North American Diversified Natural Gas Transmission And Distribution Companies

Transcription

1 Rating Methodology March 2007 Contact Phone New York Mihoko Manabe, CFA Edward Tan Steven Wood John Diaz Toronto Allan McLean North American Diversified Natural Gas Transmission And Distribution Companies Summary The purpose of this methodology is to provide investors and other interested parties with a clear understanding of how Moody's assigns ratings to North American diversified natural gas transmission and distribution companies ("diversifieds"). Our goal is to help the market understand the factors that we consider most important for this sector and how they map to specific rating outcomes. Readers should be able to use this report to gauge a company's ratings within two notches. The common characteristic of these companies is that their core business activity is the ownership of regulated natural gas distribution and transmission assets. The companies also have diversified energy activities that are upstream or downstream of the core natural gas distribution and transmission business. These diversified activities include oil and gas exploration and production, gas gathering and processing, and marketing and trading of natural gas. The rate-regulation of the core assets plays a critical role in lowering business risk and enabling the majority of these companies to obtain investment grade ratings despite leverage that is higher than average for investment grade companies in other sectors. Moody's analysis of the companies in this sector focuses on four main rating factors: 1. Scale 2. Quality of Diversification 3. Management Strategy and Financial Policy 4. Financial Strength Moody's also analyzes other factors that are common across all industries, such as ownership, liquidity, legal structure, and position in the corporate organization. We note that from time to time a company's performance on a specific factor will fall outside the expected range for a company of its rating level. These companies are categorized as "outliers" for that rating factor. A "positive outlier" would be a company whose performance on a given factor is better than its final, assigned rating would indicate. A "negative outlier" would be one whose performance for a specific factor is worse than its assigned rating would otherwise indicate. We will discuss the reasons for significant outliers.

2 ABOUT THE RATED UNIVERSE All of the rated companies in this sector are located in the U.S. and Canada. The methodology covers 21 companies, which have rated debt totaling $102 billion. The companies in this grouping are heterogeneous, engaging in various combinations of regulated natural gas transmission and/or distribution in addition to other diversified activities. What the diversifieds all have in common is a regulated gas business that constitutes the core of the company. Diversified activities often include segments (such as oil and gas production (E&P), gas gathering and processing (G&P), and energy marketing) that can integrate vertically with the regulated segments. In some cases these activities might also include regulated activities that are not gas-related, such as crude oil and petroleum product transportation. Diversified companies also differ in their position in the corporate organization, which is a rating consideration. The majority are holding companies that conduct all through subsidiaries: Questar, Consolidated Natural Gas, Peoples, Enbridge, Keyspan, National Fuel, Spectra Energy, Vectren Utility Holdings, Energen, NiSource, Williams, and El Paso. Most of the rest are utility parent companies: Equitable Resources, TransCanada PipeLines, MDU, Kinder Morgan, ONEOK, CenterPoint Energy Resources, Enogex, Atmos, and Southern Union. A few are subsidiaries of other companies: Consolidated Natural Gas, CenterPoint Energy Resources, Vectren Utility Holdings, Peoples. This methodology is one of three recently published rating methodologies for companies in the largely regulated natural gas industry. Moody's published rating methodologies for the local gas distribution companies (LDCs) and gas transmission companies (pipelines) in Many of the rated LDCs and pipelines are subsidiaries of the diversifieds. Please refer to our rating methodologies on LDCs, pipelines, and independent E&P companies for more detail on these businesses, which together comprise the diversifieds' major business lines. Rated Companies Issuer Rating (1) Outlook Country of Domicile Equitable Resources, Inc. A2 Review United States TransCanada PipeLines Ltd. A2 Stable Canada Questar Corp. P-2 (2) Stable United States Enbridge Inc. A3 Review Canada Keyspan Corporation A3 Review United States MDU Resources Group, Inc. A3 (3) Stable United States Spectra Energy Capital Baa1 Stable United States Consolidated Natural Gas Co. Baa1 Stable United States Vectren Utility Holdings, Inc. Baa1 Stable United States National Fuel Gas Company Baa1 Stable United States Energen Corporation Baa2 Stable United States Kinder Morgan, Inc. Baa2 Review United States ONEOK, Inc. Baa2 Stable United States Peoples Energy Corporation Baa2 (4) Stable United States CenterPoint Energy Resources Corp. Baa3 Stable United States Enogex Inc. Baa3 Stable United States Atmos Energy Corporation Baa3 Stable United States NiSource Inc. Baa3 Stable United States Southern Union Company Baa3 Negative United States The Williams Companies, Inc. Ba2 (5) Stable United States El Paso Corporation B2 (5)(6) Positive United States (1) Senior Unsecured Rating unless indicated otherwise (2) Questar does not have a long-term debt rating. The company has a Prime-2 short-term rating for commercial paper. For illustrative purposes for the charts and tables in this rating methodology, we have shown Questar as A3, one notch below the ratings of its regulated subsidiaries. (3) Issuer Rating (4) Peoples' senior unsecured rating of A3 reflects the guarantee of Integrys Energy Group, Inc., which acquired it in 2/07. For illustrative purposes for the charts and tables in this rating methodology, we have shown Peoples as Baa2, its rating prior to the acquisition and reflecting its pre-merger standalone credit quality. (5) Parent-level Corporate Family Rating (6) El Paso' Corporate Family Rating was upgraded to Ba3 in 3/07. For illustrative purposes for the charts and tables in this rating methodology, we have shown El Paso as B2, its rating prior to the upgrade and reflecting its historical credit quality. 1. Rating Methodology: North American Regulated Gas Distribution Industry (Local Distribution Companies), October 2006; Rating Methodology: North American Natural Gas Pipelines, December Moody s Rating Methodology

