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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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
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(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 October 13, 2004
--------------------- -------------------------------
$.01 par value 160,595,889
KEYSPAN CORPORATION AND SUBSIDIARIES
INDEX
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Part I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements
Consolidated Balance Sheet -
September 30, 2004 and December 31, 2003 3
Consolidated Statement of Income - Three and
Nine Months Ended September 30, 2004 and 2003 5
Consolidated Statement of Cash Flows -
Nine Months Ended June 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 38
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 71
Item 4. Controls and Procedures 74
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 75
Item 6. Exhibits 75
Signatures 76
2
CONSOLIDATED BALANCE SHEET
(Unaudited)
- --------------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and temporary cash investments $ 361,297 $ 205,751
Accounts receivable 806,489 1,029,459
Unbilled revenue 212,630 505,633
Allowance for uncollectible accounts (66,873) (79,184)
Gas in storage and prepaid gas 564,630 488,521
Material and supplies, at average cost 117,913 121,415
Other 84,976 115,304
-------------------------------- ----------------------------
2,081,062 2,386,899
-------------------------------- ----------------------------
Investments and Other 516,604 248,565
Property
Gas 6,790,147 6,522,251
Electric 2,356,169 2,636,537
Other 433,823 425,576
Accumulated depreciation (2,709,225) (2,610,876)
Gas exploration and production, at cost 182,114 3,088,242
Accumulated depletion (103,867) (1,167,427)
-------------------------------- ----------------------------
6,949,161 8,894,303
-------------------------------- ----------------------------
Deferred Charges
Regulatory assets 530,705 578,383
Goodwill and other intangible assets 1,688,287 1,809,712
Other 775,754 722,320
-------------------------------- ----------------------------
2,994,746 3,110,415
-------------------------------- ----------------------------
Total Assets $ 12,541,573 $ 14,640,182
================================ ============================
See accompanying Notes to the Consolidated Financial Statements.
3
CONSOLIDATED BALANCE SHEET
(Unaudited)
- --------------------------------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- --------------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND CAPITALIZATION
Current Liabilities
Current redemption of long-term debt $ 16,142 $ 1,471
Accounts payable and other liabilities 662,127 1,141,597
Commercial paper 575,375 481,900
Dividends payable 72,248 72,289
Taxes accrued 43,474 46,580
Customer deposits 43,565 40,370
Interest accrued 77,493 64,609
----------------------------------- -----------------------------
1,490,424 1,848,816
----------------------------------- -----------------------------
Deferred Credits and Other Liabilities
Regulatory liabilities:
Miscellaneous liabilities 154,059 104,034
Removal cost recovered 485,394 450,034
Deferred income tax 1,091,443 1,278,341
Postretirement benefits and other reserves 951,889 961,962
Other 113,683 121,790
----------------------------------- -----------------------------
2,796,468 2,916,161
----------------------------------- -----------------------------
Commitments and Contingencies (See Note 6) - -
Capitalization
Common stock 3,495,111 3,487,645
Retained earnings 665,823 621,430
Accumulated other comprehensive loss (66,537) (59,932)
Treasury stock (354,165) (378,487)
----------------------------------- -----------------------------
Total common shareholders' equity 3,740,232 3,670,656
Preferred stock 75,000 83,568
Long-term debt 4,423,862 5,611,432
----------------------------------- -----------------------------
Total Capitalization 8,239,094 9,365,656
----------------------------------- -----------------------------
Minority Interest in Subsidiary Companies 15,587 509,549
----------------------------------- -----------------------------
Total Liabilities and Capitalization $ 12,541,573 $ 14,640,182
=================================== =============================
See accompanying Notes to the Consolidated Financial Statements.
4
CONSOLIDATED STATEMENT OF INCOME
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Gas Distribution $ 419,208 $ 405,777 $ 3,023,350 $ 2,970,514
Electric Services 503,879 438,577 1,296,778 1,228,622
Energy Services 118,580 137,961 377,516 399,294
Energy Investments 8,767 149,499 314,134 454,061
------------------------------------------------------------------------------------
Total Revenues 1,050,434 1,131,814 5,011,778 5,052,491
------------------------------------------------------------------------------------
Operating Expenses
Purchased gas for resale 186,619 172,452 1,776,322 1,792,917
Fuel and purchased power 176,028 133,313 407,987 333,311
Operations and maintenance 434,874 507,381 1,404,835 1,515,206
Depreciation, depletion and
amortization 93,420 135,656 454,737 422,917
Goodwill impairment charge 122,229 - 122,229 -
Operating taxes 89,525 91,790 302,143 311,754
------------------------------------------------------------------------------------
Total Operating Expenses 1,102,695 1,040,592 4,468,253 4,376,105
------------------------------------------------------------------------------------
Gain on sale of long lived asset - 13,974 - 13,974
Income from Equity Investments 16,213 2,727 30,342 12,486
------------------------------------------------------------------------------------
Operating Income (Loss) (36,048) 107,923 573,867 702,846
------------------------------------------------------------------------------------
Other Income and (Deductions)
Interest charges (88,308) (78,366) (260,848) (226,503)
Gain (loss) on subsidiary stock
transactions - - 172,894 (11,325)
Cost of debt redemption (45,879) - (45,879) (24,094)
Minority interest (58) (19,894) (37,012) (50,252)
Other 4,204 10,325 26,418 24,779
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Total Other Income and (Deductions) (130,041) (87,935) (144,427) (287,395)
------------------------------------------------------------------------------------
Income Taxes
Current (176,828) (39,317) (13,330) 94,275
Deferred 126,518 46,720 180,115 71,439
------------------------------------------------------------------------------------
Total Income Taxes (50,310) 7,403 166,785 165,714
------------------------------------------------------------------------------------
Earnings (Loss) Before Change in Accounting
Principle (115,779) 12,585 262,655 249,738
Cummulative Change in Accounting Principle - - - 174
------------------------------------------------------------------------------------
Net Income (Loss) (115,779) 12,585 262,655 249,912
Preferred stock dividend requirements 1,360 1,461 4,280 4,383
------------------------------------------------------------------------------------
Earnings (Loss) for Common Stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
====================================================================================
Basic Earnings (Loss) Per Share:
Before Change in Accounting Principle (0.73) 0.07 1.61 1.56
Change in Accounting Principle - - - -
------------------------------------------------------------------------------------
Basic Earnings (Loss) Per Share $ (0.73) $ 0.07 $ 1.61 $ 1.56
====================================================================================
Diluted Earnings (Loss) Per Share:
Before Change in Accounting Principle (0.73) 0.07 1.60 1.55
Change in Accounting Principle - - - -
------------------------------------------------------------------------------------
Diluted Earnings (Loss) Per Share $ (0.73) $ 0.07 $ 1.60 $ 1.55
====================================================================================
Average Common Shares Outstanding (000) 160,357 158,783 160,139 157,871
Average Common Shares Outstanding - Diluted (000) 161,346 159,539 161,091 158,670
See accompanying Notes to the Consolidated Financial Statements.
