution service to customers in the Long Island counties of Nassau and
Suffolk and the Rockaway Peninsula of Queens County. Four gas distribution
companies - Boston Gas Company, Colonial Gas Company, Essex Gas Company, and
EnergyNorth Natural Gas Inc., each doing business under the name KeySpan Energy
Delivery New England ("KEDNE"), provide gas distribution service to customers in
Massachusetts and New Hampshire.
32
The table below highlights certain significant financial data and operating
statistics for the Gas Distribution segment for the periods indicated.
- -----------------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- -----------------------------------------------------------------------------------------------------------
Revenues $ 1,927,779 $ 1,832,701
Cost of gas 1,226,573 1,154,132
Revenue taxes 34,755 38,616
- -----------------------------------------------------------------------------------------------------------
Net Revenues 666,451 639,953
- -----------------------------------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 172,399 166,090
Depreciation and amortization 76,940 70,817
Operating taxes 37,459 38,109
- -----------------------------------------------------------------------------------------------------------
Total Operating Expenses 286,798 275,016
- -----------------------------------------------------------------------------------------------------------
Operating Income $ 379,653 $ 364,937
- -----------------------------------------------------------------------------------------------------------
Firm gas sales and transportation (MDTH) 154,316 154,627
Transportation - Electric Generation (MDTH) 4,139 5,003
Other Sales (MDTH) 52,956 54,709
Warmer (Colder) than Normal - New York (6.0)% (8.5)%
Warmer (Colder) than Normal - New England (9.4)% (10.0)%
- -----------------------------------------------------------------------------------------------------------
A MDTH is 10,000 therms (British Thermal Units) and reflects the heating
content of approximately one million cubic feet of gas. A therm reflects
the heating content of approximately 100 cubic feet of gas. One billion
cubic feet (BCF) of gas equals approximately 1,000 MDTH.
Net Revenues
Net gas revenues (revenues less the cost of gas and associated revenue taxes)
from our gas distribution operations increased by $26.5 million, or 4%, in the
first quarter of 2004 compared to same quarter last year. Net gas revenues
benefited from customer additions and oil-to-gas conversions, as well as from a
rate increase resulting from the Boston Gas Company's rate proceeding that was
concluded in the fourth quarter of 2003. As measured in heating degree days,
weather for the first quarter of 2004 in our New York and New England service
territories was approximately 6% and 9% colder than normal, respectively,
compared to approximately 9% and 10% colder than normal last year, respectively.
Weather was approximately 2% warmer than last year across KeySpan's service
territories.
Net revenues from firm gas customers (residential, commercial and industrial
customers) in our New York service territory increased by $13.1 million for the
first quarter of 2004 compared to the same period last year. Customer additions
and oil-to-gas conversions, net of attrition and conservation, added $9.4
million to net gas revenues. Further, we realized a $3.5 million benefit to net
gas revenues as a result of an additional billing day in the leap year. Weather,
which was slightly warmer than last year, resulted in an adverse impact to
comparative net gas revenues of $1.9 million. KEDNY and KEDLI each operate under
a utility tariff that contains a weather normalization adjustment that
significantly offsets variations in firm net revenues due to fluctuations in
normal weather. Since weather was colder than normal we refunded to firm
customers $13 million through the weather normalization adjustment. Also
33
included in net gas revenues is the recovery of property taxes that added $2.1
million to net revenues during the first quarter of 2004. These revenues,
however, do not impact net income since the taxes they are designed to recover
are expensed as amortization charges on the Consolidated Statement of Income.
Firm gas distribution rates for KEDNY and KEDLI in the first quarter of 2004,
other than for the recovery of gas costs, have remained substantially unchanged
from rates charged last year.
Net revenues from firm gas customers in our New England service territory
increased by $21.1 million for the first quarter of 2004 compared to the same
period last year. Customer additions and oil-to-gas conversions, net of
attrition and conservation, added $3.5 million to net gas revenues. Further, we
realized a $2.2 million benefit in net gas revenues as a result of an additional
billing day for leap year. As mentioned, the Massachusetts Department of
Telecommunications and Energy ("DTE") approved a $27 million base rate increase
for the Boston Gas Company, which became effective November 1, 2003. This rate
increase resulted in a benefit to net gas revenues of $10.6 million during the
first quarter of 2004. (See the caption under "Regulation and Rate Matters" for
further information regarding the rate filing.) The gas distribution operations
of our New England based subsidiaries do not have a weather normalization
adjustment. Weather, which was slightly warmer than last year, resulted in an
adverse impact to comparative net gas revenues of $3.0 million. To mitigate the
effect of fluctuations in normal weather patterns on KEDNE's results of
operations and cash flows, weather derivatives were in place for the 2003/2004
winter heating season. Since weather during the first quarter of 2004 was
approximately 9% colder than normal in the New England service territories, we
recorded a $4.1 million reduction to revenues to reflect the loss on these
derivative transactions. Similarly, in 2003 we recorded an $11.9 million
reduction to revenues. As a result of these transactions, comparative net
revenues were favorably impacted by $7.8 million (See Note 4 to the Consolidated
Financial Statements "Hedging and Derivative Financial Instruments" for further
information).
In our large-volume heating and other interruptible (non-firm) markets, which
include large apartment houses, government buildings and schools, gas service is
provided under rates that are designed to compete with prices of alternative
fuel, including No. 2 and No. 6 grade heating oil. These "dual-fuel" customers
can consume either natural gas or fuel oil for heating purposes. Net revenues in
these markets decreased $7.7 million during the first quarter of 2004 compared
to same period last year. This decrease reflects a lower quantity of gas sales
to customers within this market due, in part, to customers heating with an
alternative fuel. Further, since weather during January 2004 was significantly
colder than normal and last year, KeySpan discontinued sales service to a
segment of its dual-fuel customers for a number of days during the month, as
permitted under its tariff and directed by the New York State Public Service
Commission to ensure reliable service to firm customers. The majority of
interruptible profits earned by KEDNE and KEDLI are returned to firm customers
as an offset to gas costs.
34
We are committed to our expansion strategies initiated during the past few
years. We believe that significant growth opportunities exist on Long Island and
in our New England service territories. We estimate that on Long Island
approximately 36% of the residential and multi-family markets, and approximately
58% of the commercial market, currently use natural gas for space heating.
Further, we estimate that in our New England service territories approximately
53% of the residential and multi-family markets, and approximately 63% of the
commercial market, currently use natural gas for space heating purposes. We will
continue to seek growth, in all our market segments, through the expansion of
our gas distribution system, as well as through the conversion of residential
homes from oil-to-gas for space heating purposes and the pursuit of
opportunities to grow multi-family, industrial and commercial markets.
Firm Sales, Transportation and Other Quantities
Firm gas sales and transportation quantities for the quarter ended March 31,
2004 were consistent with such quantities for same period in 2003. Net revenues
are not affected by customers opting to purchase their gas supply from other
sources, since delivery rates charged to transportation customers generally are
the same as delivery rates charged to full sales service customers.
Transportation quantities related to electric generation reflect the
transportation of gas to our electric generating facilities located on Long
Island. Net revenues from these services are not material.
Other sales quantities include on-system interruptible quantities, off-system
sales quantities (sales made to customers outside of our service territories)
and related transportation. We have an agreement with Coral Resources, L.P.
("Coral"), a subsidiary of Shell Oil Company, under which Coral assists in the
origination, structuring, valuation and execution of energy-related transactions
on behalf of KEDNY and KEDLI. We also have a portfolio management contract with
Entergy Koch Trading, LP ("EKT"), under which EKT provides all of the city gate
supply requirements at market prices and manages certain upstream capacity,
underground storage and term supply contracts for KEDNE. These agreements expire
on March 31, 2006.
Purchased Gas for Resale
The increase in gas costs for the first quarter of 2004 compared to the first
quarter of 2003 of $72.4 million, or 6%, reflects an increase of 9% in the price
per dekatherm of gas purchased, and a 2% decrease in the quantity of gas
purchased. The current gas rate structure of each of our gas distribution
utilities includes a gas adjustment clause, pursuant to which variations between
actual gas costs incurred for resale to firm sales customers and gas costs
billed to firm sales customers are deferred and refunded to or collected from
customers in a subsequent period.
35
Operating Expenses
Operating expenses during the first quarter of 2004 compared to the same quarter
last year have increased by $11.8 million, or 4%. The increase in operating
expense is attributable, in part, to higher pension and other postretirement
benefits which increased by $4.1 million, net of amounts subject to regulatory
deferral accounting treatment, over the level incurred in 2003. The cost of
these benefits has risen primarily as a result of increased health care costs.
In addition, the bad debt reserve has increased primarily as a result of higher
account receivables due to higher cost of gas purchased. Higher depreciation and
amortization expense reflects the continued expansion of the gas distribution
system.
