EQT Corp (EQT) 2003 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Equitable Resources Third Quarter 2003 Earnings Conference Call. [operator instructions]

At this time it is my pleasure to turn the floor over to Mr. Pat Kane.

Thanks.

Good morning everyone and thank you for participating in Equitable's third quarter 2003 earnings conference call.

With me are Murry Gerber, Chairman, President and CEO, and Dave Porges, EVP and CFO.

In just a moment, Dave will review the third quarter financial results that were released this morning.

Murry will then regard comments regarding Equitable's future prospects.

Following Murry's remarks, we will open up the phone lines for questions.

But first, I'd like to remind you that today's call may contain forward-looking statements related to such matters as the anticipated earnings per share, targeted growth of earnings per share, the company's EPS sensitivity to change NYMEX gas prices, deviations from normal weather and effect of the possible tax bill, our capital budget, financial performance, dividend pay-out and yield, the impact of regulatory matters and the potential for changes in law and regulation, operational matters, including the success of the company's drilling program, the effectiveness of automation metering and pressure optimization projects and the company's action plan with respect to defined benefit plans and realizing value from our Westport investment without causing any undue disruption to Westport.

It should be noted that a variety of factors could cause the company's actual results to differ materially from anticipated results or other expectations expressed in the forward-looking statements.

These factors are listed in today's earnings release, the MD&A section of company's 2002 Form 10-K as well as on our web site.

Finally, the reconciliation is required under new SEC regulation G for all non-GAAP financial measures mentioned on the call today are contained in our earnings release, which is available on our web site at www.eqt.com in the Investor Relations section.

I'd like to turn over to Dave Porges.

Thank you, Pat.

Equitable Resources today announced third quarter 2003 earnings of 45 cents per diluted share, this compares with diluted earnings of 42 cents in third quarter of 2002.

It is the highest third quarter EPS our company has ever had.

As is our norm, I will briefly discuss results from each of our three business units and then discuss some other topics of potential interest to investors.

First Equitable Utilities.

This segment had operating income for the third quarter of $5.3 million compared to $3.3 million reported for the same period last year.

This increase is primarily attributable to higher storage and commercial margins and higher volumes in margins on off-system sales.

Also contributing to the increase in the operating income was a 3.6% decline in operating expenses versus the same quarter last year.

Next, Equitable Supply.

The production and gathering segment had operating income for the quarter of $50.6 million, which was 18.5% higher than the $42.7 million earned in the same period last year.

The main drivers for this increase were increases in sales volumes and prices, though there was also an increase in operating income in the gathering business.

There are three relevant volume figures each of which increased.

First, which is directly related to reported sales revenues, is the sum of net equity sales and monetized sales volumes.

This increased by 4.5% versus the prior year.

This along with 12% increase in weighted average well head sales price explains the 16% increase in total production revenue.

The second volume figure is total operated volumes, which is a proxy for well head production from operated wells.

This increased 1% versus the prior year, normalizing for the sale earlier this year of some Ohio property total operated volume increased 2%.

The third volume figure, pro forma sales is similar to the total operated volumes figure except that it nets out company usage and loss unaccounted for gas.

This figure highlights another aspect of our asset optimization strategy and pro forma sales volume increased by about 3% versus the prior year and close to 4% when factoring in the sale of Ohio properties.

Since operating volumes have not increased as much as we would like and we have focused more attention on identifying where the issues exist.

Most of our larger districts where we are focusing our capital dollars are now performing as expected.

We are not spending much money on our smaller districts and the resulting natural decline should be more than offset by the growth in the larger districts.

However, our third largest district in southern West Virginia is performing well below plan, even though it is showing improvement versus last year.

Additionally, we have found that the growth capital being devoted to wells surveillance and automation is providing -- is not providing return yet even though the technology is largely in place.

Upon studying this issue further, we have concluded that the potential for this type of investment is still great.

But there is a great cultural and behavioral learning curve that we had not anticipated resulting in a lag in getting returns from the initiatives.

Murry is going to spend more time discussing the specific steps we are taking now that we identified the areas in which the performances are not meeting expectation.

Moving on to the gathering part of the business, revenues were $1.8 million higher at $17.8 million compared with $16 million in 2002.

The increase gathering revenue is due to an increase in equity gathering volumes - gather volumes and higher gathering rates.

We believe there is more room for improvement in both of these areas, especially in rates in 2004.

Finally, I would like to discuss NORESCO.

Operating income in this segment for the third quarter was $4.8 million, or $0.3 million less than the same period last year.

Though revenues were down, the reduction was primarily in lower margin projects.

From our perspective, a truer cause of the decline in operating income was the presence in last year's quarter of a $2.4 million gain from the termination of demand-side management contract with an electric utility partly offset by the absence of last year's $1.1 million in reorganization charges.

The third quarter numbers also benefited from the consolidation of two small projects, Hunterton and Plymouth, which contributed $0.5 million in operating income, but this consolidation also resulted in increase that you see in minority interest.

Net of those three items operating income was up $0.6 million versus last year.

NORESCO's decline in construction revenue was the direct result of decline in backlog.

NORESCO's backlog coming into the third quarter was only $78 million versus $157 million in the middle of 2002.

However, NORESCO's backlog as of September 30, 2003 was $158 million, which is the highest backlog NORESCO has ever had.

As we have mentioned often, backlog is lumpy, so we are not reading too much into this record, but it obviously feels better than a lower backlog would.

Now, I'd like to turn to four other topics of potential interest.