5
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
- ------------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net income $ 262,655 $ 249,912
Adjustments to reconcile net income to net
cash provided by (used in) operating activities
Depreciation, depletion and amortization 454,736 422,917
Deferred income tax 31,517 71,439
Income from equity investments (30,342) (12,486)
Dividends from equity investments 3,970 1,021
Amortization of interest rate swaps 182 (7,396)
Gain (Loss) on subsidiary stock transactions (172,894) 11,325
Gain (Loss) on sale of property - (13,974)
(Gain) on settlement of treasury lock (12,656) -
Goodwill impairment charge 122,229 -
Amortization of prepayments 74,557 62,945
Minority interest 37,012 50,252
Changes in assets and liabilities
Accounts receivable 301,011 384,836
Materials and supplies, fuel oil and gas in storage (80,072) (239,847)
Accounts payable and other liabilities (235,171) (114,589)
Interest accrued 12,884 22,161
Captive insurance reserve 43,214 -
Property tax prepayments (55,413) (86,631)
Other 23,915 (45,211)
-------------------------------------------
Net Cash Provided by Operating Activities 781,334 756,674
-------------------------------------------
Investing Activities
Construction expenditures (563,207) (720,217)
Other investments - (50,500)
Cost of removal (21,249) (19,611)
Proceeds from sale of property 13,138 13,974
Net proceeds from sale/leaseback transaction 383,716 -
Net proceeds from subsidiary stock transactions 512,065 198,553
-------------------------------------------
Net Cash Provided by (Used In) Investing Activities 324,463 (577,801)
-------------------------------------------
Financing Activities
Treasury stock issued 24,322 76,984
Equity issuance - 473,573
Issuance of long-term debt 49,336 710,475
Payment of long-term debt (920,033) (564,506)
Issuance (Payment) of commercial paper 93,475 (271,297)
Redemption of promissory notes - (447,005)
Gain on settlement of treasury lock 12,656 -
Redemption of preferred stock (8,483) (14,293)
Preferred stock dividends paid (4,280) (4,383)
Common stock dividends paid (214,075) (203,795)
Other 16,831 12,808
-------------------------------------------
Net Cash (Used in) Financing Activities (950,251) (231,439)
-------------------------------------------
Net Increase in Cash and Cash Equivalents $ 155,546 $ (52,566)
Cash and Cash Equivalents at Beginning of Period 205,751 170,617
-------------------------------------------
Cash and Cash Equivalents at End of Period $ 361,297 $ 118,051
===========================================
Cash equivalents are short-term marketable securities purchased with maturities
of six 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 independent 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 1.1 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; and engineering and
consulting services. We also invest and participate in the development of
natural gas pipelines, electric generation and other energy-related projects.
(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 September 30, 2004, and the results of operations for the three and nine
months ended September 30, 2004 and September 30, 2003, as well as cash flows
for the nine months ended September 30, 2004 and September 30, 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 10-K 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.
Consolidated earnings are seasonal in nature primarily 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.
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.
7
We have approximately 3.5 million common stock options outstanding at September
30, 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.
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 September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
Houston Exploration dilution - (74) - (212)
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock - adjusted $ (117,139) $ 11,050 $ 258,375 $ 245,317
- -----------------------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding (000) 160,357 158,783 160,139 157,871
Add dilutive securities:
Options 989 - 952 -
Convertible preferred stock - 756 - 799
- -----------------------------------------------------------------------------------------------------------------------------------
Total weighted average shares outstanding - assuming dilution 161,346 159,539 161,091 158,670
- -----------------------------------------------------------------------------------------------------------------------------------
Basic earnings (loss )per share $ (0.73) $ 0.07 $ 1.61 $ 1.56
- -----------------------------------------------------------------------------------------------------------------------------------
Diluted earnings (loss) per share $ (0.73) $ 0.07 $ 1.60 $ 1.55
- -----------------------------------------------------------------------------------------------------------------------------------
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 four to nine years and
power purchase agreements having remaining terms that range from nine years to
23 years. The Electric Services segment also includes subsidiaries that own or
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 unit located at
the Ravenswood site ("Ravenswood Expansion"). Collectively the Ravenswood
Facility and the Ravenswood Expansion are referred to herein as the "Ravenswood
Projects." All of the energy, capacity and ancillary services related to the
8
Ravenswood Projects is sold to the New York Independent System Operator
("NYISO") energy markets. The Electric Services segment also conducts retail
marketing of electricity to commercial customers.