Other Matters
In order to serve the anticipated market requirements in our New York service
territories, KeySpan and Duke Energy Corporation formed Islander East Pipeline
Company, LLC ("Islander East") in 2000. Islander East is owned 50% by KeySpan
and 50% by Duke Energy, and was created to pursue the authorization and
construction of an interstate pipeline from Connecticut, across Long Island
Sound, to a terminus near Northport, Long Island. Applications for all necessary
regulatory authorizations were filed in 2000 and 2001. To date, Islander East
has received a final certificate from the Federal Energy Regulatory Commission
("FERC") and all necessary permits from the State of New York. However, the
State of Connecticut has denied Islander East's application for a coastal zone
management permit and a permit under Section 401 of the Clean Water Act.
Islander East has reinstated its appeal of the State of Connecticut's
determination on the coastal zone management issue to the United States
Department of Commerce. On April 16, 2004, Islander East filed a petition for a
declaratory order challenging the denial of the Section 401 permit with the
State of Connecticut's Department of Environmental Protection. Once in service,
the pipeline is expected to transport up to 260,000 DTH daily to the Long Island
and New York City energy markets, enough natural gas to heat 600,000 homes. The
pipeline will also allow KeySpan to diversify the geographic sources of its gas
supply. However, we are unable to predict when or if all regulatory approvals
required to construct this pipeline will be obtained. Various options for the
financing of pipeline construction are currently being evaluated. At March 31,
2004, total expenditures associated with the siting and permitting of the
Islander East pipeline were $17.7 million.
Electric Services
The Electric Services segment primarily consists of subsidiaries that own and
operate oil and gas fired electric generating plants in the Borough of Queens
(including the "Ravenswood facility") and the counties of Nassau and Suffolk on
Long Island. In addition, through long-term contracts of varying lengths, we
manage the electric transmission and distribution ("T&D") system, the fuel and
electric purchases, and the off-system electric sales for LIPA. The Electric
Services segment also provides retail marketing of electricity to commercial
customers, the earnings of which were previously reported in the Energy Services
segment. Financial results for 2003 have been restated to reflect these
activities in the Electric Services segment.
36
Selected financial data for the Electric Services segment is set forth in the
table below for the periods indicated.
- -------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- -------------------------------------------------------------------------------
Revenues $ 359,136 $ 397,725
Purchased fuel 101,489 139,421
- -------------------------------------------------------------------------------
Net Revenues 257,647 258,304
- -------------------------------------------------------------------------------
Operating Expenses
Operations and maintenance 147,185 164,401
Depreciation 21,605 16,620
Operating taxes 41,657 37,639
- -------------------------------------------------------------------------------
Total Operating Expenses 210,447 218,660
- -------------------------------------------------------------------------------
Operating Income $ 47,200 $ 39,644
- -------------------------------------------------------------------------------
Electric sales (MWH)* 983,106 767,349
Capacity(MW)* 2,450 2,200
Cooling degree days N/A N/A
- --------------------------------------------------------------------------------
*Reflects the operations of the Ravenswood facility only.
Net Revenues
Total electric net revenues realized during the first quarter of 2004 were
comparable to such revenues realized during the first quarter of 2003.
Net revenues from the Ravenswood facility for the first quarter of 2004 were
consistent with net revenues realized in the first quarter of 2003. Comparative
net revenues reflect higher energy margins of $3.4 million, offset by a decrease
in capacity revenues of $3.3 million. The increase in energy margins reflects a
higher level of megawatt hours ("MWh") sold into the New York Independent System
Operator ("NYISO") energy market. Energy sales quantities during the first
quarter of 2003 were adversely impacted by the scheduled major overhaul of our
largest electric generating unit.
We employ derivative financial hedging instruments to hedge the cash flow
variability for a portion of forecasted purchases of natural gas and fuel oil
consumed at the Ravenswood facility. Further, we have engaged in the use of
derivative financial hedging instruments to hedge the cash flow variability
associated with a portion of forecasted peak electric energy sales from the
Ravenswood facility. These derivative instruments resulted in hedging losses,
which are reflected in net electric margins, of $4.4 million for the quarter
ended March 31, 2004, compared to hedging gains of $1.6 million for the for the
quarter ended March 31, 2003. (See Note 4 to the Consolidated Financial
Statements "Hedging and Derivative Financial Instruments" as well as Item 3.
Quantitative and Qualitative Disclosures about Market Risk for further
information).
The decrease in capacity revenues reflects a revision to the NYISO's capacity
market procurement design. In 2003, the FERC approved a revised capacity market
procurement design with an effective date of May 21, 2003. This revised capacity
market procurement design is based on a demand curve rather than relying on
deficiency auctions to procure necessary capacity. The deficiency auction with
its associated fixed minimum capacity requirements was replaced with a spot
37
market auction that pays gradually declining prices as additional capacity is
offered and gradually increasing prices as capacity offers decrease. This new
market design recognizes the value of capacity in excess of the minimum
requirement and reduces price spikes during periods of shortage. Essentially,
the demand curve design eliminates the high and low cycles inherent in the
deficiency auction market design. This new market design also established
seasonal electric generator specific price caps. Price caps establish the
maximum price per MW that capacity can be sold into the NYISO by divested
electric generators like Ravenswood. Prior to this design change, one price cap
was established for the entire year and was effective for all electric
generators. As a result of this re-design, Ravenswood's 2003/2004 structured
winter price cap was lower than the yearly price cap effective during the
2002/2003 winter, which was prior to the implementation of the new demand curve
methodology, resulting in lower capacity revenues.
The rules and regulations for capacity, energy sales and the sale of certain
ancillary services to the NYISO energy markets continue to evolve and the FERC
has adopted several price mitigation measures that have adversely impacted
earnings from the Ravenswood facility over time. Certain of these mitigation
measures are still subject to rehearing and possible judicial review. The final
resolution of these issues and their effect on our financial position, results
of operations and cash flows cannot be fully determined at this time. (See
KeySpan's 2003 Annual Report on Form 10K for the Year Ended December 31, 2003
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations under the caption "Market and Credit Risk Management Activities"
for a further discussion of these matters.)
Net revenues for the first quarter of 2004 from the service agreements with
LIPA, including the power purchase agreements associated with two electric
peaking facilities, were comparable to such revenues earned during the first
quarter of 2003. (For a description of the LIPA Agreements and power purchase
agreements, see KeySpan's 2003 Annual Report on Form 10K for the Year Ended
December 31, 2003 Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations under the caption "Electric Services -
Revenue Mechanisms.")
Operating Expenses
Operating expenses decreased by $8.2 million, or 4%, in the first quarter of
2004 compared to the same quarter of 2003. This decrease reflects in part, the
implementation of FIN 46. As previously mentioned, this Interpretation, which
KeySpan implemented in December 2003, required KeySpan to, among other things,
consolidate the Ravenswood Master Lease and classify the lease obligation as
long-term debt on the Consolidated Balance Sheet. Further, an asset was recorded
on the Consolidated Balance Sheet for an amount substantially equal to the fair
market value of the leased assets at the inception of the lease, less
depreciation since that date. As a result of implementing FIN 46, beginning
January 1, 2004 lease payments have been reflected as interest expense on the
Consolidated Statement of Income and the leased assets are being depreciated.
The reclassification of lease payments to interest expense, partially offset by
38
the higher depreciation expense, resulted in a comparative decrease to operating
expense of approximately $3 million. (See Note 6 to the Consolidated Financial
Statements "Financial Guarantees and Contingencies" for additional information
regarding the Ravenswood leasing arrangement.) The remaining decrease in
comparative operating expenses reflects lower repair and maintenance costs on
our electric generating units, as well as the timing of certain costs related to
the LIPA service agreements.
Other Matters
During 2002, construction began on a new 250 MW combined cycle generating
facility at the Ravenswood facility site. The new facility was synchronized to
the electric grid in December 2003 and commenced operational testing in January
2004. In March, the facility completed full load Dependable Maximum Net Capacity
testing. The capacity and energy produced from this plant are anticipated to be
sold into the NYISO energy markets during the second quarter of 2004.
KeySpan is currently in the process of structuring a leveraged lease financing
for this new generating facility. KeySpan is seeking to close this transaction
to coincide with the commencement of full commercial operation of the new
facility. At the closing, the new facility will be acquired by the lessor from
our subsidiary, KeySpan Ravenswood, LLC, and simultaneously leased back to it.
All obligations of our subsidiary under the lease will be unconditionally
guaranteed by KeySpan. We anticipate that this lease transaction will generate
cash proceeds generally equivalent to the fair market value of the facility, as
determined by a third-party appraiser. It is expected that the cash proceeds
from this transaction will be used to redeem outstanding commercial paper. This
lease transaction is intended to qualify as an operating lease under SFAS 98
"Accounting for Leases: Sale/Leaseback Transactions Involving Real Estate;
Sales-Type Leases of Real Estate; Definition of the Lease Term; an Initial
Direct Costs of Direct Financing Leases, an amendment of FASB Statements No.13,
66, 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No.
79-11." The lease will have an initial term of 36 years and operating lease
expense is anticipated to be between $15 million to $17 million per year. Lease
payments will fluctuate from year to year, but are substantially paid over the
first 16 years.