The first of these pertains to the SEC.

We mentioned some time ago that the SEC was reviewing Equitable's registration statement for the debt issuances of several months ago.

This review included a review of historical financials incorporated in or referenced by that registration statement.

This process now appears to be completed as the SEC has allowed the amended S-4 to go effective and the exchange offer for the debt issues is now underway.

For closure we would like to summarize the result of this review.

First, we have filed an amended 10-K for the year 2002 and an amended 10-Q for the first quarter of 2003.

The single change in these ammended filings is in the language describing the conclusions of the CEO and CFO with respect to the effectiveness of Equitable's disclosure controls and procedures.

The change makes the disclosure clearer by removing the reasonableness qualifier.

Also as the result of the SEC review, we reviewed our accounting for certain items and made changes on a prospective basis.

Though we mentioned these in the second quarter, I would like to summarize them again in the spirit of full disclosure.

We have agreed to consolidate the results of one of the small NORESCO projects called Hunterton, in which we own 50% interest.

This consolidation has a very minor effect on the balance sheet and the specifics of that factor are shown in the second quarter’s 10-Q.

Our analysis had already concluded this entity would need to be consolidated with the implementation of the new VID rules which I will discuss further in a moment.

Secondly, we increased the book basis of our investment in Westport Resources from about $10.25 per share to about $16.50 per share.

Practically the entire value of our $13 million share stake in Westport Resources is reflected on a mark-to-market basis on our balance sheet.

The book basis numbers I just cited refer the amount of that value that is reflected in the common stock as opposed to the other comprehensive income category within the common shareholders equity section of our balance sheet.

These are the basic numbers that will be used to recognize gain or loss on any disposition of Westport stock.

Since we adopted the available for sale method of accounting for this investment as of March 31, 2003, we would not expect to see any other changes in the per share basis except in the unlikely event of distribution from Westport.

This change does not affect our tax basis, which remains about $5.30 per share.

As an aside, we did discuss with the SEC, our accounting for pre-paid forwards in the statement of cash flows.

In the end, given the significant disclosures we have already included in our financials on these transactions, the SEC did not object to the position taken by Equitable and agreed to by our auditor with respect to the very narrow facts and circumstances related to our transactions.

My next topic is pensions.

We have begun the process of dealing with both our underfunded position and our desire to insulate shareholders from investment risk associated wide these obligations.

In September, we contributed $48 million in cash to our pension plan.

This compares to our 12/31/02 reported unfunded status of $55.6 million.

We have determined that we would generally like our funded status to be above 90%, but this is a moving target given the various assumptions that various regulatory bodies like to use and change periodically.

The total of $48 million was selected because it is the maximum that we can contribute relative to our 2002 obligation and still receive a tax deduction.

And it got us into the desired funding range.

Perspectively we intend to take three additional steps regarding our pension obligations.

First, we intend to fund the $48 million contributions with the sale of approximately $3 million shares of our Westport stock.

There are timing issues involved so we do not wish to commit to a specific month.

But you should also be aware that we will agree as result of whatever transaction that involves to standard lock-up for the remaining 10 million shares at that time.

The Westport remains a non-core holding, we have no current plans for the disposal of any additional shares beyond the 3 million.

Our second pension related move, we have decided to transition the remaining non-union employees who have defined benefit plans, all of whom work for Equitable Utilities, to a defined contribution plan.

There may be a charge that we take to earnings at the time that transaction is accomplished.

Please note that the senior management at Equitable has defined contribution rather than defined benefit plans.

Our final pension related move is to get out of the business of subjecting shareholders to additional defined benefit obligations beyond those incorporated in existing agreements.

Specifically this means that in our labor contracts, we will be moving towards defined contribution arrangements such as 401-Ks.

Where this is not possible, we will buy annuities from highly rated insurance companies to make sure that effectively our shareholders are supporting a defined contribution arrangements even if the employee is receiving a defined benefit.

This latter technique will be utilized in a five-year contract agreed to this week with the union in Kentucky that had struck three years ago.

Fin-46 is my third topic.

As you are likely aware, there are new accounting standards for dealing with so-called variable interest entities or VIEs.

The jist of these standards is that VIEs probably need to be consolidated by some other entity once it is established that they are in fact VIEs.

Along with our auditor, we have tested numerous entities that are associated with Equitable in one way or another to determine if they qualify as a VIE and if so, whether we are the appropriate entity to consolidate.

We have determined to adopt this new standard, Vin-46 as of the quarter ended September 30, 2003, and if further determined one such VIE, a NORESCO project called Plemett (ph) should be consolidated by Equitable.

This brings about $4 million in additional debt on to the consolidated balance sheet.

As mentioned a moment ago, a second NORESCO project Huntington would have been consolidated as a result of our adoption this quarter of VIN 46, had we not already determined to begin consolidating it earlier this year.

As a reminder, that brought about 3 million dollars in debt under to the consolidated balance sheet.

We are further determined that another NORESCO project, Jamaica, should be de-consolidated, this removes about $16 million in debt from the consolidated balance sheet.

We did review the two sales of interest in natural gas reserves from 2000 and this resulted in the determination that our current accounting treatment remains appropriate.

Finally, we want to update you on share repurchases.

During the third quarter of 2003 we repurchased approximately 250,000 shares of Equitable Resources stock, this reduced level of repurchases is consistent with our decision of earlier this year to sharply increase our dividend.

The total number of shares repurchased since October of 1998 is approximately 16.4 million out of the current 18.8 million share repurchase authorization.