3 The wide range of ratings for the sector reflects significant differences in the degree of business risk that result from differences in asset mix. The companies are almost all investment grade with an average rating of Baa2, reflecting the stable nature of their core regulated businesses. The two non-investment grade exceptions are Williams and El Paso, which are recovering after a period of financial distress. Diversified Natural Gas Long Term Debt Ratings (21 Companies in Total) 8 7 Number of Companies A1 A3 Baa2 Ba1 Ba3 B2 Caa1 Current Rating Includes P-2 rating of Questar, Issuer Rating of MDU, Baa2 rating for Peoples, parent-level Corporate Family Ratings of Williams and El Paso Industry Overview Two key factors for the credit ratings of North American diversifieds are the nature of the regulatory environment in which they operate and the business risks of their businesses. Regulated rates provide a high degree of margin certainty. This is the fundamental credit strength of the diversifieds as it results in cash flow stability for the diversifieds' regulated. Low business risk - which is defined by a focus on the core utility business - can promote ratings stability. Among the peer group companies, business mix and related business risk (which accounts for 20% of the rating) vary significantly. We note that diversifieds are more leveraged than similarly-rated companies operating entirely in competitive industries. This is offset, however, by the stability of their cash flows and the low business risk of their regulated. Natural Gas Value Chain Exploration & Production Gathering & Processing Transmission & Storage Distribution Marketing Upstream Midstream Downstream Moody s Rating Methodology 3

4 INDUSTRY FRAMEWORK The natural gas industry has built a well developed infrastructure to gather, process, and deliver natural gas. In North America, this structure primarily developed around the domestic gas supply. Exploration and production (E&P) is "upstream" in the natural gas value chain. The "midstream" segment comprises small-diameter pipes that take the gas at the well head (the gathering and processing function or "G&P") and larger pipelines that take the gas to market. LDCs that distribute the gas to the consumer are "downstream." Diversified companies engage in some or all of these functions and in ancillary services that support them. In the U.S., the infrastructure tends to be regional, so the entire nation does not rely heavily on any single portion. In Canada, two companies -- TransCanada and Enbridge -- own critical components of Canada's energy supply. REGULATION The transportation and distribution of natural gas tends to be a regulated activity. North American LDCs and pipelines are defined by several features including: A stable regulatory framework (with a patchwork of local regulation for the LDCs and federal regulation for pipelines) A history of being unbundled (pipelines only) 2 A low likelihood of comprehensive change in the regulatory framework for the foreseeable future Highly individualized, company-specific rate mechanisms Limited use of formula-based rates A legacy of private (versus government) ownership Interstate gas pipelines are regulated federally. Federal regulation provides very limited support to the credit ratings of diversifieds' regulated pipeline subsidiaries. This regulation takes a broad, national perspective and is generally light-handed. Although this light-handed approach makes pipelines less exposed to adverse regulatory action than LDCs, it provides limited scrutiny that may serve to insulate the pipelines' credit quality. For this reason, pipeline subsidiaries tend to hold ratings that are closer to those of their diversified parent companies than do their sister LDC subsidiaries. Conversely, LDCs are usually governed at the state or provincial level. They are subject to closer regulatory scrutiny and are subject to more restrictions that limit risk-taking. This helps to protect the integrity of LDCs' credit and contribute to LDC ratings that, on average, are higher (A3) than those of the diversifieds (Baa2). As a result, the supportiveness of the regulatory framework and rate design weigh more heavily in our credit assessment of LDCs. BUSINESS RISK The stability of the diversifieds' core LDC and pipeline activities contributes to a lower business risk profile that allows them to sustain more leverage than industrial companies at the same rating level. Specifically, LDCs and pipelines earn regulated rates that lend predictability to their cash flows. In addition, these businesses employ relatively low-tech, long-lived assets and are characterized by low rates of technical innovation. As a result, these activities tend to be relatively predictable, albeit these businesses require significant capital expenditures. Further, these businesses tend to be less cyclical than that of non-regulated corporates. As regulated monopolies, LDCs and pipelines generally face limited competition and their creditworthiness benefits from varying degrees of protection from regulatory oversight and restrictions. The LDCs' business is seasonal and subject to weather variations, but these fluctuations are more muted than those in competitive industries. Although the downside is limited for LDCs and pipelines, so is the upside. Returns are modest. The average ROE for is 9% for LDCs and 11% for pipelines. The regulatory framework prevents a regulated company from earning much above its allowed returns for long. Because these businesses are generally mature and offer limited growth, companies often diversify into other businesses that promise a higher return, albeit at higher risk. Generally, diversification is into a business within the natural gas value chain and related to the company's core regulated business. For example, E&P and G&P are the most common areas of diversification. About half of the companies in this peer group engage in E&P. Our credit assessment of the E&P business is shaped by the fact that the assets are finite, depleting resources that are subject to unpredictable commodity prices. To be successful and remain in business, an E&P company must reinvest substantial capital each year to find new oil and 2. Pipelines were removed from the gas sales function in the 1990's and now serve only a delivery function. Unbundling among LDCs is not industry-wide. 4 Moody s Rating Methodology