The Energy Services segment includes companies that provide energy-related
services to customers primarily located within the Northeastern United States,
with concentrations in the New York City metropolitan area, including New
Jersey, as well as Rhode Island, Pennsylvania, Massachusetts and New Hampshire,
through the following two 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. In the third quarter of 2004, KeySpan
recorded a $122.2 million non-cash goodwill impairment charge in this segment.
See Note 12 "Goodwill Impairment" for further information regarding this charge.
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 include our
approximate 23.5% interest in The Houston Exploration Company ("Houston
Exploration") an independent natural gas and oil exploration company, as well as
our wholly-owned subsidiaries Seneca-Upshur Petroleum, Inc. ("Seneca-Upshur")
and KeySpan Exploration and Production, LLC ("KeySpan Exploration and
Production"), which is engaged in a joint venture with Houston Exploration.
In June 2004, KeySpan exchanged 10.8 million shares of common stock of Houston
Exploration for 100% of the stock of Seneca-Upshur, previously a wholly owned
subsidiary of Houston Exploration. This transaction reduced our interest in
Houston Exploration from 55% to the current level of approximately 23.5%. As
part of this transaction, Houston Exploration retired 4.6 million of its common
shares and issued 6.8 million new shares in a public offering. Based on Houston
Exploration's announced offering price of $48.00 per share, Seneca-Upshur's
shares were valued at the equivalent of $449 million, or $41.57 per share.
Seneca-Upshur's assets consisted of West Virginia gas producing properties
valued at $60 million, and $389 million in cash. This transaction resulted in a
gain to KeySpan of $150.1 million. Effective June 1, 2004, Houston Exploration's
earnings and our ownership interest in Houston Exploration have been accounted
for on the equity basis of accounting. The deconsolidation of Houston
Exploration required the recognition of certain deferred taxes on our remaining
investment resulting in a net deferred tax expense of $44.1 million. Therefore,
the net gain on the share exchange less the deferred tax provision was $106
million, or $0.66 per share. It should be noted that in the second quarter of
2004, KeySpan recorded a $48.2 million non-cash impairment charge to recognize
the reduced valuation of proved reserves. See Note 10 "Gas Exploration and
Production Property - Depletion for further information on this charge.
9
Subsidiaries in this segment also hold a 17.4% ownership interest in KeySpan
Canada, a subsidiary with natural gas processing plants and gathering facilities
in Western Canada. In April 2004, KeySpan and KeySpan Facilities Income Fund
(the "Fund"), which previously owned a 39.09% interest in KeySpan Canada,
consummated a transaction whereby the Fund sold 15.617 million units of the Fund
at a price of CDN$12.60 per unit for gross total proceeds of approximately
CDN$196.8 million. The proceeds of the offering were used by the Fund to acquire
an additional 35.91% interest in KeySpan Canada from KeySpan. We received net
proceeds of approximately CDN$186.3 million (or approximately US$135 million),
after commissions and expenses. The Fund's ownership in KeySpan Canada increased
from 39.1% to 75%, and KeySpan's ownership of KeySpan Canada decreased to 25%.
KeySpan recorded a gain of $22.8 million ($10.1 million after-tax, or $0.06 per
share) on this transaction. Effective April 1, 2004 KeySpan Canada's earnings
and our ownership interest in KeySpan Canada have been accounted for on the
equity basis of accounting.
In July 2004, the Fund issued an additional 10.7 million units, the proceeds of
which were used to fund the acquisition of the midstream assets of Chevron
Canada Midstream Inc. This transaction had the effect of further diluting
KeySpan's ownership of KeySpan Canada to 17.4%.
This segment is also engaged in pipeline development activities. KeySpan and
Duke Energy Corporation each own a 50% interest in Islander East Pipeline
Company, LLC ("Islander East"). Islander East was created to pursue the
authorization and construction of an interstate pipeline from Connecticut,
across Long Island Sound, to a terminus near Shoreham, Long Island. 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. Further, in August 2004, KeySpan
acquired a 21% interest in the Millennium Pipeline project which will transport
up to 500,000 DTH of natural gas a day from Corning to Ramapo, New York, where
it will connect to an existing pipeline.
Additionally, subsidiaries in this segment 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 the KeySpan LNG facility
in Providence, Rhode Island, a 600,000 barrel liquefied natural gas storage and
receiving facility. Further, this segment has a 50% interest in the Premier
Transmission Pipeline in Northern Ireland.
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. As a result of the Houston Exploration
stock transaction and the related deconsolidation, the total assets associated
with our gas exploration and production operations, including cash from the
transaction, were $650 million at September 30, 2004, compared to $1.5 billion
at December 31, 2003. Due to the KeySpan Canada transaction, total assets
associated with KeySpan's other energy-related investments were approximately
$607 million at September 30, 2004 compared to $900 million at December 31,
2003.
10
To better align the subsidiaries within our segments, we reclassified the
operating results of our electric marketing subsidiary from the Energy Services
segment to the Electric Services segment in the first quarter of 2004. As a
result we reclassified the financial results for all periods of 2003. The
revised reportable segment information is as follows:
- ------------------------------------------------------------------------------------------------------------------------------------
Energy Investments
-----------------------------
Gas
Gas Electric Energy Exploration Other
(In Thousands of Dollars) Distribution Services Services and Production Investments Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, 2004
Unaffiliated revenue 419,208 503,879 118,580 4,975 3,792 - 1,050,434
Intersegment revenue - - 7,172 - 1,274 (8,446) -
Operating income (Loss) (23,627) 111,158 (142,976) 12,332 4,102 2,963 (36,048)
Three Months Ended Sept. 30, 2003
Unaffiliated revenue 405,777 438,577 137,961 123,052 26,447 - 1,131,814
Intersegment revenue - 25 1,926 - 1,252 (3,203) -
Operating income (Loss) (25,134) 102,125 (15,498) 50,995 8,009 (12,574) 107,923
- ------------------------------------------------------------------------------------------------------------------------------------
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 for the three months ended September 30, 2004 and
2003 represent approximately 45% and 38%, respectively of our consolidated
revenues in both periods.