I will now turn the call over to our CEO, Murry Gerber.

David, thank you.

Good morning, everybody.

I'd like to make a few points about our Supply business building on what Dave has previously said.

First, as strategic matter after a very intensive review, I am still confident in the opportunity available to our company for providing profitable organic growth from our Supply business.

Second, as you all know, I have taken a long-term view toward investment economics in this business.

This discipline is made operational by targeting investment returns at our cost of capital using a 220 NYMEX natural gas price.

We employ this discipline cognizant of two facts.

First, we know that forecasts and actual results can vary due to factors outside of our control or due to unplanned events and we want to identify problems early and change course if required.

Secondly, we know the in an environment such as today where gas prices can be secured for a long period of time, we don't want our disciplines to prohibit us from making secure profitable investments.

We are always balancing these two competing issues and the tension created makes us a better company.

So, with that in mind, let's go through where we are today in supply from several angles.

First, from the angle of drilling.

Our analysis shows overall drilling results from our 2002 and 2003 drilling programs are meeting our volumetric expectations.

The 2003 program is a little above expectations at this point and the 2002 program is a little below.

However, as Dave mentioned in one of our districts in southern West Virginia, the results are not meeting our expectations.

In this district our analysis shows that while the drilling in total is profitable at current prices, it is not sufficiently profitable to survive our downside profitability test.

Some of the reason for this shortfall versus expectation is due to well performance and some is due to lack of sufficient and reliable pipeline capacity to get the gas to market.

In reaction to these facts, we have redirected our drilling capital to areas that based on recent performance are more likely to meet our expectations.

We still intend to drill 400 wells this year.

Secondly, references well automation and surveillance.

I would like to say that a significant aspect of our growth strategy in supply is related to getting more gas out of our existing wells.

We wish every well to produce at its maximum profitable rate every single day.

Tactically this has required a capital investment in metering, monitoring and controlling wells and pipeline assets.

It has also required a significant cultural change in the way field operations are conducted.

It is fair to say this capital investment is a work in progress, and that we are not yet seeing the production increases we hoped to see by this point in time.

We are still confident we will realize a significant return on our investment from this initiative and we will not decelerate this process of automation and surveillance.

The actions that we are currently taking include a major shift in organizational structure in our supply business to better align our engineering and operating staff.

We are putting more engineers in the field to help train and direct field operations to utilize the new technology.

And we are changing out or eliminating personnel who refuse to make the cultural change or who do not perform against realistic expectations.

Third, referencing pipeline curtailment and pressure optimization as I mentioned before, curtailment both internal and external has been a major concern for us.

So far this year curtailment has been about .5 BCSE or nearly 33% worse than our expectation.

In addition we continue to see the opportunity to enhance production by reducing pressure in our gathering system.

The actions we have taken to mitigate curtailment include the following.

A total of $18 million has been committed toward 57 projects totaling about 270 miles of new pipeline and 13,000 horse power of compression.

We believe these projects to be very profitable.

We have also secured more short-term firm capacity on Tyco to help ensure gas flows during the periods of high curtailment, mostly in the summer.

We continue to look for de-bottlenecking or pressure enhancement opportunities that lessen our dependence on third parties.

All of the results that we've seen to date will be considered in setting our 2004 capital program.

Our capital program may be affected in terms of the amount of capital and/or in terms of the distribution of capital among districts and among various asset optimization initiatives.

I will reiterate though that we will not invest your capital in projects that do not provide you with an adequate return.

With that, I will turn the call back over to Pat for questions.

That concludes the comments portion of the call.

Leander can we please open the call for questions?

Thank you.

The floor is now open for questions.

If you do have a question, please press the numbers 1 followed by 4 on your touch-tone telephone.

We do ask that if on speakerphone to please utilize your handset to provide optimum sound quality.

Once again, that is 1 followed by 4 on your touch-tone telephone to ask a question.

If at any point your question has been answered and you would like to remove yourself from the queue, remove yourself pressing the pound sign.

Our first question is coming from David Maccarrone of Goldman Sachs & Co. Please go ahead, sir.

Thank you.

Good morning, everyone.

I wanted to ask you, Murry, regarding that the statement that you won't invest in projects without an adequate return.

Can you go through how you go about evaluating whether or not your investments are generating an adequate return and what is your time horizon for making that decision in light of the capital that has been spent so far and given the economics of that you’ve stated of 220 NYMEX return on drilling projects anyway getting at least 8% return on capital and the gas prices being a lot better than that?

Yes.

David, it's a good question.

In my remarks and in our analysis, it's clear that even in the southern West Virginia area in total the profitability -- those wells are profitable at the current market prices, but they don't meet that hurdle that we talked about, which was 8% at 220.

That is the real reason that we’ve curtailed that operation.

So, we are still targeting 8% at 220.

Having said that, prices have crept up a little bit in the field.

We are spending little more per well than we had thought and these curtailment issues have required us to invest some more gathering capital.

And so, we're looking again at that balance between making investments that we can secure with hedging at this point that are profitable and strictly adhering to 8% at 220 on every single dollar that is spent.

So, I think you can understand the tension there.

We will not do investments that are unprofitable and to date even in the area we are targeting as being under-performing, we still believe those are profitable investments, they’re just not as profitable and they’re not as resilient to downside as we would like them to be if you catch the distinction there.

I think I do.

But I am trying to appreciate is the amount of investment you’ve made over the last two years or so and the relatively modest pace of production improvement you’ve made.