5 natural gas reserves and replace production 3. Because of these risks, the average rating on pure independent E&P companies is Ba2, significantly lower than those for LDCs and pipelines. Most diversifieds, particularly those with E&P, also have G&P. These are usually small, ancillary services for larger E&P affiliates. Other G&P serve mainly third parties and are revenue centers in their own right. These G&P tend to contribute more to earnings when natural gas liquids (NGL) prices are higher, and in some cases, when natural gas prices are higher. G&P is a relatively volatile business that is commodity price-sensitive. With much of its use for the petrochemical and refining industries, demand for processing products reflects economic cycles. Profitability is also affected by fluctuations in the price for alternative feedstocks. LEGAL STRUCTURE Most diversifieds are parent companies. A few are subsidiaries of other companies. Notching practices reflect the legal structure and structural subordination. Notching between the holding company and its regulated subsidiary depends on the regulated subsidiary's proportionate value to the organization, the type of legal organization, the type of regulation and degree of ring-fencing, the significance and risk of the businesses, and inter-company cash management practices. Key Rating Issues Going into the Next Decade NATURAL GAS PRICE VOLATILITY Natural gas prices are becoming more volatile. Gas prices present different opportunities and challenges for each of the diversifieds' business lines. High gas prices spur drilling activity and raise the diversifieds' E&P and G&P revenues. Cyclical, price-related effects on those businesses' financial results, however, should not affect ratings, as the ratings already incorporate an expected range of financial performance through the price cycle. CHALLENGES IN E&P INVESTING E&P companies face the prospect of declining production volumes in mature basins such as the Lower 48 in the U.S. and the Western Canadian Sedimentary Basin. In conjunction, finding and development (F&D) costs are rising as it becomes increasingly difficult to replace hydrocarbon reserves. Companies are drilling in deeper, more complex wells using modern, expensive techniques to find and extract reserves. Acquisition valuations have gone up, and so have operating costs, the latter because of increased demand for oilfield supply and services. The net result: despite higher prices, the projected return on investment - as measured by the leveraged full-cycle ratio - has not increased meaningfully for companies engaged in E&P 4. HEDGING ISSUES Moody's considers price hedging of E&P production to be a conservative business practice that protects against falling prices. However, when prices rise, highly hedged companies may miss out on much of the upside, while their costs will rise as a result of strong market conditions. MEDIUM-TERM GAS INFRASTRUCTURE CONSTRUCTION ACTIVITY A resurgence of drilling activity in mature basins and development activity in frontier areas are stimulating the construction of new gas pipeline and handling facilities. Big-ticket greenfield projects could pressure credit metrics during construction. However, such projects are not likely to affect ratings if the new capacity is fully contracted under firm long-term contracts with creditworthy shippers. LDC ISSUES RELATED TO CONSERVATION AND RATE DESIGN High gas prices have a negative financial impact on LDCs by increasing bad debt expense and consumer conservation. Per-customer usage continues to show a secular decline as a result of energy efficient homes and appliances. More LDCs are applying for appropriate rate design changes, but it will take time to first build the necessary understanding and support at the grassroots level. Rate designs that compensate LDCs for margin losses attributable to variations in gas consumption (because of weather variations or customer conservation) help to stabilize credit metrics and credit ratings. 3. Please refer to Moody's Rating Methodology: Global Independent Exploration and Production (E&P) Industry, October Moody's Rating Methodology: Global Independent Exploration and Production (E&P) Industry, October 2005, pages 5-6. Moody s Rating Methodology 5

6 In This Methodology Moody's rating methodology for the diversifieds includes the following steps: IDENTIFICATION OF THE KEY RATING FACTORS The four key rating factors used in Moody's approach to rating the diversifieds are as follows: 1. Scale 2. Quality of Diversification 3. Management Strategy and Financial Policy 4. Financial Strength These factors are critical to the analysis of the diversifieds and, in most cases, can be benchmarked across the industry. The discussion begins with a review of each factor and an explanation of its importance to the rating. Additional factors that apply more generally to most companies (as opposed to only this sector) are explained near the end of this report. These include ownership, liquidity, legal structure, and position in the corporate organization. MEASUREMENT OF THE KEY RATING FACTORS We next explain the metrics or sub-factors that we use to define each of the four rating factors. These measurements are quantitative where we can define an appropriate metric. However, for some factors, qualitative judgment or empirical observation is necessary to determine the appropriate category. The weighting for the factors and sub-factors are as follows: 1. Scale: 10% of the overall methodology indicated rating Total Assets: 5% of the overall rating Net Profit After-Tax Before Unusual Items (NPATBUI): 5% of the overall rating 2. Quality of Diversification: 20% of the overall methodology indicated rating Scale of Unregulated Exposure: 10% of the overall rating Degree of Business Risk: 10% of the overall rating 3. Management Strategy & Financial Policy: 10% of the overall methodology indicated rating 4. Financial Strength: 60% of the overall methodology indicated rating EBIT/Interest Expense: 15% of the overall rating Debt/Book Capitalization (Excluding Goodwill): 15% of the overall rating Retained Cash Flow/Debt: 15% of the overall rating Return on Equity: 15% of the overall rating MAPPING FACTORS TO THE RATING CATEGORIES Each company is mapped to an indicated rating based upon its performance on each sub-factor and each factor. For each of the nine sub-factors, we describe appropriate ranges for Moody's broad rating categories, i.e., A and above, Baa, Ba, B and Caa. For example, we specify what level of retained cash flow/debt is generally acceptable for an A credit versus a Baa credit. We provide a range or description for each of the measurement criteria. We next score each company by rating level on each of the factors. For instance, a company may score at the "A" level for "Quality of Diversification" and at the "B" level for "Financial Strength." If a simple average of just those two factors was applied, the rating would be Baa. OUTLIER DISCUSSION We recognize that any given company may perform higher or lower on a specific factor than its actual rating level would otherwise indicate. We highlight companies with sub-factor or factor mapping that is 2 or more rating categories higher or lower than the rating and offer a discussion of the general reasons for outliers within a given factor. Applying the sub-factor weightings and scoring the rating assignment for each sub-factor in this manner results in ratings that track our assigned ratings within one or two notches for all of the companies in this methodology. The results of our mapping appear in Appendix B of this report, as well as in the results section under each factor. 6 Moody s Rating Methodology