In 2003, the New York State Board on Electric Generation Siting and the
Environment issued an opinion and order which granted a certificate of
environmental capability and public need for a 250 MW combined cycle electric
generating facility in Melville, Long Island, which is now final and
non-appealable. Also in 2003, LIPA issued a Request for Proposal ("RFP") seeking
bids from developers to either build and operate a Long Island generating
facility, and/or a new cable that will link Long Island to dedicated off-Long
Island power of between 250 to 600 MW of electricity by no later than the summer
of 2007. KeySpan and American National Power Inc. ("ANP") filed a joint proposal
in response to LIPA's RFP. Under the proposal, KeySpan and ANP will jointly own
and operate two 250 MW electric generating facilities to be located on Long
Island, one of which is the Melville site and the other in the town of
Brookhaven which also has received all permits and approvals. It is anticipated
that LIPA will respond to the joint proposal in the second quarter of 2004. At
March 31, 2004, total expenditures associated with the siting, permitting and
construction of the Ravenswood expansion project, and the siting, permitting and
procurement of equipment for the Long Island 250 MW combined cycle electric
generating facility were approximately $400 million.
39
As part of our growth strategy, we continually evaluate the possible acquisition
and development of additional generating facilities in the Northeast. However,
we are unable to predict when or if any such facilities will be acquired and the
effect any such acquired facilities will have on our financial condition,
results of operations or cash flows.
Energy Services
The Energy Services segment includes subsidiaries that provide energy-related
and a minimal amount of fiber optic services to customers primarily located
within the Northeastern United States, with concentrations in the New York City
metropolitan area including New Jersey and Connecticut, as well as Rhode Island,
Pennsylvania, Massachusetts and New Hampshire, through the following lines of
business: (i) Home Energy Services, which provides residential and small
commercial customers with service and maintenance of energy systems and
appliances; (ii) Business Solutions, which provides plumbing, heating,
ventilation, air conditioning and mechanical services, as well as operation and
maintenance, design, engineering and consulting services to commercial and
industrial customers.
The table below highlights selected financial information for the Energy
Services segment.
- --------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- --------------------------------------------------------------------------
Revenues $ 132,495 $ 130,491
Less: cost of sales 105,870 105,145
- --------------------------------------------------------------------------
Gross profit 26,625 25,346
Operating expenses 45,099 34,468
- --------------------------------------------------------------------------
Operating (Loss) $ (18,474) $ (9,122)
- --------------------------------------------------------------------------
The Energy Services segment realized additional operating losses of $9.4 million
for the three months ended March 31, 2004 compared to the same period last year.
The increase in operating expenses principally reflects the write-off of
accounts receivable and contract revenues on certain projects that were
determined to be uncollectible, as well as the write-down of inventory balances.
The increase in gross profit margin is primarily a result of the operations of
Bard, Rao + Athanas Consulting Engineers LLC ("BR+A") which was acquired in the
third quarter of 2003. Total backlog for the KeySpan Services group of companies
increased to $508 million compared to $479 million at March 31, 2003, primarily
due to the BR+A acquisition.
The operating results of this segment continue to be below expectations.
Management will continue to monitor the operating performance of this segment
and will conduct a review of the carrying value of goodwill during the year. The
recorded goodwill for this segment, as a result of prior acquisitions, is
approximately $171 million. At this point in time, we are unable to predict what
effect, if any, the outcome of this review will have on the carrying value of
our goodwill or on financial position or results of operations.
40
Energy Investments
The Energy Investment segment consists of our gas exploration and production
operations, certain other domestic and international energy-related investments,
as well as certain technology related investments. Our gas exploration and
production subsidiaries include our 55% ownership interest in The Houston
Exploration Company ("Houston Exploration") and our wholly-owned subsidiary
KeySpan Exploration and Production LLC ("KES E&P"). These companies are engaged
in gas and oil exploration and production, and the development and acquisition
of domestic natural gas and oil properties.
Selected financial data and operating statistics for our gas exploration and
production activities are set forth in the following table for the periods
indicated.
- -----------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- -----------------------------------------------------------------------------------------
Revenues $ 152,419 $ 127,847
Depletion and amortization expense 61,921 47,443
Other operating expenses 28,390 24,814
- -----------------------------------------------------------------------------------------
Operating Income $ 62,108 $ 55,590
- -----------------------------------------------------------------------------------------
Natural gas and oil production (Mmcf) 30,373 26,086
Natural gas (per Mcf) realized $ 4.99 $ 4.93
Natural gas (per Mcf) unhedged $ 5.43 $ 6.35
- -----------------------------------------------------------------------------------------
* Operating income above represents 100% of our gas exploration and
production subsidiaries' results for the periods indicated. Gas reserves
and production are stated in BCFe and Mmcfe, which includes equivalent oil
reserves.
The increase in operating income of $6.5 million or 12% for the three months
ended March 31, 2004 compared to the same period of 2003, primarily reflects an
increase in revenues offset, to some extent, by an increase in operating
expenses associated with a higher depletion rate. Revenues for the first quarter
of 2004 benefited from a 16% increase in production volumes, a slight increase
in average realized gas prices (average wellhead price received for production
including hedging gains and losses), as well as from the comparative impact of
derivative hedging instruments.
Derivative financial hedging instruments are employed by Houston Exploration to
provide more predictable cash flow, as well as to reduce its exposure to
fluctuations in natural gas prices. The average realized gas price for the three
months ended March 31, 2004 was 92% of the average unhedged natural gas price,
resulting in revenues that were $12.5 million lower than revenues that would
have been achieved if derivative financial instruments had not been in place.
Houston Exploration has hedge positions in place for slightly less than 70% of
its estimated 2004 production, principally through the use of costless collars.
Further, at March 31, 2004, Houston Exploration has derivative financial
instruments in place for approximately 60% of its estimated 2005 production. The
41
average realized gas price for the first quarter of 2003 was 77% of the average
unhedged natural gas price, resulting in revenues that were approximately $35
million lower than revenues that would have been achieved if derivative
financial instruments had not been in place. Houston Exploration hedged almost
70% of its 2003 first quarter production, principally through the use of
costless collars. (See Note 4 to the Consolidated Financial Statements, "Hedging
and Derivative Financial Instruments" as well as Item 3. Quantitative and
Qualitative Disclosures about Market Risk for further information.)
The depletion rate experienced during the first quarter of 2004 was $2.04 per
Mcf, compared to $1.76 per Mcf experienced during the corresponding quarter last
year. The increase in the depletion rate is the result of additional costs to
Houston Exploration's depreciation base with fewer additions for reserves.
The table below indicates the net proved reserves of the gas exploration and
production subsidiaries at December 31, 2003.
- -------------------------------------------------------------------
BCFe %
- -------------------------------------------------------------------
Houston Exploration 755 99.1%
KSE E&P 7 0.9%
- -------------------------------------------------------------------
Total 762 100.0%
- -------------------------------------------------------------------
This segment also consists of KeySpan Canada; our 20% interest in Iroquois Gas
Transmission System LP ("Iroquois"); our wholly owned 600,000 barrel liquefied
natural gas ("LNG") storage and receiving facility located in Rhode Island
("KeySpan LNG"); and our 50% interest in Premier Transmission Limited located in
Northern Ireland.
Selected financial data and operating statistics for these energy-related
investments are set forth in the following table for the periods indicated.
- --------------------------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- --------------------------------------------------------------------------------------------------
Revenues $ 28,445 $ 26,464
Less: Operation and maintenance expense 15,388 16,644
Other operating expenses 5,852 5,353
Add: Equity earnings 5,717 5,657
- --------------------------------------------------------------------------------------------------
Operating Income $ 12,922 $ 10,124
- --------------------------------------------------------------------------------------------------
*Operating income above reflects 100% of KeySpan's Canada's results.
The increase in operating income in the first quarter of 2004, compared to the
same period last year, primarily reflects higher operating income associated
with our Canadian investments. KeySpan Canada experienced higher unit sales, as
well as higher quantities of sales of natural gas liquids, as a result of
increasing oil prices. The pricing of natural gas liquids is directly related to
oil prices.
42
We do not consider certain businesses contained in the Energy Investments
segment to be part of our core asset group.
On April 1, 2004, The KeySpan Facilities Income Fund (the "Fund") issued 15.617
million units at a price of $12.60 per unit for gross total proceeds of
approximately CDN$196.8 million. The proceeds of the offering were used to
acquire a 35.91% interest in the business of KeySpan Canada from KeySpan.
KeySpan received net proceeds of approximately CDN$186.3 million (or
approximately US$140 million), after commissions and expenses. The Fund's
ownership in KeySpan Canada has now increased from 39.1% to approximately 75%.
KeySpan's ownership of KeySpan Canada is now approximately 25%. KeySpan expects
to record a pre-tax gain of approximately $20 million on this transaction, which
will be reflected in earnings in the second quarter of 2004. The proceeds from
the transaction will be used to redeem outstanding debt.