Is it timing?

And what's the slope of the ramp-up in 2004 and then as we look out to your I think 2006 projection, is it 25 BCFs a year improvement in sales still a reasonable expectation?

I think the major issue that we're seeing in terms of the what you call the lag, doesn't have much to do with the drilling, as I mentioned.

The '02 program is providing is performing a little less well than we thought but '03 is doing better.

The reduction versus our expectation in production is due to the automation and surveillance lag.

And I think that when we get together another time we can more fully get into the details of the mix there.

But, I'm not all that -- not as troubled about the drilling results and frankly from the standpoint of surveillance and automation although it is not meeting our expectations, we know what we need to do.

I mean it involves some training, some cultural changes, putting the engineers in the field and so I think we are going get all that back.

I'm expecting that the lag -- that we're just going to see lag in the production increase rather than a reduction in the overall opportunity.

And finally, on the narrowing in guidance for 2003.

I was just wondering is it fair to say the slower pace of volume increase is the primary driver?

I'm trying to understand with respect to the tax credit it was my understanding at least going back to your initial guidance that you had anticipated those credits expiring as well as a variety of other increased pension and litigation expenses for 2003, is that a fair characterization?

Pat is going to address the guidance address issue.

But I will say that we have been conditioned to narrow the range because you always go to the top of the range.

That is one tactical reason why it is smaller.

I will let Pat discuss the guidance in more detail.

Yes, Specifically to the second 29 issue, David.

Coming into the year we acknowledged that we had approximately 10 cents in benefit from Section 29 tax credits in 2002.

The view on the energy bill has -- seems to change every month and now over 10 months into the year, it doesn't look like it is likely to happen this year.

So, rather than continue with the hope that that comes back and is retroactive, we decided it is prudent to acknowledge that it is less likely and we are lowering our guidance.

We were able to – we’re helped by price to make back up to 5 cents from the bottom of the range.

OK.

I will follow-up with you on that off line.

Thank you.

Thank you.

Our next question comes from Heinz Seagle (ph) of Wachovia.

Thanks and good morning.

Murry, if I could just follow-up on the supply business for a point of clarification, couple of questions.

One is what is the opportunity to hedge out longer-term conversely with gas prices as high as they are right now?

Is there an opportunity to do prepaid sales or maybe just sell assets right out because it would appear to me that the market might be willing to pay much greater price for reserves than what you are currently looking at when you use the 220 forecast.

That's number one.

Number two.

Along those same lines, if you believe that a $3 price was more sustainable or if you use $3 to run the economics, what would that do to your investment profile and what would that do to accelerate production going forward?

And thirdly, given the lag that you are seeing right now, is there any timeframe in which you think that these problems will get resolved?

Thanks.

Let me address the latter two questions first and then maybe David can address the first one, which is more of a financing question, I think.

As far as the lag, at this point as I said before, I'm feeling good about the drilling.

But, I don't have a specific timeframe to be able to tell you when the benefits from the automation of surveillance will start to occur.

And all I can tell you on that is we are working hard on it and we are making a lot of changes out in our Supply business.

And as I said before I'm confident that we will get more out of these wells.

Again, at another time we can be more specific about why I say that.

It involves a number of wells that aren't performing up to expectation, a lot of details.

I think we can get to that in perhaps in our annual meeting.

That's really the issue of the third question, I think you were asking.

We -- is there an opportunity for more capital investment at 3?

I mean your question basically is, are we limiting the opportunity to grow because we have such a severe downside test.

And all I can tell you about that is number one, the reason we have a downside test is because – and chop this up to my experience, there seem always in the E&P business to be factors that bite you and I don't know how to say it any other way.

It's just my experience is that a severe downside test is required to assure profitability of these production businesses.

If you look across the board, the E&P business in our country is profoundly unprofitable and I think it's for lack of discipline to test these projects at lower prices.

So, frankly I am not going to move off of this philosophy to test our projects at a very severe downside price.

Now, again, as I said in my comments, there is a tension.

If we can absolutely secure a particular price and we are very certain of the volumes, then we are willing to invest that money.

But if you see what happened in southern West Virginia, we thought we had a secure program and it didn't quite perform the way we wanted.

And as a result, we didn't meet our expectations.

So, the direct answer to your second question is I don't believe -- I believe there could be more volume opportunity by lessening the standard.

But, I don't believe there would be more profit opportunity when you use cost of capital as your benchmark.

I hope that answers your question and then David can talk about the financing issues.

Broadly, Yves, our view is we are open to the idea of selling off non-core properties and high grading the operation.

I mean, that is broadly something we are interested in.

The Ohio sale, the earlier oil sale that we had from a year or so ago was consistent with that, as well.

So, it is something that we think about from a strategic perspective.

As far as the monetizing aspect of it, we are also interested in that.

As some of you probably may recall, we did not want to go down the road of doing more monetizations until the Vin 46 rules which we knew were coming, had settled down.

Certainly they seem to be settling down though I think there are probably still some interpretive stuff out there as far as other transactions that we might consider.

In addition I am from what I have seen, I am optimistic about us getting the returns from the surveillance and the well automation.

And as a result I'm not that anxious to get us engaged in monetizations, while we are still not seeing the volumes that we will see from those, in my opinion, from the well automation and the surveillance activities.

So there is a couple of things that causes not to be anxious to do something right away even though we recognize prices are up.

As for the prepaid forward specifically, we never want to say never, but I am not that inclined personally to advocate more prepaid forwards.