7 DETERMINING THE METHODOLOGY INDICATED RATING To determine the overall rating, each of the 9 assigned sub-factor ratings is converted into a numeric value based on the following scale: Ratings Scale Each sub-factor's numeric value is multiplied by an assigned weight and then summed. The total sum of the factors is then mapped to the ranges specified in the table below, and the indicated alpha-numeric rating is determined based on where the total score falls within the ranges shown. NOTES ON OUR MEASUREMENT APPROACH This methodology report includes financial ratios derived from publicly and privately reported financial statements using Moody's standard analytical adjustments. 5 Moody's ratings are forward looking and consider future expectations for company performance as well as historical information. While the rating process also makes use of anticipated financial results, the presentation for illustrative purposes in this document relies primarily upon historic data for a three year period. Key Rating Factors Aaa Aa A Baa Ba B Caa Factor Numerics Composite Rating Sub-Factor Rating Indicated Rating Aggregate Weighted Factor Score Indicated Rating Factor Score Aaa < 1.5 Aaa 1 Aa1 1.5 <2.5 Aa2 2.5 <3.5 Aa 3 Aa3 3.5 <4.5 A1 4.5 <5.5 A2 5.5 <6.5 A 6 A3 6.5 <7.5 Baa1 7.5 <8.5 Baa2 8.5 <9.5 Baa 9 Baa3 9.5 <10.5 Ba <11.5 Ba <12.5 Ba 12 Ba <13.5 B <14.5 B <15.5 B 15 B <16.5 Caa <17.5 Caa <18.5 Caa 18 Caa3 >18.5 FACTOR 1) SCALE Scale generally correlates highly with ratings in this sector. Larger companies are generally more broadly diversified, which can reduce volatility and lower credit risk. Larger companies benefit from greater financial resources, liquidity, and economies of scale Positive Rating Indicators Total assets of over $5 billion Annual NPATBUI of over $300 million 5. Please see Moody's Approach to Global Standard Adjustments in the Analysis of Financial Statements for Non-Financial Corporations - Part I, February 2006 Moody s Rating Methodology 7

8 Measurement Criteria Total assets at the most recent reporting date Average of the last three years' annual NPATBUI Notes on Measurement Criteria The most recent period-end total assets serve as the latest publicly-available gauge of a company's scale. In most cases, the average of the last three years' net income before unusual items is a reasonable indication of a company's earnings power. Averaging reduces reliance on any one period, which could be affected by unusual events or market conditions. Criteria for Mapping Factor 1: Scale Sub-factor Weighting Aaa Aa A Baa Ba B Caa Factor 1: Scale (10% weighting) Total Assets (US$B) 5.0% >$11 $8-$11 $5-$8 $3-$5 $2-$3 $1-$2 <$1 NPATBUI (US$MM) 5.0% >$700 $500-$700 $300-$500 $100-$300 $50-$100 $0-$50 <$0 Results of Mapping Factor 1: Scale Factor 1: Scale Issuer Current Ratings Indicated Ratings for Factor 1 Total Assets NPATBUI Sub-Factor Weights 5% 5% Equitable Resources, Inc. A2 Baa Baa Baa TransCanada PipeLines Ltd. A2 Aaa Aaa Aaa Questar Corp. P-2 Baa Baa Baa Enbridge Inc. A3 Aa Aaa A Keyspan Corporation A3 Aa Aaa A MDU Resources Group, Inc. A3* A A Baa Spectra Energy Capital Baa1 Aaa Aaa Aaa Consolidated Natural Gas Co. Baa1 Aa Aaa Aa Vectren Utility Holdings, Inc. Baa1 Baa Baa Ba National Fuel Gas Company Baa1 Baa Baa Baa Energen Corporation Baa2 Baa Ba Baa Kinder Morgan, Inc. Baa2 Aa Aaa A ONEOK, Inc. Baa2 A Aa Baa Peoples Energy Corporation Baa2 Baa Baa Ba CenterPoint Energy Resources Corp. Baa3 A A Baa Enogex Inc. Baa3 Ba B Ba Atmos Energy Corporation Baa3 A A Baa NiSource Inc. Baa3 Aa Aaa A Southern Union Company Baa3 A A Baa The Williams Companies, Inc. Ba2** A Aaa Baa El Paso Corporation B2** Baa Aaa Caa *Issuer Rating **Parent-level Corporate Family Rating Positive Outlier Negative Outlier Observations and Outliers There are no negative outliers for the Net Income sub-factor and only one (Enogex) for the Total Assets sub-factor. The positive outliers for both the Net Income and Total Asset sub-factors are Spectra Energy Capital and TransCanada. Their strong performance overall on this factor is offset by a weaker performance on Factor 4 (Financial Strength) due to relatively weak financial metrics. 8 Moody s Rating Methodology

9 This balance between a strong performance on the Total Assets sub-factor and a weaker performance on Factor 4 also exists for most of the larger companies: Enbridge, Keyspan, Kinder Morgan, NiSource, Williams, and El Paso. Conversely, Enogex, the sole negative outlier in terms of Total Assets, balances smaller size against stronger financial metrics. We note that the use of three-year historical average figures is less meaningful for several companies that have changed significantly during that period, and whose ratings more heavily reflect their current and near-term forecasted performance. Most notable are Southern Union and Kinder Morgan, which made major acquisitions that altered their credit profiles during the three-year period. Other exceptions are Williams and El Paso, whose credit profiles are recovering after a period of financial distress. In such cases, a rating committee might vary the range of years used for this factor or rely more heavily upon our expectations for future performance to best reflect an evolving credit situation. FACTOR 2) QUALITY OF DIVERSIFICATION Why It Matters Unsuccessful diversification into businesses that are riskier than the stable and largely regulated core transmission and distribution activity has been a factor in many downgrades in this sector. The "Quality of Diversification" factor measures and ranks the degree of business risk. This factor is divided into two sub-factors: "Scale of Unregulated Exposure" and "Degree of Business Risk." Scale of Unregulated Exposure This quantifies the degree of exposure to businesses. For most diversifieds, businesses comprise a minor portion of assets and earnings. However, issuers with greater exposure to businesses will have more volatile performance and greater credit risk in comparison to more stable regulated activities. This methodology uses operating income as a percentage of total operating income, or alternatively, assets as a percentage of total assets, as a measure for the scale of exposure. Degree of Business Risk Diversifieds typically diversify into businesses that are upstream or downstream of their core natural gas distribution and transmission business: E&P, G&P, and energy marketing. As shown in the chart, these businesses present varying degrees of business risk. Thus, we seek to determine the relative risk level of activities as well as the scale of these activities. Business Risk Spectrum Distribution Transmission Gathering & Processing Exploration & Production Trading & Marketing Positive Rating Indicators Least Risky LDC and pipelines account for the majority of operating income Relatively high allowed rates of return and supportive regulatory relationships Minimal, if any, exposure to G&P or any other diversified business Most Risky Measurement Criteria The higher of: assets/total assets or operating income/total operating income. For regulated business segments, all assets and operating income are considered to be regulated for this calculation. For business segments, all assets and operating income are considered to be for this calculation. Business risk indicated by the model rating according to the Moody's methodology for the company's major businesses (LDC, pipeline, and/or E&P) Percentage of G&P volumes and margins from keep-whole processing contracts Moody s Rating Methodology 9