We have stated in the past that we may sell or otherwise dispose of all or a
portion of our non-core assets. Based on current market conditions, however, we
cannot predict when, or if, any additional sales or dispositions of our non-core
assets may take place, or the effect that any such additional sale or
disposition may have on our financial position, results of operations or cash
flows.
Allocated Costs
We are subject to the jurisdiction of the Securities and Exchange Commission
("SEC") under the Public Utility Holding Company Act ("PUHCA") as amended. As
part of the regulatory provisions of PUHCA, the SEC regulates various
transactions among affiliates within a holding company system. In accordance
with the SEC's regulations under PUHCA and the New York State Public Service
Commission, we have service companies that provide: (i) traditional corporate
and administrative services; (ii) gas and electric transmission and distribution
systems planning, marketing, and gas supply planning and procurement; and (iii)
engineering and surveying services to subsidiaries. During the first quarter of
2003, these non-operating subsidiaries incurred expenses related to consulting,
auditing and legal costs associated with the implementation of the
Sarbanes-Oxley Act that were not allocated to the various operating
subsidiaries. Further, the operating income variation as reflected in
"elimination and other" is due, in part, to the timing of certain corporate
expenses.
Liquidity
Cash flow from operations increased $82.3 million, or 17%, in the first quarter
of 2004 compared to the same time last year, reflecting generally higher cash
earnings and higher cash flow from gas exploration and production activities. In
addition, during the first quarter of 2004, we consolidated our newly created
"captive" insurance company, which included $43.2 million of cash and short-term
marketable securities.
43
At March 31, 2004, we had cash and temporary cash investments of $256.9 million.
During the three months ended March 31, 2004, we repaid $187.8 million of
commercial paper and, at March 31, 2004, $294.2 million of commercial paper was
outstanding at a weighted average annualized interest rate of 1.1%. We had the
ability to borrow up to an additional $1 billion at March 31, 2004, under the
terms of our credit facility.
KeySpan has a $1.3 billion revolving credit facility, syndicated among sixteen
banks. The facility is used to support KeySpan's commercial paper program, and
consists of two separate credit facilities with different maturities but
substantially similar terms and conditions: a $450 million facility that extends
for 364 days (or until June 25, 2004), and a $850 million facility that is
committed for three years. The fees for the facilities are subject to a
ratings-based grid, with an annual fee that ranges from eight to twenty five
basis points on the 364-day facility and ten to twenty basis points on the
three-year facility. Both credit agreements allow for KeySpan to borrow using
several different types of loans; specifically, Eurodollar loans, ABR loans, or
competitively bid loans. Eurodollar loans are based on the Eurodollar rate plus
a margin. ABR loans are based on the highest of the Prime Rate, the base CD rate
plus 1%, or the Federal Funds Effective Rate plus 0.5%, plus a margin.
Competitive bid loans are based on bid results requested by KeySpan from the
lenders. The margins on both facilities are ratings based and range from zero
basis points to 112.5 basis points. The margins are increased if outstanding
loans are in excess of 33% of the total facility. In addition, the 364-day
facility has a one-year term out option, which would cost an additional 0.25% if
utilized. We do not anticipate borrowing against this facility; however, if the
credit rating on our commercial paper program were to be downgraded, it may be
necessary to do so.
The credit facility contains certain affirmative and negative operating
covenants, including restrictions on KeySpan's ability to mortgage, pledge,
encumber or otherwise subject its property to any lien, as well as certain
financial covenants that require us to, among other things, maintain a
consolidated indebtedness to consolidated capitalization ratio of no more than
64%. Violation of this covenant could result in the termination of the credit
facility and the required repayment of amounts borrowed thereunder, as well as
possible cross defaults under other debt agreements.
Under the terms of the credit facility, KeySpan's debt-to-total capitalization
ratio reflects 80% equity treatment for the MEDS Equity Units issued in 2002. At
March 31, 2004, consolidated indebtedness, as calculated under the terms of the
credit facility was 56.1% of consolidated capitalization.
The credit facility also requires that net cash proceeds from the sale of
significant subsidiaries be applied to reduce consolidated indebtedness.
Further, an acceleration of indebtedness of KeySpan or one of its subsidiaries
for borrowed money in excess of $25 million in the aggregate, if not annulled
within 30 days after written notice, would create an event of default under the
Indenture dated November 1, 2000, between KeySpan Corporation and the
JPMorganChase Bank as Trustee. At March 31, 2004, KeySpan was in compliance with
all covenants.
Houston Exploration had a revolving credit facility with a commercial banking
syndicate that provided Houston Exploration with a commitment of $300 million.
The credit facility was amended on April 1, 2004 and, as amended, provides
Houston Exploration with a commitment of $400 million which may be increased
with prior approval from the banking syndicate to a maximum of $450 million. The
credit facility is subject to borrowing base limitations. Pursuant to the April
44
1, 2004 amendment, the borrowing base was increased from $300 million to $375
million. The $375 million borrowing base is expected to remain in effect until
the next scheduled redetermination on October 1, 2004. Up to $40 million of the
borrowing base is now available for the issuance of letters of credit.
Outstanding borrowings continue to be unsecured and with the exception of trade
payables, the facility ranks senior to Houston Exploration's $175 million 7%
subordinated notes. The amended facility matures on April 1, 2008
Under the Houston Exploration credit facility, interest on base rate loans is
payable at a fluctuating rate, or base rate, equal to the sum of (a) the greater
of the federal funds rate plus 0.50% or the bank's prime rate plus (b) a
variable margin between 0% and 0.50%, depending on the amount of borrowings
outstanding under the credit facility. Interest on fixed rate loans is payable
at a fixed rate equal to the sum of (a) a quoted reserve adjusted LIBOR rate,
plus (b) a variable margin between 1.25% and 2.00%, depending on the amount of
borrowings outstanding under the credit facility.
Financial covenants under the new facility require Houston Exploration to, among
other things, (i) maintain an interest coverage ratio of at least 3.00 to 1.00
of earnings before interest, taxes and depreciation ("EBITDA") to cash interest;
(ii) maintain a total debt to EBITDA ratio of not more than 3.50 to 1.00; and
(iii) generally prohibits the hedging of more than 85% of natural gas and oil
production during any 12-month period. At March 31, 2004, Houston Exploration
was in compliance with all financial covenants.
During the first quarter of 2004, Houston Exploration borrowed $20 million under
its credit facility and repaid $77 million. At March 31, 2004, $70 million of
borrowings remained outstanding at a weighted average annualized interest rate
of 3.27%. Also, $0.4 million was committed under outstanding letters of credit
obligations. Currently, Houston Exploration has $304.6 million of borrowing
capacity available to it.
KeySpan Canada has a credit facility that has two tranches with the following
maturities: (i) $37.5 million matures in 364 days: and (ii) $37.5 million
matures in two years. During the first quarter of 2004, KeySpan Canada repaid
$17.7 million under the facility and at March 31, 2004, $57.3 million was
available for future borrowing.
A substantial portion of consolidated revenues are derived from the operations
of businesses within the Electric Services segment, that are largely dependent
upon two large customers - LIPA and the NYISO. Accordingly, our cash flows are
dependent upon the timely payment of amounts owed to us by these customers.
We satisfy our seasonal working capital requirements primarily through
internally generated funds and the issuance of commercial paper. We believe that
these sources of funds are sufficient to meet our seasonal working capital
needs.
45
Capital Expenditures and Financing
Construction Expenditures
The table below sets forth our construction expenditures by operating segment
for the periods indicated:
- -------------------------------------------------------------------------------
Three Months Ended March 31,
(In Thousands of Dollars) 2004 2003
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
Gas Distribution $ 82,235 $ 78,013
Electric Services 36,617 56,731
Energy Investments 97,215 84,309
Energy Services and other 4,157 1,726
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
$ 220,224 $ 220,779
- -------------------------------------------------------------------------------
Construction expenditures related to the Gas Distribution segment are primarily
for the renewal, replacement and expansion of the distribution system.
Construction expenditures for the Electric Services segment reflect costs to:
(i) maintain our generating facilities; and (ii) expand the Ravenswood facility.
Construction expenditures related to the Energy Investments segment primarily
reflect costs associated with gas exploration and production activities.
Expenditures also include development costs associated with the joint venture
with Houston Exploration, as well as costs related to KeySpan Canada's gas
processing facilities.
Financing
KeySpan did not engage in any financing transactions during the first quarter of
2004. However, we anticipate replacing outstanding commercial paper used to
finance the construction of a new 250 MW combined cycle generating facility at
the Ravenswood facility site with the proceeds from a proposed sale/leaseback
transaction anticipated to be completed in the second quarter of 2004. (See the
earlier discussion under the caption "Electric Services" for further details on
this proposed transaction). We will continue to evaluate our capital structure
and financing strategy for the remainder of 2004 and beyond. We believe that our
current sources of funding (i.e., internally generated funds, the proposed
sale/leaseback transaction, and the availability of commercial paper) are
sufficient to meet our anticipated capital needs for the foreseeable future.