They seem -- I view them frankly as relatively simple transactions.

It sounds like you may view them as relatively simple transactions.

There are portions, the investment community, the rating agency community, the SEC, that do not see them in the same way.

They seem to be viewed in a more confusing way than I think they are.

But if they are perceived to be confusing, then they are confusing and therefore, our tendency, the bias at this point is to just let the existing one run out.

As you recall, we have two prepaid forwards.

One of them does conclude at end of 2003 and the other one has two more years to run.

So at this point we are thinking that is not the direction we are likely to head in.

I appreciate those answers.

Could I follow-up with two last questions and then I will pass it on.

What I was trying to get at is how liquid is the market?

How far out can you go with hedges or the like just to lock in I think pretty attractive prices.

And then, the final question I promise, is just on marketing.

You have done a really nice job of growing that business.

Can you just give the outlook on the sustainability of the level where you are at now and maybe any thoughts on how much that business can grow?

Thank you for your answers.

I will take the hedging piece.

And then I will turn it over to Murry about the marketing.

What you can observe, you can probably go out to around about 20-10 or so in the over-the-counter market.

I think some of you know better than I do, we are right know going out to about maybe early 2009 or mid 2009 on the NYMEX.

That is something anybody can look up.

But I believe it is a rapid sometime in 2009 the last NYMEX contract -- it is not extremely liquid, frankly, it’s not that liquid once you get beyond a couple of years.

But there is volume and we have taken advantage of that market.

We think you can generally speaking go out to I guess that would mean including over the market or over the counter rather about 8 years would be my gut reaction on how far you can go out and get deals done even though the liquidity does drop off significantly after the first couple of years.

Murry.?

On the marketing and trading piece.

Keep in mind, Eve, this is just utilizing our assets better.

If we are not using them we sell them or rent them to somebody else. or whatever and That is all that is about.

We have absolutely no intention to expand that operation beyond the best utilization of our own assets.

My view is that plus or minus where we are now is a fairly sustainable range.

We do not want to introduce a lot of volatility in our earnings due to marketing and trading operations.

We stopped doing that several years ago and we are not going to get back into that business if well as long as I am here.

We are not going to do that.

I intend to be here, so please do not write any of that stuff.

I am staying here. but we just do not view that as a profitable business.

Enhancing our assets a little is good.

But we just do not think cost of capital can be earned in that marketing and trading business.

I hope that answers your question.

About sustainable, do not expect it to go up that much.

Great.

Thank you very much.

Thank you.

Our next question comes from Jay Unello of UBS Warburg.

Good morning, Murry.

We will stop writing that stuff.

Thanks, Jay.

My comp (ph) committee.

I promise.

A Couple of questions.

How much have you spent year-to-date on surveillance and well automation?

What is the budget kind of going forward?

Without getting into too many details or kind of slinging mud, can you give us downturn examples of what is not being applied there?

Just some simple examples of what is not being used.

Murry, do you have that number?

Its about $10 million.

That was the estimate. and in addition I gave you the number on the pipelines, which Is about $18 or 19 million.

In terms of mud-slinging what did you want to know?

Jay

Without slinging mud, you said there is culture issue and there might be personnel -

Yes.

I know but I do not really want to get into that all that much.

I think if you can appreciate, you are not the only ones on this call.

I Sufficed to say, I have been in the field.

I have reviewed, I have been extensively in the field.

I have reviewed the work of a lot of our people out there engineering and operations, and suffice to say that significant changes need to occur in some areas.

Can I leave it at that?

I guess so.

I will go on to another topic.

I am being very pliable today.

I will go on to another topic.

About the high gas prices and that being passed on to the customers, are you juicing up bad debt expense yet, amortization for that?

Or is it a steady assumption and you will catch up later in the year if it gets higher?

We make accurate assumptions as we see them Jay.

That we did in the first quarter of course, to beef up our reserves for bad debt.

At that time what we said was that we didn't want to get in a position where we were reporting earnings that were a little frothy in the Q1 only to later realize that we had a lot of bad debt expense.

At that time people were wondering why we juiced up our reserve a little bit.

I don't -- we have no reason at this point to think that that was a bad decision or that - maybe David.

We will reassess it as appropriate.

The winter got obviously is a big deal in the utilities.

It is just one of those things that you will be more likely to reassess at the end of the year.

I will tell you that we have reorganized some of our efforts there earlier in the year.

We put some of our brighter folks into that area.

I believe they've been making progress.

But, my sense at this point, let's see what kind of progress they continue to make and see if that affects what we need to be doing on the reserve front.

The technical matter, the regulatory matter, I guess is what you would say Jay.

I don't want to be long-winded on this.

There are two groups of customers that don't pay.

There is one group that don't pay and can pay.

There is another group that don't pay and can't pay.

And as you know, I'm sure Pennsylvania is not much different than other states.

There is great sympathy among commissions to give forgiveness to people that don't pay and can't pay.

I think that's a social cost and a regulatory issue that I think we've accepted as a country.

We may not like it, but we’ve kind of accepted it.

What David is referring to is we've done a lot more work on segmenting our customers among those two basic groups and we are working with the commission to have a better rate structure to deal with the don't pay-can't-pay people.

Further more, it is more regulatory relief so that we can take stronger actions with the people that don't pay and can pay.

And that's what David was referring to.

That is all our work in progress right now.

OK

I'm Sorry that is long winded, but that's the way it is.

No, that's fine.

Thank you.

Thanks Jay.

Thank you.

