Item 1. Wholesale Services
Our wholesale services segment, which consists primarily of Sequent, focuses on asset management, transportation, storage, producer and peaking services and wholesale marketing. Sequent captures economic value from idle or underutilized natural gas assets, which are typically amassed by companies through investments in or contractual rights to natural gas transportation and storage assets. Operating margin is typically created in this business by participating in transactions that balance the needs of varying markets and time horizons.
In addition, Sequent takes advantage of arbitrage opportunities within the natural gas supply, storage and transportation markets to generate earnings, and its profitability is correlated to volatility in these markets. Natural gas market volatility can result from a number of factors, such as weather fluctuations or the change in supply of, or demand for, natural gas in different regions of the country. Sequent seeks to capture value from the price disparity among geographic locations and various time horizons created by this volatility. In doing so, Sequent also seeks to mitigate the risks associated with this volatility and protect its operating margin through a variety of risk management and hedging activities.
Sequent provides its customers with natural gas from the major producing regions and market hubs primarily in the eastern and mid-continental United States. Sequent purchases transportation and storage capacity to meet its delivery requirements and customer obligations in the marketplace and its customers benefit from its logistics expertise and ability to deliver natural gas at prices that are advantageous relative to other alternatives. Sequent has entered into agreements that have facilitated the expansion of its operations into the western United States and Canada and plans to pursue additional opportunities in these regions during 2008. Sequent continues to work on projects and transactions to extend its operating territory and is entering into agreements of longer duration, as well as evaluating opportunities to expand its business focus and models including its commercial and industrial customer base through acquisitions and organic growth.
Competition Sequent competes for asset management business with other energy wholesalers, often through a competitive bidding process. There has been significant consolidation of energy wholesale operations, particularly among major natural gas producers. Financial institutions have also entered the marketplace. As a result, energy wholesalers have become increasingly willing to place bids for asset management transactions that are priced to capture market share. We expect this trend to continue in the near term, which could result in downward pressure on the volume of asset management transactions and the related operating margin available in this portion of Sequent's business.
Asset Management Transactions Sequent's asset management customers include affiliated utilities, nonaffiliated utilities, municipal utilities, power generators and large industrial customers. These customers, due to seasonal demand or levels of activity, may have contracts for transportation and storage capacity, which may exceed their actual requirements. Sequent enters into structured agreements with these customers, whereby Sequent, on behalf of the customer, optimizes the transportation and storage capacity during periods when customers do not use it for their own needs. Sequent may capture incremental operating margin through optimization, and either share margins with the customers or pay them a fixed amount.
The following table provides additional information on Sequent's asset management agreements with its affiliated utilities
In October 2007, the Georgia Commission extended the asset management agreement between Sequent and Atlanta Gas Light to March 2012. Under the terms of the extended agreement, the sharing percentages are unchanged; however the agreement now includes guaranteed minimum annual payments to be made by Sequent of approximately $4 million. The contract year under the extended agreement will be April 1 to March 31 with Sequent making quarterly sharing payments. Sequent is actively negotiating the renewal of its remaining affiliate asset management agreements scheduled to expire in 2008, which require regulatory approval.
Transportation Transactions Sequent contracts for natural gas transportation capacity and participates in transactions that manage the natural gas commodity and transportation costs in an attempt to achieve the lowest cost to serve its various markets. Sequent seeks to optimize this process on a daily basis as market conditions change by evaluating all the natural gas supplies, transportation alternatives and markets to which it has access and identifying the least-cost alternatives to serve the various markets. This enables Sequent to capture geographic pricing differences across these various markets as delivered natural gas prices change.
As Sequent executes transactions to secure transportation capacity, it often enters into forward financial contracts to hedge its positions. The hedging instruments are derivatives, and Sequent reflects changes in the derivatives' fair value in its reported operating results. During 2007, Sequent reported unrealized gains of $5 million associated with transportation capacity hedges, most of which are expected to be realized as these positions are settled in 2008. During 2006, Sequent reported unrealized gains of $12 million associated with transportation capacity hedges. The majority of this amount was realized during 2007 as the positions were settled. Sequent did not report any significant gains or losses on these types of hedges during 2005.
