MD&A
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Executive Summary
In support of our goals for 2007, we focused our efforts around five key operating priorities as discussed below.
Marketing and customer retention investments in distribution operations and retail energy operations
We targeted overall net customer growth rates for our distribution operations business in the range of 1% to 1.5%. In each of our utility service areas, we implemented targeted marketing and growth programs aimed at emphasizing natural gas as the fuel of choice for customers and expanding the use of natural gas through a variety of promotional activities. In 2007, we grew our average customer count by approximately 21,000, a 0.9% increase as compared to last year. While this increase is slightly below our targeted range, the increase in the growth rate is an improvement over our relatively flat customer growth in 2006. Last year we had slower customer growth coming out of the winter heating season due in part to much higher natural gas prices, warmer weather and a higher average customer attrition rate of 1.9% in 2006 as compared to 1.2% in 2007, which reflects a 37% improvement. Our customer growth rate was negatively impacted by the downturn in the housing market during 2007; factors which are expected to continue to have a negative impact on customer growth in 2008. We continue to focus significant efforts in our distribution operations business on improving our net customer growth trends, despite the overall economy and the industry-wide challenges of rising natural gas prices, competition from alternative fuels and declining natural gas usage per customer.
These factors also impact customer growth at SouthStar where we are also focused on similar customer growth initiatives. We will continue to enter new markets and improve the overall profitability of its customers through a variety of enhancements to existing, and the implementation of new, product offerings and pricing plans. In 2007, SouthStar grew its average customer count by approximately 7,000 or a 1.3% increase over last year.
Return to normal weather and usage patterns
In 2007, we saw average customer usage patterns related to natural gas price and weather conditions return to levels more consistent with historical averages. As the weather grew colder, compared to last year, and moved closer to 10-year average weather patterns primarily in Maryland, New Jersey and Virginia, we saw the conservation that occurred a year ago largely reverse itself and return to expected levels. Due to these factors, coupled with our targeted marketing and growth programs mentioned above, our overall throughput in 2007 at distribution operations increased 1% as compared to prior year and 3% at SouthStar for its customers in Georgia. While we saw these improvements in throughput and weather that was colder than last year by 10% in Maryland, 17% in New Jersey and 6% in Virginia, weather did not completely return to normal and consequently our earnings continue to be negatively impacted by warmer-than-normal weather. We attempt to stabilize and mitigate the impact to our earnings due to weather through hedging activities at SouthStar and through WNA regulatory mechanisms in distribution operations. While our hedging activities in 2007 at SouthStar largely offset the negative impact to earnings due to weather that was warmer than normal, distribution operations earnings were negatively impacted by $9 million due to weather that was warmer than normal and because the WNA regulatory mechanisms did not completely offset the negative impact to earnings from decreased consumption resulting from the warmer weather. These WNA regulatory mechanisms are most effective in reasonable temperature ranges relative to normal weather using historical averages due in part to their inherent design but also due to customer consumption patterns that are affected by weather conditions other than temperature. These other weather conditions include wind, cloud cover, precipitation and the duration of colder weather, among others, that are not captured in weather normalization adjustments, which are based primarily on average temperatures.
There are a number of legislative and regulatory proposals to address greenhouse gas emissions such as carbon dioxide, which are in various phases of discussion or implementation. We continue to actively monitor these proposals and discussions because the results could negatively impact our operations through reduced demand for natural gas and increased costs to our business. While we are unable to predict the outcome and quantify any impacts from these discussions and proposals at this point, we are active in promoting natural gas as the cleanest and most efficient burning fossil fuel with the lowest carbon content as compared to oil and coal.
Volatility in wholesale markets
Lower volatility in the natural gas markets, as compared to last year, has limited Sequent's asset optimization and arbitrage opportunities to generate operating margin in 2007. An important component of Sequent's business is its ability to capture operating margin based on seasonal and locational spreads, both of which were significantly reduced in 2007 as compared to 2006. We continue to expect less volatility in the natural gas markets and, therefore, we expect Sequent's abilities to capture economic value from asset optimization and arbitrage opportunities to be more consistent with those captured in 2007 as opposed to 2006 and 2005.