Our next question is coming from Craig Shere of Standard & Poor's.

Hello, two questions.

Murry, can you tell us if the new union contract helps you a lot with these efforts to implement culture change?

Do you expect that the efforts in that regard toward getting returns from the automation investments will see improvement by the first half of 2004?

The second question, David.

I'm a little confused by all the changes with pension, what is implicit in your guidance.

What is the year-over-year change going into ‘04 that you're assuming in terms of pension impact on the income statement?

There is not a big change in that.

Just because the way accounting works and the way the cash works, are kind of disconnected from each other.

So I wouldn't spend a lot of time on what the earnings impact is between 2003 and 2004.

My philosophical concern and I probably have been the one driving this, in the company, I don't think it is appropriate for the shareholder to take equity market risks on behalf of we employees or frankly retired employees.

Now, there is some things we can do and some we can't do.

But it is a much more of a philosophical issue about what risks we should be taking as a corporation and therefore what risk our shareholders should be taking and should not be forced to take.

And it is more that than it is about trying to bump earnings up from one period to another period.

But with that Murry, I would turn it over to you.

Yes, as some of you may have seen we did come to agreement with our union in Kentucky West and this is a union that by and large looks after the gathering system down there.

And this is the union that several years ago -- three years ago, actually -- struck the company.

And over a number of issues that related to productivity, wages, number of employees and a whole bunch of other things.

This time around we came to agreement with them and there are provisions in the contract that do advance the ball forward a bit.

You know, not as much as we'd like, but it advanced the ball a bit to achieve some of these productivity issues that we're talking about in the automation and surveillance.

I don't think, however, that there's anything in those particular contracts and in this one if any of the union contracts and this one in particular that prohibit us from making the progress that we need to make on auto and surveillance.

OK

And Murry, is it reasonable to see some clear progress in that regard by first half '04?

I'm betting on it.

And David, there's no implicit assumption of at least some cents per share in reduced expense to the income statement from the pension plan?

It might be something like a penny or something like that but really what we are doing is insulating ourselves from the risk of degradation and look my belief and 10 years from now you can check back and see if I am right or wrong.

Companies that are not dealing with their defined benefit programs now are going to go through periods where they have bad things happen to them.

So, we're not looking to create good things by taking say, charges now and then get earnings later.

We are just looking to prevent bad things from happening in the future.

I am confident the steps we are taking will do that.

My own belief is other companies out there who aren't taking those steps will have problems periodically in the future.

Great.

Thank you.

Thank you.

Our next question comes from John Edwards of Deutsche Bank.

Yes, good morning.

Murry, I'm trying to get a better sense here.

You were mentioning some of these improvements in production and some of it is your changing the drilling where you are focusing the drilling.

Some you are changing it on these cultural behaviors.

If you -- where are you getting the bigger bang for the buck?

Is it on drilling changes or these cultural and behavioral changes?

I think maybe I can give a vignette – but the direct answer to your question, I think the cultural changes more relate -- I'm sorry to back up.

Remember that what we want to do, is we want to make sure we are getting the most out of the existing wells and then drill up the inventory as much as we can.

Those are the two main value drivers again meeting our profitability criteria of course, but those are the two drivers.

I think the drilling in general, as I said earlier, is volumetrically meeting our expectations.

It is also operationally meeting our expectations.

When we say we are going to drill 400 wells, we do it.

And although we don't talk much about the work it takes to do that, it is a fairly noble project.

What I'm referring to culturally is two things.

One, an emphasis on – a little bit of emphasis away from a drilling culture and more -- which is let's go get the new wells drilled -- and more towards getting them most out of the old wells.

That is one cultural aspect.

Everybody is mostly enamored with new wells and not so enamored with getting the most out of the old well.

So that’s a cultural norm that we are putting, even it is hard for a lot of production-oriented companies to get that norms, so that's one big issue.

The second cultural issue is the embracing of the technology and recognizing that the skills required to make progress with new technology are different than the old ones and just a vignette -- we have some of these automated wells now that pump water out by themselves.

In the old days there were two or three, four settings on these automated pumpers and they certainly weren’t remotely operated or anything, you just go out there and crank a setting here, crank a setting there.

Now, there are hundreds or more settings.

They need to be -- these wells can be more precisely tuned to maximize the production.

I think first of all, some of the existing people are overwhelmed by that new information.

And we have to train them.

But, it is unacceptable for them to say, "I won't be trained or I don't want to make progress."

That is the cultural change I am talking about.

But the lag we have talked about which is why we think the lag will continue to exist on surveillance and automation is we did underestimate the amount of training that is required and that training is going to be required any time we put in new automation.

Frankly, that was a myth on our part.

We identified it and we are dealing with it, it doesn't mean there is not a lag, though It means there is going to be a lag going forward.

We are going to have training.

And the process is going to have to be reengineered to best take advantage of that new information.

That is going to take some time too.

So we do recognize a big piece of the issue is we have got to put our people in a position to succeed.

And we probably didn't do a very good job of that in the first year or so of putting this stuff in.

We’ve identified that as an issue and we are taking the corrective action.

But it is forever going to mean that putting in new automation is going to have -- we're going to have a lag involved in getting the returns off those kinds of investments.

OK.

We will try to bring more color to that later.

But I think one of the things that happens with all this new information is that people are finding all kinds of different things to do with it.

And I think they are seeing lots of opportunities, but they’re not able yet to implement all those opportunity says.

But we will talk more about that later this year or early next year.