10 Notes on Measurement Criteria Moody's maps ratings on this factor in accordance with each company's business risk spectrum. Higher exposure to riskier businesses is correlated to lower ratings. When a model-derived rating is available under a published rating methodology 6, Moody's will use it to compare the of the diversified against rated pure-play companies and will refer to the model outcome when ranking the company under this sub-factor. The mapping grid for the Quality of Diversification factor considers that LDCs and gas pipelines are low risk businesses that improve the overall risk profile of a diversified company. When the benefits of diversification (limited performance correlation) are factored in, the improvement in business risk is greater than would be indicated by the score of these business segments on a stand-alone basis under the LDC and pipeline methodologies. For example, a score in the A category under the LDC methodology results in a mapping of Aa for the Degree of Business Risk sub-factor under factor 2 the Quality of Diversification. LDCs: Generally speaking, LDCs have the lowest business risk. This is attributable to their high degree of regulation. Interstate gas pipelines: Interstate gas pipelines fall next on the spectrum because they are more lightly regulated, less ring-fenced from their affiliates, and often face more competition. In the mapping grid, the above regulated businesses could range from Aaa to A depending on the level of returns, regulatory support, and attractiveness of the service territory (as defined in Moody's rating methodologies for LDCs and pipelines). Such industry-specific factors as they map under the LDC and pipeline methodology will be used for the Degree of Business Risk sub-factor, if there are no businesses of meaningful size. Gathering & Processing: Exposures to G&P can range from A to Caa. Mapping here depends on Moody's assessment of the quality of the and financial performance. This includes a determination of the level of gas processing activity, and if that is significant, exposure to keep-whole processing contracts. For example, we would view a G&P operation more favorably if it has established a competitive position in a long-lived or growing basin. We also view favorably a lack of keep-whole processing contracts or keepwhole processing contracts with terms that mitigate keep-whole risk. We view less favorably small G&P in which production is declining, competition is high, and keep-whole exposure is significant. E&P : We assess the business risk of a diversified's E&P on the mapping grid from Moody's E&P rating methodology. If a diversified engages in E&P, it is normally its riskiest business. Consequently, the rating outcome for this sub-factor is based upon the rating under the E&P methodology, even if the company also has other businesses. Compared to G&P which is also sensitive to price and volume, E&P in general has higher risk because of its greater capital reinvestment requirements. G&P businesses have greater flexibility to cut capital spending, which helps them weather adverse price environments. Oftentimes, diversifieds' businesses are smaller, compare less favorably against pure-play companies, and would not likely be rated investment grade on a standalone basis. For example, Moody's independent E&P peer group has an average rating of Ba2. Because the E&P of diversifieds tend to be small and concentrated (scale and diversity of reserves account for 36% of the weighting in Moody's E&P rating methodology), many of these on a standalone basis would likely be of non-investment grade quality. To be rated investment grade under the E&P rating methodology, a company needs to have established E&P in a long-lived basin, a large acreage position that leads to economies of scale, a history of organic reserve replacement, and low full-cycle costs. Diversifieds may engage in other activities. When a Moody's rating methodology is available for that industry, we will use the model-derived rating. 6. Moody's has published rating methodologies for numerous industries. The most pertinent ones for the diversifieds are those for LDCs, pipelines, and independent E&P. 10 Moody s Rating Methodology

11 Criteria for Mapping Factor 2: Quality of Diversification Sub-factor Weighting Aaa Aa A Baa Ba B Caa Factor 2: Quality of Diversification (20% weighting) the higher % of the higher % of the higher % of the higher % of the higher % of the higher % of the higher % of Scale of Unregulate d Exposure Degree of Business Risk 10.0% Operating income from <20% of operating income. Operating income from between 20-30% of operating income. Operating income from between 30-40% of operating income. Operating income from between 40-50% of operating income. Operating income from between 50-60% of operating income. Operating income from >60% of operating income. Portfolio may evidence some stress that could lead to writedowns. Operating income from >60% of operating income. Significant losses evident in the portfolio. or or or or or or or Segment assets from <20% of segment assets. Segment assets from between 20-30% of segment assets. Segment assets from between 30-40% of segment assets. Segment assets from between 40-50% of segment assets. Segment assets from between 50-60% of segment assets. Segment assets from >60% of segment assets. Segment assets from >60% of segment assets. 10.0% Aaa-Aa in LDC and Pipe methodologies A-Baa in LDC and Pipe methodologies non-ig in LDC and Pipe methodologies gathering only Aaa-Baa in E&P methodology; gathering and processing; minimal keepwhole processing risk; large competitive position in long-lived/ growing basin; geographically diversified Ba in E&P methodology; gathering and processing; moderate keepwhole processing risk; good competitive position in long-lived/ growing basin; moderate geographic diversification B in E&P methodology; gathering and processing; significant keepwhole processing risk; average competitive position in average-lived/ mature basin; modest geographic diversification Caa in E&P methodology; gathering and processing; significant keepwhole processing risk; small, weak competitive position in short-lived/ declining basin; no geographic diversification Moody s Rating Methodology 11