- ------------------------------------------------------------------------------------------------------------------------------------
Energy Investments
---------------------------
Gas
Gas Electric Energy Exploration Other
(In Thousands of Dollars) Distribution Services Services and Production Investments Eliminations Consolidated
- ------------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended Sept. 30, 2004
Unaffiliated revenue 3,023,350 1,296,778 377,516 276,320 37,814 - 5,011,778
Intersegment revenue - - 14,755 - 3,817 (18,572) -
Operating income (Loss) 391,090 226,273 (166,356) 85,828 22,473 14,559 573,867
Nine Months Ended Sept. 30, 2003
Unaffiliated revenue 2,970,514 1,228,622 399,294 373,774 80,287 - 5,052,491
Intersegment revenue - 76 4,894 - 3,756 (8,726) -
Operating income (Loss) 371,420 193,869 (35,083) 156,733 27,207 (11,300) 702,846
- ------------------------------------------------------------------------------------------------------------------------------------
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 for the nine months ended September 30, 2004 and
2003 represent approximately 25% and 22%, respectively of our consolidated
revenues for both periods.
11
3. COMPREHENSIVE INCOME
The table below indicates the components of comprehensive income:
- ------------------------------------------------------------------------------------------------------------------------------------
Three Months Ended Sept. 30, Nine Months Ended Sept. 30,
(In Thousands of Dollars) 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) for common stock $ (117,139) $ 11,124 $ 258,375 $ 245,529
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax
Reclassification adjustments for loss (gains) realized in
net income (13,945) 8,431 2,586 19,602
Foreign currency translation adjustments 576 366 (16,487) 27,892
Unrealized gains (losses) on marketable securities (1,259) 1,209 (717) 3,458
Premiums on derivative financial instruments - - 3,437 (3,437)
Deconsolidation of certain subsidiaries - - (6,711) -
Unrealized gain (losses) on derivative financial instruments 12,461 13,740 11,288 (7,193)
- ------------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax (2,167) 23,746 (6,604) 40,322
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive Income $ (119,306) $ 34,870 $ 251,771 $ 285,851
- ------------------------------------------------------------------------------------------------------------------------------------
Related tax (benefit) expense
Reclassification adjustments for loss (gains) realized in
net income (8,623) 4,540 279 10,555
Foreign currency translation adjustments 310 197 (8,878) 15,019
Unrealized gains (losses) on marketable securities (955) 652 (665) 1,863
Premiums on derivative financial instruments - - 1,851 (1,851)
Deconsolidation of certain subsidiaries - - 5,016
Unrealized gain (losses) on derivative financial instruments 8,101 7,398 7,470 (3,873)
- ------------------------------------------------------------------------------------------------------------------------------------
Total Tax (Benefit) Expense $ (1,167) $ 12,787 $ 5,073 $ 21,713
- ------------------------------------------------------------------------------------------------------------------------------------
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 distribution
operations, gas exploration and production activities and its electric
generating facilities at the Ravenswood site.
Derivative financial instruments are employed by our gas distribution operations
to reduce the cash flow variability associated with the purchase price for a
portion of future natural gas purchases for our regulated firm gas sales
customers. The accounting for these derivative instruments is subject to SFAS 71
"Accounting for the Effects of Certain Types of Regulation." See the caption
below "Firm Gas Sales Derivative Instruments - Regulated Utilities" for a
further discussion of these derivatives. Certain derivative instruments employed
by our gas distribution operations are not subject to SFAS 71. Utility tariffs
applicable to certain large-volume customers permit gas to be sold at prices
established monthly within a specified range expressed as a percentage of
prevailing alternate fuel oil prices. KEDNY uses natural gas swap contracts,
with offsetting positions in fuel oil swap contracts of equivalent energy value,
to hedge the cash-flow variability of specified portions of gas purchases and
12
sales associated with these customers. The maximum length of time over which we
have hedged cash flow variability associated with forecasted purchases and sales
of natural gas and fuel oil is through February 2005. We use standard New York
Mercantile Exchange ("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 September 30, 2004 was a liability of
$1.4 million, all of which is expected to be reclassified from other
comprehensive income into earnings over the next twelve months.
Seneca-Upshur utilizes over-the-counter ("OTC") natural gas index swaps to hedge
the cash flow variability associated with forecasted sales of a portion of its
natural gas production. At September 30, 2004, Seneca-Upshur has hedge positions
in place for approximately 85% of its estimated remaining 2004 gas production,
net of gathering related costs. Further, Seneca-Upshur has hedge positions in
place for approximately 85% of its estimated 2005 through 2007 gas production,
net of gathering costs. We use forward index prices to value these swap
positions. The maximum length of time over which Seneca-Upshur has hedged such
cash flow variability is through December 2007. The fair market value of these
derivative instruments at September 30, 2004 was a liability of $2.0 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 $1.4 million, or
approximately $0.9 million after-tax.
Derivative financial instruments are employed by Houston Exploration to hedge
cash flow variability associated with forecasted sales of natural gas. Since
Houston Exploration is no longer a consolidated subsidiary, the fair market
value of their outstanding derivative instruments are not reflected on KeySpan's
September 30, 2004 Consolidated Balance Sheet.
The Ravenswood Projects use 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 Projects also
hedge the cash flow variability associated with a portion of on-peak electric
energy sales.