46
The following table represents the ratings of our long-term debt at March 31,
2004. Currently, Standard & Poor's and Moody's Investor Services ratings on
KeySpan's and its subsidiaries' long-term debt are on negative outlook.
Moody's Investor Standard
Services & Poor's FitchRatings
- --------------------------------------------------------------------------------------------------------
KeySpan Corporation A3 A A-
KEDNY N/A A+ A+
KEDLI A2 A+ A-
Boston Gas A2 A N/A
Colonial Gas A2 A+ N/A
Electric Generation A3 A N/A
- --------------------------------------------------------------------------------------------------------
Off-Balance Sheet Arrangements
Guarantees
KeySpan has a number of financial guarantees with its subsidiaries that have
remained substantially unchanged since December 31, 2003. At March 31, 2004,
KeySpan has fully and unconditionally guaranteed: (i) $525 million of
medium-term notes issued by KEDLI; (ii) the obligations of KeySpan Ravenswood
LLC, the lessee under the $425 million Master Lease Agreement associated with
the Ravenswood facility; and (iii) the payment obligations of our subsidiaries
related to $128 million of tax-exempt bonds issued through the Nassau County and
Suffolk County Industrial Development Authority for the construction of the
Glenwood and Port Jefferson electric-generation peaking facilities. The
medium-term notes, the Master Lease Agreement and the tax-exempt bonds are
reflected on the Consolidated Balance Sheet. Further, KeySpan has guaranteed:
(i) up to $169 million of surety bonds associated with certain construction
projects currently being performed by subsidiaries within the Energy Services
segment; (ii) certain supply contracts, margin accounts and purchase orders for
certain subsidiaries in an aggregate amount of $51 million; and (iii) $74
million of subsidiary letters of credit. These guarantees are not recorded on
the Consolidated Balance Sheet. At this time, we have no reason to believe that
our subsidiaries will default on their current obligations. However, we cannot
predict when or if any defaults may take place or the impact such defaults may
have on our consolidated results of operations, financial condition or cash
flows. (See Note 6 to the Consolidated Financial Statements, "Financial
Guarantees and Contingencies" for additional information regarding KeySpan's
guarantees.)
In addition, KeySpan intends to guarantee the payment obligations of its
subsidiaries in connection with the proposed sale/leaseback transaction for the
financing of the new 250 MW electric generating facility located on the
Ravenswood site.
Variable Interest Entity
We have an arrangement with a variable interest entity through which we lease a
portion of the Ravenswood facility. We acquired the Ravenswood facility, in
part, through the variable interest entity from The Consolidated Edison Company
of New York, Inc. ("Consolidated Edison") on June 18, 1999 for approximately
$597 million. In order to reduce the initial cash requirements, we entered into
47
a lease agreement (the "Master Lease") with a variable interest, unaffiliated
financing entity that acquired a portion of the facility, three steam generating
units, directly from Consolidated Edison and leased it to a KeySpan subsidiary.
The variable interest unaffiliated financing entity acquired the property for
$425 million, financed with debt of $412.3 million (97% of capitalization) and
equity of $12.7 million (3% of capitalization). Monthly lease payments equal the
monthly interest expense on the debt securities. This variable interest entity
is fully consolidated in KeySpan's financial statements. (See Note 6 to the
Consolidated Financial Statements, "Financial Guarantees and Contingencies" for
additional information regarding the Master Lease.)
Contractual Obligations
KeySpan has certain contractual obligations related to its outstanding long-term
debt, outstanding credit facility borrowings, outstanding commercial paper
borrowings, operating and capital leases, and demand charges associated with
certain commodity purchases. These obligations have remained substantially
unchanged since December 31, 2003. (For additional details regarding these
obligations see KeySpan's Annual Report on Form 10K for the Year Ended December
31, 2003, Item 7 Management's Discussion and Analysis of Financial Condition and
Results of Operations, Note 6 "Long-Term Debt", as well as Note 7 to those
Consolidated Financial Statements "Contractual Obligations, Financial Guarantees
and Contingencies.")
Discussions of Critical Accounting Policies and Assumptions
In preparing our financial statements, the application of certain accounting
policies requires difficult, subjective and/or complex judgments. The
circumstances that make these judgments difficult, subjective and/or complex
have to do with the need to make estimates about the impact of matters that are
inherently uncertain. Actual effects on our financial position and results of
operations may vary significantly from expected results if the judgments and
assumptions underlying the estimates prove to be inaccurate. At March 31, 2004,
KeySpan's critical accounting policies and assumptions have remained
substantially unchanged since December 31, 2003. Below is a brief discussion of
those critical accounting policies requiring such subjectivity. For a more
detailed discussion of these policies and assumptions see KeySpan's Annual
Report on Form 10K for the Year Ended December 31, 2003, Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations
"Discussion of Critical Accounting Policies and Assumptions."
Percentage of Completion Accounting
Percentage-of-completion accounting is a method of accounting for long-term
construction type contracts in accordance with Generally Accepted Accounting
Principles and, accordingly, the method used for engineering and mechanical
contracting revenue recognition by the Energy Services segment. Due to
uncertainties inherent within estimates employed to apply
percentage-of-completion accounting, it is possible that estimates will be
revised as project work progresses. Changes in estimates resulting in additional
future costs to complete projects can result in reduced margins or loss
contracts.
48
Valuation of Goodwill
KeySpan records goodwill on purchase transactions, representing the excess of
acquisition cost over the fair value of net assets acquired. In testing for
goodwill impairment under Statement of Financial Accounting Standards ("SFAS")
142 "Goodwill and Other Intangible Assets", significant reliance is placed upon
a number of estimates regarding future performance that require broad
assumptions and significant judgment by management. A change in the fair value
of our investments could cause a significant change in the carrying value of
goodwill. The assumptions used to measure the fair value of our investments are
the same as those used by us to prepare annual operating segment and
consolidated earnings and cash flow forecasts. In addition, these assumptions
are used to set annual budgetary guidelines.
Although management determined that the fair value of KeySpan's assets
adequately exceeded their carrying value for the year ended December 31, 2003,
the operating performance of the Energy Services segment continues to be below
expectations. Management will continue to monitor the operating performance of
this segment and will conduct a review of the carrying value of goodwill during
the year. The recorded goodwill for this segment, as a result of prior
acquisitions, is approximately $171 million. At this point in time, we are
unable to predict what effect, if any, the outcome of this review will have on
the carrying value of our goodwill or on financial position or results of
operations.
Management will continue to review and focus on its overall strategy for each of
KeySpan's business units and accordingly will continue to evaluate the carrying
value of goodwill. While we believe that our assumptions are reasonable, actual
results, however, may differ from our projections.
Accounting for the Effects of Rate Regulation on Gas Distribution Operations
The financial statements of the Gas Distribution segment reflect the ratemaking
policies and orders of the New York Public Service Commission ("NYPSC"), the New
Hampshire Public Utilities Commission ("NHPUC"), and the Massachusetts
Department of Telecommunications and Energy ("DTE").
Four of our six regulated gas utilities (KEDNY, KEDLI, Boston Gas Company and
EnergyNorth Natural Gas, Inc.) are subject to the provisions of SFAS 71,
"Accounting for the Effects of Certain Types of Regulation." This statement
recognizes the actions of regulators, through the ratemaking process, to create
future economic benefits and obligations affecting rate-regulated companies.
In separate merger-related orders issued by the DTE, the base rates charged by
Colonial Gas Company and Essex Gas Company have been frozen at their current
levels for a ten-year period ending 2009. Due to the length of these base rate
freezes, the Colonial and Essex Gas Companies had previously discontinued the
application of SFAS 71.
As is further discussed under the caption "Regulation and Rate Matters," the
rate plans previously in effect for KEDNY and KEDLI have expired. The continued
application of SFAS 71 to record the activities of these subsidiaries is
contingent upon the actions of regulators with regard to future rate plans. We
49
are currently evaluating various options that may be available to us including,
but not limited to, proposing new plans for KEDNY and KEDLI. The ultimate
resolution of any future rate plans could have a significant impact on the
application of SFAS 71 to these entities and, accordingly, on our financial
position, results of operations and cash flows. However, management believes
that currently available facts support the continued application of SFAS 71 and
that all regulatory assets and liabilities are recoverable or refundable through
the regulatory environment. It should be noted that the DTE approved a base
revenue increase for the Boston Gas Company in the fourth quarter of 2003. (See
the discussion under the caption "Regulation and Rate Matters" for additional
information regarding the Boston Gas Company's filing.)
Rate regulation is undergoing significant change as regulators and customers
seek lower prices for utility service and greater competition among energy
service providers. In the event that regulation significantly changes the
opportunity for us to recover costs in the future, all or a portion of our
regulated operations may no longer meet the criteria for the application of SFAS
71. In that event, a write-down of our existing regulatory assets and
liabilities could result. In management's opinion, our regulated subsidiaries
that currently are subject to the provisions of SFAS 71 will continue to be
subject to SFAS 71 for the foreseeable future.