Producer Services Sequent's producer services business primarily focuses on aggregating natural gas supply from various small and medium-sized producers located throughout the natural gas production areas of the United States, principally in the Gulf Coast region. Sequent provides producers with certain logistical and risk management services that offer producers attractive options to move their supply into the pipeline grid. Aggregating volumes of natural gas from these producers allows Sequent to provide markets to producers who seek a reliable outlet for their natural gas production.
Park and Loan Transactions Sequent routinely enters into park and loan transactions with various pipelines, which allow it to park gas on or borrow gas from the pipeline in one period and reclaim gas from or repay gas to the pipeline in a subsequent period. The economics of these transactions are evaluated and price risks are managed in much the same way traditional reservoir and salt dome storage transactions are evaluated and managed.
Sequent enters into forward NYMEX contracts to hedge its park and loan transactions. While the hedging instruments mitigate the price risk associated with the delivery and receipt of natural gas, they can also result in volatility in Sequent's reported results during the period before the initial delivery or receipt of natural gas. During this period, if the forward NYMEX prices in the months of delivery and receipt do not change in equal amounts, Sequent will report a net unrealized gain or loss on the hedges.
Although Sequent's quarterly results were modestly impacted by unrealized hedge losses during 2007 and 2006, on an annual basis Sequent did not report any significant gains or losses on park and loan hedges during 2007, 2006, or 2005.
Mark-to-Market Versus Lower of Average Cost or Market Sequent purchases natural gas for storage when the current market price it pays plus the cost for transportation and storage is less than the market price it could receive in the future. Sequent attempts to mitigate substantially all of the commodity price risk associated with its storage portfolio and uses derivative instruments to reduce the risk associated with future changes in the price of natural gas. Sequent sells NYMEX futures contracts or over-the-counter derivatives in forward months to substantially lock in the operating margin it will ultimately realize when the stored gas is actually sold.
We view Sequent's trading margins from two perspectives. First, we base our commercial decisions on economic value, which is defined as the locked-in gain to be realized in the statement of income at the time the physical gas is withdrawn from storage and ultimately sold and the derivative instrument used to hedge natural gas price risk on that physical storage is settled. Second is the GAAP reported value both prior to and at the point of physical withdrawal. The GAAP amount is impacted by the process of accounting for the financial hedging instruments in interim periods at fair value between the time the natural gas is injected into storage and when it is ultimately withdrawn and the financial instruments are settled. The change in the fair value of the hedging instruments is recognized in earnings in the period of change and is recorded as unrealized gains or losses. The actual value, less any interim recognition of gains or losses on hedges and adjustments for LOCOM, is realized when the natural gas is delivered to its ultimate customer.
Sequent accounts for natural gas stored in inventory differently than the derivatives Sequent uses to mitigate the commodity price risk associated with its storage portfolio. The natural gas that Sequent purchases and injects into storage is accounted for at the lower of average cost or current market value. The derivatives that Sequent uses to mitigate commodity price risk are accounted for at fair value and marked to market each period. This difference in accounting treatment can result in volatility in Sequent's reported results, even though the expected operating margin is essentially unchanged from the date the transactions were consummated. These accounting differences also affect the comparability of Sequent's period-over-period results, since changes in forward NYMEX prices do not increase and decrease on a consistent basis from year to year. During most of 2007 and 2006, Sequent's reported results were positively impacted by decreases in forward NYMEX prices, which resulted in the recognition of unrealized gains; however, the impact was more significant for 2006. During 2005, the reported results were negatively impacted by increases in forward NYMEX prices. As a result the more significant unrealized gains during 2006 increased the unfavorable variance between 2007 and 2006 and had a positive impact on the favorable variance between 2006 and 2005.