12 Results of Mapping Factor 2: Quality of Diversification Factor 2: Quality of Diversification Scale of Unregulated Exposure Issuer Current Ratings Indicated Ratings for Factor 2 Sub-Factor Weights 10% 10% Equitable Resources, Inc. A2 Ba B Baa TransCanada PipeLines Ltd. A2 A Aa Baa Questar Corp. P-2 Ba B Baa Enbridge Inc. A3 A Aaa Baa Keyspan Corporation A3 A A Baa MDU Resources Group, Inc. A3* Ba B Baa Spectra Energy Capital Baa1 A Aa Baa Consolidated Natural Gas Co. Baa1 Ba B Baa Vectren Utility Holdings, Inc. Baa1 Aa Aaa Aa National Fuel Gas Company Baa1 Ba Baa B Energen Corporation Baa2 Ba B Baa Kinder Morgan, Inc. Baa2 A Aa Baa ONEOK, Inc. Baa2 Baa Ba Baa Peoples Energy Corporation Baa2 Ba Baa B CenterPoint Energy Resources Corp. Baa3 A Aa A Enogex Inc. Baa3 Ba B Ba Atmos Energy Corporation Baa3 Aa Aa A NiSource Inc. Baa3 Aa Aaa A Southern Union Company Baa3 A Aa Ba The Williams Companies, Inc. Ba2** B Caa Ba El Paso Corporation B2** Ba Baa Ba *Issuer Rating **Parent-level Corporate Family Rating Degree of Business Risk Positive Outlier Negative Outlier Observations and Outliers Positive outliers include NiSource, whose high proportion of regulated earnings and low business risk allows it to support a fairly leveraged financial position. Vectren Utility Holdings is a positive outlier that is purely regulated, and the "Degree of Business Risk" (mapping to Aa) reflects the low risk of these regulated utility activities. Atmos and Enbridge are positive outliers for the "Scale of Unregulated Exposure," reflecting the high proportion of these companies' business that is regulated. The high scores on this sub-factor are offset by scores on financial strength under Factor 4 that are lower than the ratings. National Fuel and Peoples are negative outliers under "Degree of Business Risk" because of the high business risk attributed historically to their E&P businesses. However, these lower scores are offset by a more favorable performance under the "Scale of Unregulated Exposure" sub-factor. FACTOR 3) MANAGEMENT STRATEGY & FINANCIAL POLICY Why It Matters Management's strategy and track record are meaningful for credit risk. The typical regulated gas business model offers stable baseline earnings from the regulated businesses, modest growth - either organic, via acquisitions, or via diversification -- and a steady dividend. In this sector, dividends tend to be a fixed cash requirement with pay-out levels that are higher than average for corporate issuers, leaving less flexibility to deal with fluctuations in cash flow or capital expenditure needs. In this sector, companies with a stated strategy to grow through acquisitions tend to be riskier than those that grow organically. Acquisition-related risk can also vary depending on whether a company is prone to making large and transforming acquisitions, if it is a serial acquirer or if has a weak record in integrating past acquisitions. 12 Moody s Rating Methodology

13 Measurement Criteria Relationship of acquisitions to existing business and management expertise Frequency and materiality of acquisitions (number of acquisitions made annually, the percentage change in earnings and total assets, change in mix of segment operating income) Proportion of capital expenditures for organic growth vs. acquisitions Frequency and materiality of write-downs (number of write-downs over five years, write-downs as percentage of earnings and equity) Degree to which acquisitions are funded with a substantial equity component Criteria for Mapping Factor 3: Management Strategy and Financial Policy Sub-factor Weighting Aaa Aa A Baa Ba B Caa Factor 3: Management Strategy & Financial Policy (10% weighting) Management Strategy & Financial Policy 10.0% Diversifies consistently in areas of inhouse expertise. Growth substantially organic. Excellent management track record for many yrs. Demonstrated commitment to having one of the highest ratings in the sector. Diversifies consistently in areas of inhouse expertise. Minor acquisition event risk. Good management track record for many years. Demonstrated commitment to having one of highest ratings in the sector. Strategic step-out possible occasionally, but w/proven ability to execute. Moderate acquisition event risk. Aboveaverage management track record for many yrs. Demonstrated commitment to A rating. Strategic step-out possible. Meaningful acquisition event risk. Transforming transaction possible. Average management track record over more than several years. Demonstrated commitment to minimal investment grade. Strategic step-out possible. Meaningful acquisition event risk. Belowaverage/short management track record. Write-downs indicate inadequate risk controls. No stated commitment or demonstrated record of issuing equity. Weak/very short management track record. Large writedowns raise potential for liquidity issues and restructuring. Questionable ability to issue equity. Poor management track record. Substantial write-downs likely to result in liquidity problems and restructuring. Unlikely access to new equity. Moody s Rating Methodology 13