Pension and Other Postretirement Benefits
KeySpan participates in both non-contributory defined benefit pension plans, as
well as other post-retirement benefit ("OPEB") plans (collectively
"postretirement plans"). KeySpan's reported costs of providing pension and OPEB
benefits are dependent upon numerous factors resulting from actual plan
experience and assumptions of future experience. Pension and OPEB costs
(collectively "postretirement costs") are impacted by actual employee
demographics, the level of contributions made to the plans, earnings on plan
assets, and health care cost trends. Changes made to the provisions of these
plans may also impact current and future postretirement costs. Postretirement
costs may also be significantly affected by changes in key actuarial
assumptions, including anticipated rates of return on plan assets and the
discount rates used in determining the postretirement costs and benefit
obligations. Actual results that differ from our assumptions are accumulated and
amortized over ten years.
Historically, we have funded our qualified pension plans in excess of the amount
required to satisfy minimum ERISA funding requirements. At March 31, 2004, we
had a funding credit balance in excess of the ERISA minimum funding
requirements. Although we have presently exceeded ERISA funding requirements,
our pension plans, on an actuarial basis, are currently underfunded. Therefore,
for 2004, KeySpan expects to contribute a total of $147 million to its funded
and unfunded post-retirement plans. Future funding requirements are heavily
dependent on actual return on plan assets and prevailing interest rates. (In
addition to Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations in KeySpan's Annual Report on Form 10K for the Year
Ended December 31, 2003, see also Note 4 of those Consolidated Financial
Statements, "Postretirement Benefits.")
50
Full Cost Accounting
Our gas exploration and production subsidiaries use the full cost method to
account for their natural gas and oil properties. Under full cost accounting,
all costs incurred in the acquisition, exploration, and development of natural
gas and oil reserves are capitalized into a "full cost pool." Capitalized costs
include costs of all unproved properties, internal costs directly related to
natural gas and oil activities, and capitalized interest.
Under full cost accounting rules, total capitalized costs are limited to a
ceiling equal to the present value of future net revenues, discounted at 10%,
plus the lower of cost or fair value of unproved properties less income tax
effects (the "ceiling limitation"). A quarterly ceiling test is performed to
evaluate whether the net book value of the full cost pool exceeds the ceiling
limitation. If capitalized costs (net of accumulated depreciation, depletion and
amortization) less deferred taxes are greater than the discounted future net
revenues or ceiling limitation, a write-down or impairment of the full cost pool
is required.
Natural gas and oil reserve quantities represent estimates only. Under full cost
accounting, reserve estimates are used to determine the full cost ceiling
limitation as well as the depletion rate. Houston Exploration estimates its
proved reserves and future net revenues using sales prices estimated to be in
effect as of the date it makes the reserve estimates. Further, Houston
Exploration employs independent petroleum engineers in the preparation of
estimated reserve quantities. Natural gas prices, which have fluctuated widely
in recent years, affect estimated quantities of proved reserves and future net
revenues. Any estimates of natural gas and oil reserves and their values are
inherently uncertain, including many factors beyond our control.
Valuation of Derivative Instruments
We employ derivative instruments to manage commodity and financial market risk.
All of our derivative instruments, except for certain weather derivatives, are
reported on the Consolidated Balance Sheet at fair value in accordance with SFAS
133; weather derivatives are accounted for in accordance with Emerging Issues
Task Force ("EITF") 99-2. None of KeySpan's derivative instruments qualify as
"energy trading contracts" as defined by current accounting literature.
For those derivative instruments designated as cash flow hedges under SFAS 133,
which are the majority of KeySpan's derivative instruments, changes in the
derivative's fair market value are recorded in other comprehensive income on the
Consolidated Balance Sheet, (in line with effectiveness measurements) and are
recorded through earnings at the time of settlement. To the extent hedge
contracts are deemed ineffective, that portion will impact earnings.
Additionally, we use derivative financial instruments to reduce cash flow
variability associated with the purchase price for a portion of future natural
gas purchases for our regulated gas distribution activities; the accounting for
such derivative instruments is subject to SFAS 71. KeySpan's non-regulated
subsidiaries may employ a limited number of financial derivatives that do not
qualify for hedge accounting treatment under SFAS 133, and, therefore, changes
in the market value of these derivative instruments are recorded through
earnings.
51
When available, quoted market prices are used to record a derivative contract's
fair value. Fair value is the amount at which derivative instruments could be
exchanged in a current transaction between willing parties, other than in a
liquidation sale. However market values for certain derivative contracts may not
be readily available or determinable. If no active market exists for a
commodity, a specific contract type, or for the entire term of a contract's
duration, fair values are based on pricing models. Such models employ matrix
pricing based on contracts with similar terms and risks, including pricing based
on broker quotes and industry publications. A substantial percentage of the fair
value of KeySpan's derivative contracts is based on observable market prices or
is derived from such prices. Changes in market conditions or the occurrence of
unforeseen events could affect the timing of recognition of changes in fair
value of certain hedging derivatives.
See Note 4 to the Consolidated Financial Statements "Hedging and Derivative
Financial Instruments and Item 3, "Quantitative and Qualitative Disclosures
About Market Risk" for a further description of our derivative instruments.
Regulation and Rate Matters
Gas Matters
As of March 31, 2004, the rate agreements for KEDNY and KEDLI have expired.
Under the terms of the KEDNY and KEDLI rate agreements, gas distribution rates
and all other provisions will remain in effect until changed by the NYPSC. At
this time, we are currently evaluating various options that may be available to
us regarding the KEDNY and KEDLI rate plans, including but not limited to,
proposing new rate plans.
Regarding the Boston Gas Company, in 2003 the DTE approved a $25.9 million
increase in base revenues with an allowed return on equity of 10.2% assuming an
equal balance of debt and equity. On January 27, 2004 the DTE issued orders on
Boston Gas Company's Motion for Recalculation, Reconsideration and Clarification
that granted an additional $1.1 million in base revenues, for a total of $27
million. The DTE also approved a Performance Based Rate Plan (the "Plan") for up
to ten years.
For an additional discussion of our current gas distribution rate agreements,
see KeySpan's Annual Report on Form 10K for the Year Ended December 31, 2003,
Item 7 Management's Discussion and Analysis of Financial Condition and Results
of Operations "Regulation and Rate Matters."
Electric Matters
KeySpan sells to LIPA all of the capacity and, to the extent requested, energy
conversion services from our existing Long Island based oil and gas-fired
generating plants. Sales of capacity and energy conversion services are made
under rates approved by the FERC in accordance with the Power Supply Agreement
("PSA") entered into between KeySpan and LIPA in 1998. The current FERC approved
rates, which have been in effect since May 1998, expired on December 31, 2003.
KeySpan filed with the FERC an updated cost of service for the Long Island based
generating plants in October 2003. The rate filing included, among other things,
52
an annual revenue increase of 2.1% or approximately $6.4 million, a return on
equity of 11%, updated operating and maintenance expense levels and recovery of
certain other costs. FERC approved implementation of new rates starting January
1, 2004, subject to refund. Settlement negotiations with LIPA are currently
ongoing.
Securities and Exchange Commission Regulation
KeySpan and its subsidiaries are subject to the jurisdiction of the SEC under
PUHCA. The rules and regulations under PUHCA generally limit the operations of a
registered holding company to a single integrated public utility system, plus
additional energy-related businesses. In addition, the principal regulatory
provisions of PUHCA: (i) regulate certain transactions among affiliates within a
holding company system including the payment of dividends by such subsidiaries
to a holding company; (ii) govern the issuance, acquisition and disposition of
securities and assets by a holding company and its subsidiaries; (iii) limit the
entry by registered holding companies and their subsidiaries into businesses
other than electric and/or gas utility businesses; and (iv) require SEC approval
for certain utility mergers and acquisitions.
KeySpan has the authorization, under PUHCA to do the following through December
31, 2006 (the "Authorization Period"): (a) to issue and sell up to an additional
amount of $3.0 billion of common stock, preferred stock, preferred and
equity-linked securities, and long-term debt securities (the "Long-Term
Financing Limit") in accordance with certain defined parameters; (b) in addition
to the Long-Term Financing Limit, to issue and sell up to an aggregate amount of
$1.3 billion of short-term debt (the "Short-Term Financing Limit"); (c) to issue
up to 13 million shares of common stock under dividend reinvestment and
stock-based management incentive and employee benefit plans; (d) to maintain
existing and enter into additional hedging transactions with respect to
outstanding indebtedness in order to manage and minimize interest rate costs;
(e) to issue guarantees and other forms of credit support in an aggregate
principal amount not to exceed $4.0 billion outstanding at any one time; (f) to
refund, repurchase (through open market purchases, tender offers or private
transactions), replace or refinance debt or equity securities outstanding during
the Authorization Period through the issuance of similar or any other type of
authorized securities; (g) to pay dividends out of capital and unearned surplus
as well as paid-in-capital with respect to certain subsidiaries, subject to
certain limitations; (h) to engage in preliminary development activities and
administrative and management activities in connection with anticipated
investments in exempt wholesale generators, foreign utility companies and other
energy-related companies; (i) to organize and/or acquire the equity securities
of entities that will serve the purpose of facilitating authorized financings;
(j) to invest up to $3.0 billion in exempt wholesale generators and foreign
utility companies; (k) to create and/or acquire the securities of entities
organized for the purpose of facilitating investments in other non-utility
subsidiaries; and (l) to enter into certain types of affiliate transactions
between certain non-utility subsidiaries involving cost structures above the
typical "at-cost" limit.