If we translate this into growth in production, I mean, what should we -- now be thinking about as far as in terms of volumes going forward?

What's -- I think we were always thinking about something like 5% to 7% annual production growth in that ballpark.

I can't remember, I can maybe --.

What should we be thinking about now in terms of annual production growth or plan going forward?

First of all, we will be doing our capital budget in December, okay?

And then we will get that approved by the Board because there are obviously lot of trade-off says we need to make.

I would like to defer that discussion until - after we have approval of that capital program.

OK And there was something you said that I wasn't quite sure, it’s on the gathering.

It was you or Dave was messing.

On the gathering rates you saw that as an opportunity.

Can you talk more about that?

Briefly I think,-- generally speaking the gathering rates, there is always a tension between the producers and gatherers in any producing basin and it's our view that the gathering rates that we're charging on our gathering system, some of which are held down because of in some years past we deregulated some of our pipelines and there are sort of moratorium rates out there that we've had for some years.

But it looks like that those moratorium rates are less than what the market should be bearing.

So, that's really the nature of the opportunity.

And Look another kind of a vignette, we cannot at current rates, afford economically to make some of the investments in our gathering system that the producers, including our own producers, want to make.

That clearly in this environment makes no sense.

So what it means is we are only making return on the depreciated value of the assets.

And with the returns the rates have got to be sufficient to allow for reasonable return on incremental investments.

OK.

And then a last question and then I will get up, give the mic to somebody else, it’s just anything new we should be thinking about in terms of performance-based rates on the regulated side?

There is a lot of work being done on performance-based rates.

I think the team in the utility has done a real good job of taking almost all of the pieces of that pie that I show routinely and converting them into performance-based rates.

This issue of the people that don't pay and can't pay is a key part of that and I'm looking forward to getting all of those pieces of the pie secured under some kind of a rate, you know sort of a frozen rate, where we can actually make some progress in the -- soon.

Alright.

But I don't want to front-run the regulatory process on that.

Great.

Thanks.

Thank you.

Our next question comes from Anatol Feygin of J.P. Morgan.

Good morning everyone, couple -- I guess sort of follow-up questions.

One, on the improvement in line losses that you guys reported, about 22% better.

Is that something that is a result of the measurement and controls that you've put in place?

Should we expect that to flatten out going forward or to continue to improve?

Are you speaking of Line loss on the utility?

I'm sorry.

No, no, in the supply business.

Yes, It Looks like there has been some improvement this year.

We will continue to see some improvement going forward.

Again, the measurement and monitoring is helping us to identify that problem a little more clearly.

But, yes, we are expecting to see some more improvement there.

I think though that the major improvements in that business comes from the getting the gas out of the wells and making sure pressure is optimized.

I think those are the two main factors.

Line loss is important.

It is shrinking a little bit I think incremental opportunity is more on the those other areas rather than a line loss.

Great.

Not to beat a dead horse.

But on the southwest Virginia issue, just trying to reconcile the cultural and behavioral lag and I guess de-emphasizing investment in that area.

Is that because it has all the investment it needs and now it's sort of more of a question of training?

Or is it that you think that the returns from that training process will be more difficult than deploying capital elsewhere?

First of all at Southern, let's make sure we are clear, it’s southern West Virginia.

Right.

I think your question is, is there enough capital out there and do we just have to train the people or do we need more capital?

It is a bit of both.

I think you will see more capital employed and more training.

What's the scale of the southern West Virginia operations relative to -- is it 10% of the supply business in terms of reserves or production or -

Well, just do it in terms of the -- we are talking about issues of growth here.

In the 2003 drilling program that we first -- when we first started, West Virginia in total represented about 150 of the 400 wells and the southern West Virginia was plus or minus 90 or 100 of those wells.

So, you know, it was about a quarter.

And I think it's about that share of the production, as well.

Great.

Last question I guess mostly for Dave, on the prepaids, as you mentioned one of them rolls off at end of this year.

Thoughts on that incremental equity production, is that just -- should we just look at that as incremental cash flow accruing to the firm or -

Yeah, our view -- I view the prepaids as being a form of financing and really all that is happening when you see that deferred revenue is it is the equivalent of amortizing financial - its amortizing a liability.

As it happens, we do guess transfers files, that's not really financial directly but we are amortizing a liability and that amortization on that portion will stop.

On that one was about $100 million deal over a three-year period, so it's been about a little over that.

It has been about $34 million a year.

The other one is a little over 100 over five years.

So, you should see the deferred revenue number there dropping -- associated with those -- dropping from the low $50 million per year level to about $20 million per year next year.

And, yeah, that's just more cash flow.

Great.

Thanks very much, everyone.

Thank you.

Our next question comes from Carol Coale of Prudential.

Actually thank you, my questions have been answered.

Thanks, Carol.

Thank you and our next question is coming from Mike Heim of A.G. Edwards.

Thanks, just three left-over questions.

They’re all short so I will ask them together.

The larger loss at the corporate line, is that just the expensing of options or is there anything else going on there?

Two, the sale of the 3 million shares of Westport stock, by mentioning a lockout is the implication that those shares says will be sold back to Westport?

No.

The third question is just any update on regulatory front, any incentive stuff you are working on?

Thanks, the incentive stuff I will leave to Murry because I think that's just a follow-up on the utility questions.

So let’s see, on the other items, that really is primarily, it's not really options.

It is -- as I think we’ve mentioned before, but actually I will mention it again.