14 Results of Mapping for Factor 3: Management Strategy and Financial Policy Factor 3: Management Strategy and Financial Policy Issuer Current Ratings Indicated Rating for Factor 3 Sub-Factor Weight 10% Equitable Resources, Inc. A2 Aaa TransCanada PipeLines Ltd. A2 A Questar Corp. P-2 Aa Enbridge Inc. A3 A Keyspan Corporation A3 Baa MDU Resources Group, Inc. A3* Aaa Spectra Energy Capital Baa1 Baa Consolidated Natural Gas Co. Baa1 Baa Vectren Utility Holdings, Inc. Baa1 Baa National Fuel Gas Company Baa1 Baa Energen Corporation Baa2 Baa Kinder Morgan, Inc. Baa2 Baa ONEOK, Inc. Baa2 Baa Peoples Energy Corporation Baa2 Baa CenterPoint Energy Resources Corp. Baa3 Ba Enogex Inc. Baa3 Baa Atmos Energy Corporation Baa3 A NiSource Inc. Baa3 Baa Southern Union Company Baa3 Ba The Williams Companies, Inc. Ba2** Baa *Issuer Rating **Parent-level Corporate Family Rating Positive Outlier Negative Outlier Observations and Outliers The "Management Strategy & Financial Policy" factor tracks actual ratings closely. Equitable and MDU are positive outliers. There are no negative outliers. The majority of the companies are assessed as "Baa" for this factor, which coincides with the Baa actual ratings for over half of the peer group. This is indicative of the tendency for companies in this sector to manage their financial policies around Baa1-Baa2 target levels, which provides some flexibility to diversify and to make large capital investments. FACTOR 4) FINANCIAL STRENGTH Why It Matters Credit metrics of regulated businesses are largely determined by the levels of capitalization and returns that regulators allow. Consequently, their earnings, returns, and capitalization ratios are highly predictable and correlate highly with ratings. Their financial leverage is higher and profitability more modest than similarly-rated industrial companies. Diversifieds also have businesses that result in less stable earnings and cash flow and which tend to be capitalized with less leverage than the regulated. Measurement Criteria EBIT/Interest Debt/Book Capitalization (excluding goodwill) Retained Cash Flow/Debt ROE 14 Moody s Rating Methodology

15 Criteria for Mapping Factor 4: Financial Strength Sub-factor Weighting Aaa Aa A Baa Ba B Caa Factor 4: Financial Strength (60% weighting) EBIT/Interest Expense 15.0% > 6X 5 to 6X 4 to 5X 3 to 4X 2 to 3X 1 to 2X < 1X Debt/Book Capitalization (Excluding Goodwill) 15.0% < 25% 25 to 35% 35 to 45% 45 to 60% 60 to 70% 70 to 80% > 80% Retained Cash Flow/Debt 15.0% > 40% 30 to 40% 20 to 30% 10 to 20% 6 to 10% 3 to 6% <3% Return on Equity 15.0% > 19% 16 to 19% 13 to 16% 10 to 13% 7 to 10% 4 to 7% < 4% Results for Mapping Factor 4: Financial Strength Factor 4: Financial Strength Indicated Ratings for Factor 4 EBIT / Interest Expense Debt / Book Capitalizatio n Retained Cash Flow / Debt Current Issuer Ratings Sub-Factor Weights 15% 15% 15% 15% Equitable Resources, Inc. A2 Aa Aaa A Baa Aaa TransCanada PipeLines Ltd. A2 Baa Ba Ba Ba A Questar Corp. P-2 Aa Aaa A Aaa Aa Enbridge Inc. A3 Baa Ba Ba Ba A Keyspan Corporation A3 Baa Baa Ba Baa A MDU Resources Group, Inc. A3* A Aa Baa A A Spectra Energy Capital Baa1 Baa Baa Baa Ba A Consolidated Natural Gas Co. Baa1 A A A A Baa Vectren Utility Holdings, Inc. Baa1 Baa Baa Baa Baa Ba National Fuel Gas Company Baa1 Baa Baa Baa A A Energen Corporation Baa2 Aa Aa Baa Aa Aa Kinder Morgan, Inc. Baa2 Baa Baa B B Aa ONEOK, Inc. Baa2 A A Ba Baa Aa Peoples Energy Corporation Baa2 Baa Baa A Baa Ba CenterPoint Energy Resources Corp. Baa3 Ba Ba Ba Baa B Enogex Inc. Baa3 Baa Baa A Ba Baa Atmos Energy Corporation Baa3 Ba Ba Ba Baa Ba NiSource Inc. Baa3 Ba Ba B Ba Ba Southern Union Company Baa3 Ba Ba Baa Ba Ba The Williams Companies, Inc. Ba2** Ba B Ba Baa B El Paso Corporation B2** Caa Caa Caa B Caa *Issuer Rating **Parent-level Corporate Family Rating Return on Equity Positive Outlier Negative Outlier Observations and Outliers The single outlier under Factor 4 is Energen, which is a positive outlier for all but one of the sub-factor ratios. Energen is one of a number of companies with significant E&P businesses that have benefited from rising commodity prices (other examples are Equitable and Questar). Their ratings consider the risks of their E&P, expected financial performance at mid-cycle, and variance through the price cycle. The Canadian companies, TransCanada and Enbridge, are negative outliers for several sub-factors because of the higher levels of debt relative to comparably rated U.S. diversified companies. These higher debt levels are in large measure reflective of the deemed capital structures in the Canadian regulated utility subsidiaries of these companies. Other sub-factor negative outliers are companies whose relatively weak financial metrics are mitigated by the large scale and low business risk of their regulated (e.g., CenterPoint, NiSource). Moody s Rating Methodology 15