In addition, we have committed that during the Authorization Period, our common
equity will be at least 30% of our consolidated capitalization and each of our
utility subsidiaries' common equity will be at least 30% of such entity's
capitalization. At March 31, 2004 KeySpan's consolidated common equity was 39%
of its consolidated capitalization, including commercial paper, and each of its
utility subsidiaries common equity was at least 35% of its respective
capitalization.
53
Environmental Matters
KeySpan is subject to various federal, state and local laws and regulatory
programs related to the environment. Ongoing environmental compliance
activities, which have not been material, are charged to operation and
maintenance activities. We estimate that the remaining cost of our manufactured
gas plant ("MGP") related environmental cleanup activities, including costs
associated with the Ravenswood facility, will be approximately $263.1 million
and we have recorded a related liability for such amount. We have also recorded
an additional $24.3 million liability representing the estimated environmental
cleanup costs related to a former coal tar processing facility. Further, as of
March 31, 2004, we have expended a total of $108.6 million on environmental
remediation. (See Note 6 to the Consolidated Financial Statements, "Financial
Guarantees and Contingencies".)
Market and Credit Risk Management Activities
Market Risk: KeySpan is exposed to market risk arising from potential changes in
one or more market variables, such as energy commodity price risk, interest rate
risk, foreign currency exchange rate risk, volumetric risk due to weather or
other variables. Such risk includes any or all changes in value whether caused
by commodity positions, asset ownership, business or contractual obligations,
debt covenants, exposure concentration, currency, weather, and other factors
regardless of accounting method. We manage our exposure to changes in market
prices using various risk management techniques for non-trading purposes,
including hedging through the use of derivative instruments, both
exchange-traded and over-the-counter contracts, purchase of insurance and
execution of other contractual arrangements.
Credit Risk: KeySpan is exposed to credit risk arising from the potential that
our counterparties fail to perform on their contractual obligations. Our credit
exposures are created primarily through the sale of gas and transportation
services to residential, commercial, electric generation, and industrial
customers and the provision of retail access services to gas marketers, by our
regulated gas businesses; the sale of commodities and services to LIPA and the
NYISO; the sale of gas, power and services to our retail customers by our
unregulated energy service businesses; entering into financial and energy
derivative contracts with energy marketing companies and financial institutions;
and the sale of gas, natural gas liquids, oil and processing services to energy
marketing and oil and gas production companies.
We have regional concentration of credit risk due to receivables from
residential, commercial and industrial customers in New York, New Hampshire and
Massachusetts, although this credit risk is spread over a diversified base of
residential, commercial and industrial customers. Customers' payment records are
monitored and action is taken, when appropriate. Companies within the Energy
Services segment have a concentration of credit risk to large customers and to
the governmental and healthcare industries.
54
We also have concentrations of credit risk from LIPA, our largest customer, and
from other energy companies. Concentration of energy company counterparties may
impact overall exposure to credit risk in that our counterparties may be
similarly impacted by changes in economic, regulatory or other considerations.
We actively monitor the credit profile of our wholesale counterparties in
derivative and other contractual arrangements, and manage our level of exposure
accordingly. In instances where counterparties' credit quality has declined, we
may limit our credit exposure by restricting new transactions with the
counterparty, requiring additional collateral or credit support and negotiating
the early termination of certain agreements.
Equity and Debt Securities Risk: KeySpan is exposed to price risk due to
investments in equity and debt securities held to fund benefit payments for
various employee pension and other postretirement benefit plans. To the extent
that the values of investments held decline, the effect will be reflected in
KeySpan's recognition of periodic cost of such employee benefit plans and the
determination of the amount of cash to be contributed to the employee benefit
plans.
Regulatory Issues and Competitive Environment: We are subject to various other
risk exposures and uncertainties associated with our gas and electric
operations. The most significant contingency involves the evolution of the gas
distribution and electric industries towards more competitive and deregulated
environments. These risks have not changed substantially since December 31,
2003. For additional information regarding these risks see KeySpan's Annual
Report on Form 10K for the Year Ended December 31, 2003, Item 7 Management's
Discussion and Analysis of Financial Condition and Results of Operations "Market
and Credit Risk Management Activities."
Cautionary Statement Regarding Forward-Looking Statements
Certain statements contained in this Quarterly Report on Form 10-Q concerning
expectations, beliefs, plans, objectives, goals, strategies, future events or
performance and underlying assumptions and other statements that are other than
statements of historical facts, are "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
Without limiting the foregoing, all statements under the captions "Item 2.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Item 3. Quantitative and Qualitative Disclosures About Market
Risk" relating to our future outlook, anticipated capital expenditures, future
cash flows and borrowings, pursuit of potential future acquisition opportunities
and sources of funding, are forward-looking statements. Such forward-looking
statements reflect numerous assumptions and involve a number of risks and
uncertainties and actual results may differ materially from those discussed in
such statements.
Among the factors that could cause actual results to differ materially are:
- volatility of energy prices used to generate electricity;
- fluctuations in weather and in gas and electric prices;
- general economic conditions, especially in the Northeast United
States;
- our ability to successfully reduce our cost structure and operate
efficiently;
55
- our ability to successfully contract for natural gas supplies required
to meet the needs of our firm customers;
- implementation of new accounting standards;
- inflationary trends and interest rates;
- the ability of KeySpan to identify and make complementary
acquisitions, as well as the successful integration of recent and
future acquisitions;
- available sources and cost of fuel;
- creditworthiness of counterparties to derivative instruments and
commodity contracts;
- the resolution of certain disputes with LIPA concerning each party's
rights and obligations under various agreements;
- retention of key personnel;
- federal and state regulatory initiatives that increase competition,
threaten cost and investment recovery, and place limits on the type
and manner in which we invest in new businesses and conduct
operations;
- the impact of federal and state utility regulatory policies and orders
on our regulated and unregulated businesses;
- potential write-down of our investment in natural gas properties when
natural gas prices are depressed or if we have significant downward
revisions in our estimated proved gas reserves;
- competition facing our unregulated Energy Services businesses,
including but not limited to competition from other mechanical,
plumbing, heating, ventilation and air conditioning, and engineering
companies, as well as, other utilities and utility holding companies
that are permitted to engage in such activities;
- the degree to which we develop unregulated business ventures, as well
as federal and state regulatory policies affecting our ability to
retain and operate such business ventures profitably;
- changes in political conditions, acts of war or terrorism;
- changes in rates of return on overall debt and equity markets could
have an adverse impact on the value of pension assets;
- changes in accounting standards or GAAP which may require adjustment
to financial statements;
- a change in the fair value of our investments that could cause a
significant change in the carrying value of goodwill;
- timely receipts of payments from our two largest customers LIPA and
the NYISO; and
56
- other risks detailed from time to time in other reports and other
documents filed by KeySpan with the SEC.
For any of these statements, KeySpan claims the protection of the safe harbor
for forward-looking information contained in the Private Securities Litigation
Reform Act of 1995, as amended. For additional discussion on these risks,
uncertainties and assumptions, see "Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations."
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Financially-Settled Commodity Derivative Instruments - Non-Regulated Hedging
Activities: From time to time, KeySpan subsidiaries have utilized derivative
financial instruments, such as futures, options and swaps, for the purpose of
hedging the cash flow variability associated with changes in commodity prices.
KeySpan is exposed to commodity price risk primarily with regard to its gas
exploration and production activities and its electric generating facilities.
Derivative financial instruments are employed by Houston Exploration to hedge
cash flow variability associated with forecasted sales of natural gas. The
Ravenswood facility uses derivative financial instruments to hedge the cash flow
variability associated with the purchase of natural gas and oil that will be
consumed during the generation of electricity. The Ravenswood facility also
hedges the cash flow variability associated with a portion of peak electric
energy sales.
For derivative instruments associated with gas exploration and production
activities, KeySpan uses standard New York Mercantile Exchange ("NYMEX") future
price quotes to value swap positions and published volatility in its
Black-Scholes calculation for outstanding options. Further, KeySpan uses
standard NYMEX futures prices to value gas futures contracts and market quoted
forward prices to value oil swap and natural gas basis swap contracts associated
with its Ravenswood facility. We also use market quoted forward prices to value
electric derivatives associated with the Ravenswood facility.
The following tables set forth selected financial data associated with these
derivative financial instruments noted above that were outstanding at March 31,
2004.