With respect to price exposure associated with fuel purchases for the Ravenswood
Projects, 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 by the Ravenswood Projects. The maximum length of time over
which we have hedged cash flow variability associated with forecasted purchases
of natural gas is through September 2005. The maximum length of time over which
we have hedged cash flow variability associated with forecasted purchases of
fuel oil is through April 2006. 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 September
30, 2004 was $0.5 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.
13
We have also engaged in the use of cash-settled swap instruments to hedge the
cash flow variability associated with a portion of forecasted electric energy
sales from the Ravenswood Projects. Our hedging strategy is to hedge
approximately 50% of forecasted on-peak summer season electric energy sales and
a portion of forecasted 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 September 30, 2004 was $2.3 million. The estimated amount of gains 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 $2.1 million, or approximately $1.4 million after-tax.
The above noted 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. As noted,
the fair market value of Houston Exploration's outstanding derivative
instruments are not reflected on the September 30, 2004 Consolidated Balance
Sheet. Gains and losses are reclassified from accumulated other comprehensive
income to the Consolidated Statement of Income in the period the hedged
transaction affects 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.
The table below summarizes the fair value of outstanding financially-settled
commodity derivative instruments that qualify for hedge accounting at September
30, 2004 and the 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. As
noted earlier, derivative instruments employed by Houston Exploration are no
longer reflected on KeySpan's Consolidated Balance Sheet.
14
- ----------------------------------------------------------------------------------------------------------
(In Thousands of Dollars) September 30, 2004 December 31, 2003
- ----------------------------------------------------------------------------------------------------------
Gas Contracts:
Other current assets $ 5,318 $ 3,458
Accounts payable and other liabilities - (35,592)
Other deferred liabilities (606) (4,734)
Oil Contracts:
Other current assets 527 -
Accounts payable and other liabilities (8,060)
Other deferred charges 25 385
Electric Contracts:
Other current assets 2,083 -
Other deferred charges 194 259
- ----------------------------------------------------------------------------------------------------------
$ (519) $ (36,224)
- ----------------------------------------------------------------------------------------------------------
Financially-Settled Commodity Derivative Instruments that Do Not Qualify for
Hedge Accounting: KeySpan subsidiaries also have employed a limited number of
financial derivatives that do not qualify for hedge accounting treatment under
SFAS 133. In September 2004, we purchased a series of call options on the spread
between the price of heating oil and the price of natural gas. The options cover
the period September 2004 through February 2005 and further complement our
hedging strategy noted above regarding sales to certain large-volume customers.
As stated, we sell gas to certain large-volume customers at prices established
monthly within a specified range expressed as a percentage of prevailing
alternate fuel oil prices. Utility tariffs, however, establish an upper limit on
the price KeySpan can charge for the sale of natural gas to these customers.
These options are intended to limit KeySpan's exposure to heating oil price
spikes. These options do not qualify for hedge accounting treatment under SFAS
133. We recorded a $0.6 million charge in other income and deductions on the
Consolidated Statement of Income to reflect the change in the market value
associated with this derivative instrument.
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. 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 September 30, 2004, these
derivatives had a fair market value of $87.1 million and are reflected as a
regulatory liability on the Consolidated Balance Sheet.
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
15
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 September 30, 2004, these derivatives had a fair
market value of $3.7 million and are reflected as a 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. In the first quarter of 2004, we paid
our counterparty an average interest rate of 6.44%, and as a result, we realized
interest savings of $0.5 million.
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, was being recorded as a reduction to
interest expense over the remaining life of the bonds. In August 2004, we
redeemed these bonds and recorded the remaining benefit.
KeySpan has a leveraged lease financing arrangement associated with the
Ravenswood Expansion. In May 2004, the facility was acquired by a lessor from
our subsidiary, KeySpan Ravenswood, LLC, and simultaneously leased back to that
subsidiary. In connection with this sale/leaseback transaction, KeySpan utilized
a $275 million treasury lock (at 4.2%) to hedge the 10-year US Treasury
component of the underlying notes issued by the lessor to purchase the facility.
The treasury lock was in effect for a five-week period during which time the
10-year US Treasury increased 70 basis points. KeySpan did not designate this
derivative instrument as a hedge for accounting purposes. The treasury lock
settled in May 2004 and KeySpan received cash proceeds of $12.6 million which
was recorded in other income and (deductions) in the Consolidated Statement of
Income. (See Note 6. "Financial Guarantees and Contingencies" for additional
information regarding the sale/leaseback transaction.)
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 September 2004, we entered into heating-degree day put options to mitigate
the effect of fluctuations from normal weather on KEDNE's financial position and
cash flows for the 2004/2005 winter heating season - November 2004 through March
2005. These put options will pay KeySpan $40,000 per heating degree day when the
actual temperature is below 4,140 heating degree days, or approximately 5%
warmer than normal, based on the most recent 20-year average for normal weather.
The maximum amount KeySpan may receive on these purchased put options is $16
16
million. The net premium cost for these options was $1.6 million. Unlike
previous years (see below) if weather is colder than normal KeySpan will have no
financial obligation. 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.
In October 2003, KEDNE entered into heating-degree day call and put options 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 then 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. 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.
Derivative contracts are primarily used to manage exposure to market risk
arising from changes in commodity prices, interest rates and weather. 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 May 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff
Position ("FSP") 106-2 "Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003." This
guidance supersedes FSP 106-1 issued in January 2004 and clarifies 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.
17
KeySpan's retiree health benefit plan currently includes a prescription drug
benefit that is provided to retired employees. KeySpan implemented the
requirements of FSP 106-2 in September 2004 and determined that the savings
associated with the Act will reduce KeySpan's retiree health care costs by
approximately $10 million in 2004. However, KEDLI and Boston Gas Company are
subject to certain deferral accounting requirements mandated by the New York
State Public Service Commission ("NYPSC") and the Massachusetts Department of
Telecommunications and Energy ("MA DTE"), respectively for pension costs and
other postretirement benefit costs. Further, in accordance with our service
agreements with LIPA, variations between pension costs and other postretirement
benefit costs incurred by KeySpan compared to those costs recovered through
rates charged to LIPA are deferred subject to recovery from or refund to LIPA.