Operational efficiency and cost control
We continue to focus on operating our business as efficiently as possible, especially within our distribution operations and corporate segments through control of our operating costs. One of the key metrics we monitor in distribution operations is our operation and maintenance expenses per customer that was $145 per customer for 2007 as compared to $156 per customer in 2006, a 7% decrease year-over-year. This decrease was largely driven by a decrease in incentive compensation for employees at distribution operations and corporate as compared to last year due to lower payouts resulting from lower earnings per share in 2007 as compared to our AIP earning per share goals. Additionally in 2006 our earnings per share results were at the top end of the goals under the AIP, resulting in higher incentive compensation for 2006.
We further utilize outside vendors to assist us with the execution of business processes that are ancillary to our delivery of natural gas and related to the performance of basic business functions. This allows us to control operating costs, increase the efficiency through which these functions are executed and improve our service levels to customers. Most recently, we partnered with third parties in India to provide certain call center operations, as well as certain support functions related to information technology, finance, supply chain and engineering.
New market growth and regulatory opportunities
The four previous operating priorities require us to actively and continuously monitor the emerging issues and trends within our current operations and industry to allow us to take advantage of opportunities that complement and add value to our existing business operations. In 2007, we continued to expand Sequent's operations into the western United States and Canada, as well as SouthStar's operations into Ohio and Florida. Further, in October 2007, we acquired and have included within our wholesale services operating segment Compass Energy, which has enabled us to serve a broader geography of commercial and industrial customers. Additionally, we continued to focus our efforts around our storage business, particularly our Golden Triangle Storage underground natural gas storage project. We achieved a significant milestone in this project at the end of 2007 as the FERC issued an order granting a Certificate of Public Convenience and Necessity to construct and operate the underground storage project and approving market-based rates for the services Golden Triangle Storage will provide. In January 2008, we accepted the FERC's certificate and expect construction to begin in the first half of 2008.
In distribution operations, we were also successful with certain regulatory initiatives that are critical to the fundamentals of our business as they help to preserve the long-term success and earnings potential of our utility businesses. In September 2007, we received approval from the Georgia Commission on our capacity supply plan in Georgia, and a key part of that agreement was the ability to diversify our supply sources by gaining more access to the Elba Island LNG facility. As a result, we have negotiated an agreement with SNG to obtain an undivided interest in pipelines connecting our Georgia service territory to the Elba Island LNG facility and have filed a joint application with the FERC for approval of the project, which is expected to cost $22 million. In October 2007, the Georgia Commission approved the extension of the asset management agreement between Sequent and Atlanta Gas Light through March 2012. We are actively working with the respective commissions to renew or amend the existing agreements set to expire in 2008 in our other jurisdictions.
In September 2007, the Virginia Commission approved Virginia Natural Gas' WNA rider for commercial customers that applies to the 2007 and 2008 heating seasons. In Florida, we received approval from the Florida Commission in December 2007 to include the amortization of certain components of the purchase price we paid for Florida City Gas in our return on equity calculation for regulatory reporting purposes. Additionally, the Florida Commission's approval included provisions for a five-year stay out. As a result, Florida City Gas' base rates will not change during this period, except for unforeseen events beyond our control and the Florida Commission initiating base rate proceedings.
In November 2007, Elkton Gas filed a base rate case with the Maryland Commission requesting a rate increase of less than $1 million. Starting in 2009 through 2011, we will be required to file base rate cases for Atlanta Gas Light, Virginia Natural Gas, Elizabethtown Gas and Chattanooga Gas. While we are unable to predict the outcome of these base rate proceedings, we will focus on incorporating and potentially proposing regulatory solutions into our base rate filings for many of the areas related to our key operation priorities as well as other emerging issues and trends impacting our utilities.