- -----------------------------------------------------------------------------------------------------------------------------------
Year of Volumes Fixed Current Fair Value
Type of Contract Maturity mmcf Floor $ Ceiling $ Price $ Price $ ($000)
- -----------------------------------------------------------------------------------------------------------------------------------
Gas
Collars 2004 55,000 3.75 5.05 - 5.11 - 6.19 (32,688)
2005 54,750 4.50 5.69 - 5.30 - 6.44 (24,526)
Swaps/Futures - Short Natural Gas 2004 11,000 - - 4.96 5.11 - 6.19 (11,267)
2005 18,250 - - 4.77 5.30 - 6.44 (15,355)
Swaps/Futures - Long Natural Gas 2004 50 - - 5.11 - 5.14 5.93 - 6.04 43
2005 10 - - 4.95 5.28 3
- -----------------------------------------------------------------------------------------------------------------------------------
139,060 (83,790)
- -----------------------------------------------------------------------------------------------------------------------------------
57
- -------------------------------------------------------------------------------------------------------------------------
Year of Volumes Current Fair Value
Type of Contract Maturity Barrels Fixed Price $ Price $ ($000)
- -------------------------------------------------------------------------------------------------------------------------
Oil
Swaps - Long Fuel Oil 2004 69,104 22.40 - 30.80 28.58 - 30.90 194
2005 42,000 24.85 - 30.80 28.88 - 31.16 69
- -------------------------------------------------------------------------------------------------------------------------
111,104 263
- -------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------
Year of Fixed Margin/ Current Fair Value
Type of Contract Maturity MWh Price $ Price $ ($000)
- ------------------------------------------------------------------------------------------------------------------------
Electricity
Swaps - Energy 2004 536,800 15.09 - 45.25 16.10 - 45.00 (134)
2005 335,200 13.74 - 48.64 15.57 - 48.57 (915)
- ------------------------------------------------------------------------------------------------------------------------
872,000 (1,049)
- ------------------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
2004
Change in Fair Value of Derivative Instruments ($000)
- -------------------------------------------------------------------------------
Fair value of contracts at January 1, $(36,224)
Losses on contracts realized 16,968
(Decrease) in fair value of all open contracts (65,320)
- -------------------------------------------------------------------------------
Fair value of contracts outstanding at March 31, $(84,576)
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars)
- -------------------------------------------------------------------------------------------------------------------
Fair Value of Contracts
- -------------------------------------------------------------------------------------------------------------------
Mature Within Total
Sources of Fair Value 12 Months Thereafter Fair Value
- -------------------------------------------------------------------------------------------------------------------
Prices actively quoted $ (52,529) (8,388) $ (60,917)
Prices based on models and
other valuation methods (10,958) (11,915) $ (22,873)
Local published indicies (315) (471) $ (786)
- -------------------------------------------------------------------------------------------------------------------
$ (63,802) $ (20,774) $ (84,576)
- -------------------------------------------------------------------------------------------------------------------
We measure the commodity risk of our derivative hedging instruments using a
sensitivity analysis. The sensitivity analysis performed on these derivative
positions measures the potential change in the fair market value based on a
hypothetical 10% movement in energy prices. Based on a 10% increase in the
forward commodity curve for natural gas from the March 31, 2004 level, it was
estimated that the fair market value of outstanding derivative instruments
expected to be settled in 2004 associated with our gas exploration and
production activities would decrease by approximately $27 million. A 10%
decrease in the forward commodity curve for natural gas would increase the fair
market value of these outstanding derivative instruments by approximately $24
million. We also perform sensitivity analysis on the estimated physical sale of
natural gas by our gas exploration and production subsidiaries. Based on a 10%
increase in the forward commodity curve for natural gas from the March 31, 2004
58
level, it was estimated that pre-tax income from our gas exploration and
production activities would increase by approximately $58 million for the
remainder of 2004. A 10% decrease in the forward commodity curve for natural gas
would decrease pre-tax income by approximately $57 million. Based upon the
preceding sensitivity analysis, the net impact of a 10% increase in the forward
commodity curve for natural gas would benefit pre-tax income by approximately
$31 million. A 10% decrease in the forward commodity curve for natural gas would
result in a net decrease to pre-tax income of approximately $34 million. The
fact that a 10% change in the forward commodity curve for natural gas has a
significant impact on pre-tax income is indicative of the fact that our gas
exploration and production subsidiaries do not hedge 100% of their estimated
production.
Based on sensitivity analysis performed on derivative instruments associated
with the operations of the Ravenswood facility, it is estimated that a 10%
increase in the forward commodity curves for electricity and fuel from the March
31, 2004 level would decrease the fair market value of outstanding derivative
instruments that hedge the cash flow variability associated with a portion of
peak electric energy sales by $1 million. A 10% decrease in the forward
commodity curves for electricity and fuel would increase the fair market value
of these derivative instruments by a similar amount. We also perform sensitivity
analysis on the estimated physical sale of electricity by the Ravenswood
facility. Based on a 10% increase in the forward commodity curves for
electricity and fuel from the March 31, 2004 level, it was estimated that
pre-tax income from the Ravenswood facility would increase by approximately $11
million for the remainder of 2004. A 10% decrease in the forward commodity
curves for electricity and fuel would decrease pre-tax income by approximately
$9 million. Based upon the preceding sensitivity analysis, the net impact of a
10% increase in the forward commodity curves for electricity and fuel would
benefit pre-tax income by approximately $9 million. A 10% decrease in the
forward commodity curves for electricity and fuel would result in a net decrease
to pre-tax income of approximately $8 million.
Firm Gas Sales Derivative Instruments - Regulated Utilities: We use derivative
financial instruments to reduce the cash flow variability associated with the
purchase price for a portion of future natural gas purchases associated with our
Gas Distribution operations. The accounting for these derivative instruments is
subject to SFAS 71 "Accounting for the Effects of Certain Types of Regulation."
Therefore, changes in the fair value of these derivatives have been recorded as
a regulatory asset or regulatory liability on the Consolidated Balance Sheet.
Gains or losses on the settlement of these contracts are initially deferred and
then refunded to or collected from our firm gas sales customers consistent with
regulatory requirements.
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The following table sets forth selected financial data associated with these
derivative financial instruments that were outstanding at March 31, 2004.
- ---------------------------------------------------------------------------------------------------------------------------------
Year of Volumes Floor Ceiling Fixed Current Fair Value
Type of Contract Maturity mmcf ($) ($) Price ($) Price ($) ($000)
- ---------------------------------------------------------------------------------------------------------------------------------
Options 2004 2,310 4.50 - 5.25 4.76 - 6.00 - 5.11 - 6.19 309
2005 1,520 4.50 - 5.25 5.00 - 6.00 - 5.30 - 6.44 285
Swaps 2004 13,900 - - 5.44 - 5.59 5.11 - 6.19 8,976
2005 15,440 - - 5.60 - 5.64 5.30 - 6.44 8,873
- ---------------------------------------------------------------------------------------------------------------------------------
33,170 18,443
- ---------------------------------------------------------------------------------------------------------------------------------
See Note 4 to the Consolidated Financial Statements "Hedging and Derivative
Financial Instruments" for a further description of all our derivative
instruments.
Item 4. Controls and Procedures
KeySpan maintains "disclosure controls and procedures", as such term is defined
under Exchange Act Rule 13a-15(e), that are designed to ensure that information
required to be disclosed by KeySpan in the reports it files or submits under the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms, and that such information
is accumulated and communicated to KeySpan's management, including its Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure.
An evaluation of the effectiveness of KeySpan's disclosure controls and
procedures as of March 31, 2004 was conducted under the supervision and with the
participation of KeySpan's Chief Executive Officer and Chief Financial Officer.
Based on that evaluation, KeySpan's Chief Executive Officer and Chief Financial
Officer have concluded that KeySpan's disclosure controls and procedures were
adequate and designed to ensure that material information relating to KeySpan
and its consolidated subsidiaries would be made known to the Chief Executive
Officer and Chief Financial Officer by others within those entities,
particularly during the periods when periodic reports under the Exchange Act are
being prepared. Furthermore, there has been no change in KeySpan's internal
control over financial reporting, identified in connection with the evaluation
of such control, that occurred during KeySpan's last fiscal quarter that has
materially affected, or is reasonably likely to materially affect, KeySpan's
internal control over financial reporting. Refer to the Certifications by
KeySpan's Chief Executive Officer and Chief Financial Officer filed as exhibits
31.1 and 31.2 to this report.
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PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings
See Note 6 to the Consolidated Financial Statements "Financial Guarantees and
Contingencies".
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1*Certification of the Chairman and Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*Certification of the Executive Vice President and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*Certification of the Chairman and Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
32.2*Certification of the Executive Vice President and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(b) Reports on Form 8-K
In our report on Form 8-K dated February 5, 2004, we reported that KeySpan had
issued a press release concerning, among other things, consolidated earnings for
the year ended December 31, 2003.
- ----------------------
*Filed Herewith
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KEYSPAN CORPORATION AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on behalf of the undersigned
there unto duly authorized.
KEYSPAN CORPORATION
(Registrant)
Date: April 30, 2004 /s/ Gerald Luterman
-----------------------------
Gerald Luterman
Executive Vice President
and Chief Financial Officer
62