As a result of these various requirements, KeySpan estimates that approximately
$7 million of savings attributable to the implementation of FSP 106-2 and the
Act will be deferred and used to offset increases in overall pension and
postretirement benefit costs, with the remaining approximately $3 million
available to KeySpan. Therefore, in September 2004, KeySpan recorded
approximately $2.2 million as a reduction to its health care costs representing
nine months of the benefit. The implementation of FSP 106-2 and the Act had no
impact on KeySpan's cash flow.
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
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 six 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.
The initial term of the Master Lease expired on June 20, 2004 and was extended
until June 20, 2009 pursuant to the terms of the Master Lease. On all future
semi-annual payment dates, we have the option 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; or (ii) terminate the Master Lease and dispose of the facility. 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.
18
We have classified the Master Lease as $412.3 million of 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 $380
million. Under the terms of our two credit facilities, the Master Lease is
considered debt in the ratio of debt-to-total capitalization. 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.
Sale/leaseback Transaction: KeySpan also has a leveraged lease financing
arrangement associated with the Ravenswood Expansion. In May 2004, the unit was
acquired by a lessor from our subsidiary, KeySpan Ravenswood, LLC, and
simultaneously leased back to that subsidiary. All the obligations of KeySpan
Ravenswood, LLC have been unconditionally guaranteed by KeySpan. This lease
transaction generated cash proceeds of $385 million, before transaction costs,
which approximates the fair market value of the facility, as determined by a
third-party appraiser. This lease transaction qualifies 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 has an initial term of 36 years and the yearly operating
lease expense is approximately $17 million per year. Lease payments will
fluctuate from year to year, but are substantially paid over the first 16 years.
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 that existed at
the inception of the obligation. At the time of implementation, KeySpan recorded
an asset retirement obligation related to its investment in Houston Exploration
and its other gas exploration and production subsidiaries. Since Houston
Exploration's operations have been deconsolidated, Houston Exploration's
liability is no longer reflected on KeySpan's Consolidated Balance Sheet. The
remaining asset retirement obligation is related to our investment in
Seneca-Upshur and was approximately $6.6 million at September 30, 2004.
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 was 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 such obligation.
19
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 27 sites
will be investigated and, if necessary, remediated under the terms and
conditions of Administrative Orders on Consent ("ACO"), Voluntary Cleanup
Agreements ("VCA") or Brownfield Cleanup Agreements ("BCA"). Expenditures
incurred to date by us with respect to KEDNY MGP-related activities total $46.9
million.
We have identified 15 of these sites as being associated with the historical
operations of KEDLI. Expenditures incurred to date by us with respect to KEDLI
MGP-related activities total $39.4 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, VCAs or BCAs.
We presently estimate the remaining cost of our KEDNY and KEDLI MGP-related
environmental remediation activities will be $210.7 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 $86.3 million.
With respect to remediation costs, the KEDNY and KEDLI rate plans generally
provide for the recovery from customers of investigation and remediation costs.
At September 30, 2004, we have reflected a regulatory asset of $232.4 million
for our KEDNY/KEDLI MGP sites. In accordance with NYPSC policy, KeySpan records
a reduction to regulatory liabilities as costs are incurred for environmental
clean-up activities. At September 30, 2004, these previously deferred regulatory
liabilities totaled $43.2 million. In October 2003, KEDNY and KEDLI filed a
joint petition with the NYPSC, which is still pending, 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 $3.1 million, which amount has been
accrued by us. Expenditures incurred to date total $1.9 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.
20
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 eight other
sites. In addition, Boston Gas Company, Colonial Gas Company, and Essex Gas
Company have each assumed responsibility for remediating three 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 $21.1 million, which amount
has been accrued by us as a reasonable estimate of probable cost for known
sites. Expenditures incurred by KeySpan with respect to these MGP-related
activities total $16.5 million.
In September 2004, Boston Gas Company reached an agreement with an insurance
carrier for recovery of a portion of previously incurred environmental
expenditures. Under a previously issued MA DTE rate order, insurance and
third-party recoveries, after deducting legal fees, are shared between Boston
Gas and its firm gas customers. As a result of this agreement, in September 2004
Boston Gas Company recorded a $5 million benefit to operations and maintenance
expense.
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 $12.5 million, which amount has been
accrued by us as a reasonable estimate of probable cost for known sites.
Expenditures incurred by KeySpan, with respect to these MGP-related activities
total $9.0 million.
By rate orders, the MA DTE and the New Hampshire Public Utility Commission
("NHPUC") provide for the recovery of site investigation and remediation costs
and, accordingly, at September 30, 2004, we have reflected a regulatory asset of
$49.6 million for the KEDNE MGP sites. Colonial Gas Company and Essex Gas
Company are not subject to the provisions of SFAS 71 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.
21
KeySpan New England, LLC Sites: We are aware of three non-utility sites
associated with KeySpan New England, LLC 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 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 $22.0 million, which
amount has been accrued by us as a reasonable estimate of probable costs for
known sites. Expenditures incurred by KeySpan with respect to these sites total
$10.8 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 10-K 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 10-K 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.
22
As previously reported, 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 June 2004, the parties reached an agreement in principle to settle the
consolidated class action lawsuit. The proposed settlement provides for KeySpan
to make certain payments to plaintiffs, all of which is to be funded by the
insurance carrier providing liability coverage for KeySpan's directors and
officers. While KeySpan continues to deny any wrongdoing, we believe the
proposed settlement is in the best interest of KeySpan and its shareholders. The
settlement is subject to court approval and finalization of all necessary
documentation, the timing of which cannot be determined.