16 Other Considerations This rating methodology explains the factors that are most important for rating diversified natural gas transmission and distribution companies. In addition to the key factors that have been discussed, there can be other credit considerations that affect a company's rating, some of which are common to all corporate issuers. OWNERSHIP A diversified's rating may be lifted by a notch or more if it is owned by a strong parent company that has demonstrated support and retains strong strategic interests in it. We would be less likely to incorporate benefit from the ownership if the parent if the company has no integration with or connection to the parent's other holdings, or if there is less confidence in the parent's intention to hold the subsidiary over the longer term. CORPORATE GOVERNANCE We would view positively board members with proven professional experience in the segments in which the diversified company operates. For regulated businesses, it is desirable for the board to have regulatory affairs experience. Corporate governance has not been a primary rating driver for most diversified companies but it can be a credit concern if there is a particularly low level of director independence, if succession is a concern, if senior executive compensation appear to be weighted toward the short term, if the company moves in and out of assets, or if the company appears to be highly prone to event risk. LIQUIDITY Liquidity of diversifieds can be affected by seasonality, commodity prices, inter-company cash management practices, and the quality of alternate liquidity sources. Seasonality drives the liquidity profile of LDCs, with working capital demands peaking during the winter heating season, but falling, predictably, during the spring. Trading and marketing could require substantial working capital to buy and sell gas. Hedging E&P production could require substantial liquidity resources for margining when volumes are heavily hedged at prices below market levels. RING-FENCING AND INTERCOMPANY MOVEMENT OF CASH Ring-fencing is a regulatory mandate that can insulate the creditworthiness of regulated utilities from their affiliates. Commonly, a public utility is subject to broad statutory restrictions to preserve its financial integrity to be able to provide its services in an effective manner. Utilities are generally prohibited from lending their creditworthiness (e.g., providing guarantees) to support non-utility activities. Depending on the company, utilities may also be subject to more explicit ring-fencing orders. For example, an LDC may be required to maintain an allowed equity ratio that would, in effect, limit dividends it can make to the parent. It may be restricted from participating in corporate money pool arrangements and may be required to get regulatory approval prior to any significant financing activity. The stronger the ring-fencing, the more the rating of a regulated entity will reflect its standalone credit quality (and the less it will reflect the credit quality of non-utility affiliates). Stronger ring-fencing could result in more than a one-notch rating difference between the regulated subsidiary and its parent company. LEGAL STRUCTURE AND STRUCTURAL SUBORDINATION Diversifieds are legally organized as either non-operating holding companies or utility parent companies with regulated and subsidiaries. Operating subsidiary debt is usually rated at least a notch higher than that at a nonoperating holding company, whose debt is structurally subordinated. Notching between the holding company and the regulated subsidiary depends on the proportion of value that the regulated subsidiary represents to the organization; the type of legal organization; the degree of ring-fencing; the significance and risk of the businesses; and inter-company cash management practices. It is possible for a utility parent and its subsidiary to be rated at the same level if the distinct credit quality of each legal entity puts it, on balance, on par with the other. Examples are TransCanada PipeLines, which is both a holding company and a substantial operating company, and its regulated subsidiaries NOVA Gas Transmission and Gas Transmission Northwest, Southern Union and its regulated subsidiary Panhandle Eastern, and ONEOK and its MLP affiliate ONEOK Partners. 16 Moody s Rating Methodology

17 Summary Considerations We score a company on each of the factors by assigning a rating category. To derive the modeled rating for a company, each of the nine sub-factors is individually assessed using the mapping tables in this report. Those ratings are each equivalent to a numerical rating score and each represents a percentage of the overall methodology implied rating. In this methodology, we cover 21 diversifieds. After placing these companies in the rating factor grid, 14 companies have actual ratings that match the rating indicated by the grid, four have actual ratings lower than the rating indicated by the grid, and three have ratings higher than that indicated by the grid. All companies' indicated ratings fall within two notches of their actual rating. Moody s Rating Methodology 17

18 Appendices APPENDIX A: CONSOLIDATED RATING FACTORS GRID North American Diversified Natural Gas Methodology Mapping Grid Sub-factor Weighting Aaa Aa A Baa Ba B Caa Factor 1: Scale (10% weighting) Total Assets (US$B) 5.0% >$11 $8-$11 $5-$8 $3-$5 $2-$3 $1-$2 <$1 NPATBUI (US$MM) 5.0% >$700 $500-$700 $300-$500 $100-$300 $50-$100 $0-$50 <$0 Factor 2: Quality of Diversification (20% weighting) the higher % of the higher % of the higher % of the higher % of the higher % of the higher % of the higher % of Scale of Unregulated Exposure 10.0% Operating income from <20% of operating income. Operating income from between 20-30% of operating income. Operating income from between 30-40% of operating income. Operating income from between 40-50% of operating income. Operating income from between 50-60% of operating income. Operating income from >60% of operating income. Portfolio may evidence some stress that could lead to writedowns. Operating income from >60% of operating income. Significant losses evident in the portfolio. or or or or or or or Segment assets Segment assets Segment assets Segment assets Segment assets Segment assets Segment assets from from from from from from from <20% >60% >60% of between 20-30% between 30-40% between 40-50% between 50-60% of of segment assets. of of of of segment assets. segment assets. segment assets. segment assets. segment assets. segment assets. Degree of Business Risk 10.0% LDC w/very good LDC w/reasonable LDC w/inadequate E&P w/reserve E&P w/reserve E&P w/reserve E&P w/reserve regulatory support regulatory support regulatory support profile, reserve profile, reserve profile, reserve profile, reserve and rate design and rate design and rate design replacement, fullcycle replacement, full- replacement, full- replacement, full- that promotes that promotes that promotes costs cycle costs cycle costs cycle costs sustained sustained sustained consistent with consistent with Ba consistent with B consistent with profitability profitability profitability investment grade in E&P in E&P Caa in E&P consistent with consistent with A- consistent with rating in E&P methodology; methodology; methodology; Aaa-Aa under LDC Baa under LDC non-ig under LDC methodology; gathering and gathering and gathering and methodology; methodology; methodology; gathering and processing w/ processing w/ processing w/ Pipeline w/scope, Pipeline w/scope, Pipeline w/scope, processing w/ moderate significant significant contract stability, contract stability, contract stability, minimal keepwhole keepwhole keepwhole and market/supply and market/supply and market/supply keepwhole processing risk; processing risk; processing risk; attributes attributes attributes processing risk; good competitive average small, weak consistent with consistent with A- consistent with large competitive position in longlived/growing competitive competitive Aaa-Aa under Baa under pipeline non-ig under position in longlived/growing position in position in short- pipeline methodology pipeline basin; moderate average-lived/ lived/declining methodology methodology; basin; geographic mature basin; basin; no gathering without geographically diversification modest geographic geographic processing diversified across diversification diversification major basins 18 Moody s Rating Methodology