For the senior management we shifted the focus of our long-term incentive programs such that about 75% of it is in the form of in essence performance shares and we, performance units, I'm sorry.

Our General Counsel has appropriately corrected me as opposed to options.

So, for instance, Murry and I have had our, the number of options we receive reduced by a quite a fair amount.

So, you are seeing more of the long-term plan -- even without the adoption of option expensing you are seeing much more of our long term incentive compensation showing up on the income statement as an expense than it used to even though the amounts aren’t really changing, but it’s more of it showing on the income statement.

That’s primarily what’s going on there in the quarter.

You will recall from earlier in the year when we made the contribution to a charitable foundation when we founded that also would have showed up in that line item.

So, if you look at year-to-date numbers, you see that going on as well as what we call Epic, which is the performance unit.

Let’s see, if you handle the regulatory I think.

Frankly Mike, oh, you asked about Westport, no we would not be planning on selling those things back to Westport.

I just mean any kind of offering involving a public company, even if it is tiny, will presumably be or at least a number of those things involve some type of a 90 day, 180-day something like that lock-up.

And that is all I am referring to.

Whatever we wind up doing will probably wind up involving some type of a lock-up.

I was really only trying to communicate though that we think we fixed in on what the appropriate amount of shares is for that and that really what I was driving at is that is how we are funding the pension contribution.

OK

On the regulatory front, Mike. as I mentioned before We have-got the performance based rate on the demand side.

We have authority to do something on the commodity price side.

But, the market has not provided good opportunity, hasn’t yet provided good opportunity to implement that while we have we let customers fix their -- fixed sales service.

On the operating side, I think really there is three issues that we are trying to embed in some regulatory reform.

First is the one I talked about regarding the people that can not pay versus the people that can pay and sort of structuring something that allows us to recognize that there are some people who can not pay out there.

So that is one piece of the rates that we want to get settled.

Secondly is allowing ourselves to manage the loss then unaccounted for us inside the utility.

Third is to manage the operating cost, other operating costs out there.

So those are the three kind of general area says that we are looking at, trying to embed them in an overall rate that allows us to work on all those simultaneously.

That is kind of what is in the work trade now.

OK.

Very good Thanks for the update.

OK.

I might mention one thing. and This is really in reference to John's question earlier about the what is the volume going forward in the supply business.

As you can tell from our guidance, we are still looking at low double digit growth in '04. and Despite the lag that we are seeing in supply, we are not backing off our low double-digit growth going forward.

I hope that helps you, but we are not backing off that at this point.

Thank you.

Our next question comes from Sam Brothwell of Merrill Lynch.

Hello, I think you have answered most of them.

But just one that following up on one an earlier discussion.

If the energy bill did somehow revive section 29, would that have any impact for your outlook next year?

Yes, but you know we are not going to speculate.

We have heard so much on the debate on what it will involve, how long term it will be, existing wells versus new wells.

So at this point you know we have lived and died so many times with the darn energy bill at this point we are numb to it and will wait until we actually have something signed and then we will do the calculation and let you know.

OK.

Thanks a lot.

Thanks Sam

Our next question comes from Dinaldo Asey (ph) of Royalist Research.

Hello Murry and David, OK David you mentioned you may be shifting some of the benefit cost over and that may or may not result in charge, I guess depending on how much you get on the West port stock, etc.

Do you have magnitude at all in timing of that?

Would it be still this year or next?

And what you might be talking about?

I do not want to pre-empt any of the discussions but our Human resources group is having with the Utility or I am going to get in trouble after the call.

We are not talking about a big number.

Basically the economic value of the benefit would be the same.

All we are doing is shifting risk.

I understand.

Maybe I should go to say, whenever you shift any of that benefit, that risk to somebody else you have got to make sure when that happens you have fully funded whatever that piece is.

So really what is going on is you take a charge for any of the piece you took out that was not entirely fully funded.

I don't view it as being a particularly big deal on America; again it's just a risk issue going forward.

Fair enough.

Thanks for the update, guys.

OK, thanks Dinaldo.

Thank you.

We have a follow-up question from David Maccarrone of Goldman Sachs & Co.

Thanks, Murry, I wanted to ask you about the horizontal drilling and what the performance year-to-date has been and how you see that going forward?

We have completed a horizontal well and it is producing natural gas.

It is in sort of a clean up and evaluation phase at this point, that's about all these results are interesting.

And as I said, it will take us some time to evaluate it.

We did drill one.

I think we drilled 13,000 feet of hole and a few little laterals, and about 12,000 feet of it is in cold measures.

It is cleaning up right now, so, there is really no definitive results.

Relative to, I thought it was maybe four wells to drill this year, is it just a function of the learning process?

Yes, sir.

We've decided that we are going to drill and fully evaluate this well before we proceed with the next three.

OK.

And for Dave, any FAS 133 over or under effectiveness issues on the hedges?

OK.

It's about a $2 million this year, this quarter-- about $2 million of an increase in income.

OK.

And then finally on the -

This is Murry, I do always say David, that just gets buried in what are all in--at price number is.

Sure.

Finally on the union contract at the utility and implementation of the mobile workforce initiative, anything new there?

Now that the Kentucky one is finished, the contract you are referring to is the Steel Workers here in Pittsburgh.

We think that that, well we are hopeful that will come to a conclusion here very shortly.

What we hope one is going to positively impact the other.

OK, Thank you.

Thank you.

If there are final questions, once again, that is 1, followed by 4 on your touch-tone telephone.

Gentlemen, we appear to have no further questions.

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