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.
23
Financial Guarantees
KeySpan has issued financial guarantees in the normal course of business, on
behalf of its subsidiaries, to various third-party creditors. At September 30,
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:
- -----------------------------------------------------------------------------------------------------------------
Amount of
Nature of Guarantee (In Thousands of Dollars) Exposure Expiration Dates
- -----------------------------------------------------------------------------------------------------------------
Medium-Term Notes - KEDLI (i) $ 525,000 2008-2010
Industrial Development Revenue Bonds (ii) 128,000 2027
Ravenswood - Master Lease (iii) 425,000 2019
Ravenswood - Sale/leaseback (iv) 385,000 2040
Surety Bonds (v) 269,000 Revolving
Commodity Guarantees and Other (vi) 77,000 2005
Letters of Credit (vii) 74,000 2005
- -----------------------------------------------------------------------------------------------------------------
$ 1,883,000
- -----------------------------------------------------------------------------------------------------------------
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. 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 two
electric-generation peaking plants on Long Island. 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 Master Lease. The initial term of the
Master Lease expired on June 20, 2004 and was 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 guaranteed all payment and performance obligations of KeySpan
Ravenswood, LLC, the lessee under the sale/leaseback transaction associated
with the 250 MW Ravenswood Expansion. The initial term of the lease is for
36 years. As noted previously, this lease qualifies as an operating lease
and is therefore not reflected on the Consolidated Balance Sheet.
24
(v) 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.
(vi) 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 September 30, 2004.
(vii)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 29, 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.
25
In addition, LIPA is in the process of performing a long-term strategic review
initiative regarding its future direction. It has engaged a team of advisors and
consultants and is conducting public hearings to develop recommendations to be
submitted to the LIPA Trustees by year-end. Some of the strategic options that
LIPA is considering include whether LIPA should continue its operations as they
presently exist, fully municipalize or privatize, sell some, but not all of
their assets and become a regulator of rates and services, or merge with one or
more utilities. In the near term, LIPA must make a determination by May 2005 as
to whether they will exercise its option to purchase our Long Island generating
plants pursuant to the terms of the Generation Purchase Rights Agreement. Until
LIPA makes a determination on its future direction, we are unable to determine
what the outcome of this strategic review will have on our financial condition,
results of operations or cash flows. Any action that may be taken will have to
take into consideration the long-term nature of our existing contracts.
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.
(Beginning in 2004, KeySpan officers that serve on the Houston Exploration Board
of Directors do 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,
net income and earnings per share would have decreased to the pro-forma amounts
indicated below. The 2004 pro-forma impact of Houston Exploration's stock
options are reflected for the five month period ended May 31, 2004.
26
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Three Months Ended September 30, Nine Months Ended September 30,
(In Thousands of Dollars, Except Per Share Amounts) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings available for common stock: $ (117,139) $ 11,124 $ 258,375 $ 245,529
As reported
Add: recorded stock-based compensation expense, net of tax 1,363 868 4,156 3,132
Deduct: total stock-based compensation expense, net of tax (1,935) (2,707) (6,894) (9,043)
- -----------------------------------------------------------------------------------------------------------------------------------
Pro-forma earnings $ (117,711) $ 9,285 $ 255,637 $ 239,618
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings per share:
Basic - as reported $ (0.73) $ 0.07 $ 1.61 $ 1.56
Basic - pro-forma $ (0.73) $ 0.06 $ 1.60 $ 1.52
Diluted - as reported $ (0.73) $ 0.07 $ 1.60 $ 1.55
Diluted - pro-forma $ (0.73) $ 0.06 $ 1.59 $ 1.51
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8. POSTRETIREMENT BENEFITS
Pension Plans: The following information represents the consolidated net
periodic pension cost for the nine months ended September 30, 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 NYPSC and MA 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.
The calculation of net periodic pension cost is as follows:
- ----------------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 39,681 $ 35,648
Interest cost on projected benefit obligation 108,181 103,703
Expected return on plan assets (118,700) (97,917)
Net amortization and deferral 47,480 50,212
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Total pension cost $ 76,642 $ 91,646
- ----------------------------------------------------------------------------------------------------------------------
Other Postretirement Benefits: The following information represents the
consolidated net periodic other postretirement benefit cost for the nine months
ended September 30, 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.
27
Net periodic other postretirement benefit cost included the following
components:
- ----------------------------------------------------------------------------------------------------------------
Nine Months Ended September 30,
(In Thousands of Dollars) 2004 2003
- ----------------------------------------------------------------------------------------------------------------
Service cost, benefits earned during the period $ 15,090 $ 14,119
Interest cost on accumulated
postretirement benefit obligation 55,508 52,352
Expected return on plan assets (25,419) (20,648)
Net amortization and deferral 35,097 26,861
- ----------------------------------------------------------------------------------------------------------------
Other postretirement cost $ 80,276 $ 72,685
- ----------------------------------------------------------------------------------------------------------------
In 2004, KeySpan is expected to contribute approximately $102 million to its
pension plans and approximately $40 million to its other postretirement benefit
plans. For the nine months ended September 30, 2004, $130 million has been
contributed. These estimated contribution levels are subject to change based on
future market returns, interest rates and certain other measurements. Actual
contributions, therefore, may vary from these levels.
9. LONG-TERM DEBT and COMMERCIAL PAPER
In August 2004, KeySpan redeemed approximately $758 million of outstanding debt.
The table below indicates the various series of debt redeemed and the associated
KeySpan subsidiary:
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KeySpan Subsidiary Series Due Date Amount ($000)
- ----------------------------------------------------------------------------------------------------------------------------------
KeySpan Corporation 7.25% Medium Term Notes November 2005 $ 700,000
EnergyNorth Natural Gas 9.70% Series B September 2019 7,000
EnergyNorth Natural Gas 9.75% Series C September 2020 10,000
EnergyNorth Natural Gas 8.44% Series D January 2009 1,667
EnergyNorth Natural Gas 7.40% Series E September 2027 21,285
Essex Gas Company 10.10% Series 1990 December 2020 8,000
Essex Gas Company 7.28% Series 1996 December 2016 10,000
- ----------------------------------------------------------------------------------------------------------------------------------
$ 757,952
- ----------------------------------------------------------------------------------------------------------------------------------
KeySpan incurred $54.5 million in call premiums associated with these
redemptions, of which $45.9 was expensed and recorded in other income and
deductions on the Consolidated Statement of Income. The remaining amount of the
call premiums have been deferred for future recovery. Further, KeySpan wrote-off
$8.2 million of previously deferred financing costs which have been reflected in
interest expense on the Consolidated Statement of Income. The total after-tax
expense of the debt redemption was $29.3 million or $0.18 per share.
28
Also during the third quarter of 2004, KEDNY retired a portion, $8.0 million, of
its outstanding Gas Facilities Revenue Bonds. The funds used to retire this debt
were drawn from a special deposit defeasance trust previously established by
KEDNY. Approximately $640 million of Gas Facilities Revenue Bonds remain
outstanding.
At September 30, 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, in May 2005, three
years after the date of issuance of the MEDS Equity Units, 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.
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 KeySpan's 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 shares
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 KeySpan's 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.
In June 2004, KeySpan completed the restructuring of its credit facilities. We
entered into a new $640 million five year revolving credit facility to replace
the $450 million, 364 day facility which expired in June. We also amended our
existing three year $850 million facility due June 2006 to reduce commitments
thereunder by $190 million to a new level of $660 million. The two credit
facilities total $1.3 billion and are each syndicated among sixteen banks. These
facilities continue to support KeySpan's commercial paper program for working
capital needs.
The fees for these facilities are subject to a ratings-based grid, with an
annual fee of 0.08% on the new five-year facility and 0.125% on the existing
three-year facility. Both credit agreements allow for KeySpan to borrow using
several different types of loans; specifically, Eurodollar loans, Adjustable
Bank Rate (ABR) loans, or competitively bid loans. Eurodollar loans in the
five-year facility are based on the Eurodollar rate plus a margin of 0.40% for
loans up to 33% of the total five-year facility, and an additional 0.125% for
29
loans over 33% of the total five-year facility. In the three-year facility
Eurodollar loans are based on the Eurodollar rate plus a margin of 0.625% for
loans up to 33% of the total three-year facility, and an additional 0.125% for
loans over 33% of the total three-year facility. 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%. Competitive bid loans are based on bid results
requested by KeySpan from the lenders. We do not anticipate borrowing against
these facilities; however, if the credit rating on our commercial paper program
were to be downgraded, it may be necessary to do so.
The facilities contain 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% until the
expiration of the existing three-year facility in 2006, at which time it will be
lowered to 62%. Violation of this covenant could result in the termination of
the facilities and the required repayment of amounts borrowed thereunder, as
well as possible cross defaults under other debt agreements.
10. GAS EXPLORATION and PRODUCTION PROPERTY - DEPLETION
As described in Note 2 "Business Segments," KeySpan's investments in gas
exploration and production activities consists of its approximate 23.5%
ownership interest in Houston Exploration, as well as KeySpan's wholly-owned
subsidiary KeySpan Exploration and Production, which is engaged in a joint
drilling program with Houston Exploration. Further, KeySpan's investments in
these activities also includes its wholly-owned subsidiary Seneca-Upshur. These
assets are accounted for under the full cost method of accounting. Under the
full cost method, costs of acquisition, exploration and development of natural
gas and oil reserves plus asset retirement obligations are capitalized into a
"full cost pool" as incurred. Unproved properties and related costs are excluded
from the depletion and amortization base until a determination as to the
existence of proved reserves. Properties are depleted and charged to operations
using the unit of production method.
To the extent that such capitalized costs (net of accumulated depletion) less
deferred taxes exceed the present value (using a 10% discount rate) of estimated
future net cash flows from proved natural gas and oil reserves and the lower of
cost or fair value of unproved properties, less deferred taxes, such excess
costs are charged to operations, but would not have an impact on cash flows.
Once incurred, such impairment of gas properties is not reversible at a later
date even if gas prices increase. The ceiling test is calculated using natural
gas and oil prices in effect as of the balance sheet date, adjusted for
outstanding derivative instruments, held flat over the life of the reserves.
As a result of the stock transaction previously mentioned, KeySpan now accounts
for its investment in Houston Exploration on the equity method, i.e. Houston
Exploration's operations are not consolidated with KeySpan's other subsidiaries.
Therefore, we are now required to calculate the ceiling test on KeySpan
Exploration and Production's and Seneca-Uphsur's assets independently of Houston
Exploration's assets. Based on a report furnished by an independent reservoir
30
engineer during the second quarter of 2004, it was determined that the remaining
proved undeveloped oil reserves held in the joint venture required a substantial
investment in order to develop. Therefore, KeySpan and Houston Exploration
elected not to develop these oil reserves. As a result, in the second quarter of
2004, we recorded a $48.2 million non-cash impairment charge to write down our
wholly-owned gas exploration and production subsidiaries' assets. This charge
was recorded in depreciation, depletion and amortization on the Consolidated
Statement of Income.
11. PREFERRED STOCK
In July 2004, KeySpan redeemed 83,268 shares of preferred stock 6.00% Series A
par value $100 that were previously issued in a private placement. KeySpan
redeemed these shares at a 2% premium and incurred a cash