DBRS Confirms Union Gas Limited at A, R-1 (low) and Pfd-2, Stable Trends

DBRS has today confirmed the Unsecured Debentures/Medium-Term Note Debentures (MTNs), Commercial Paper and Cumulative Redeemable Preferred Share ratings of Union Gas Limited (Union or the Company) at “A”, R-1 (low) and Pfd-2, respectively, all with Stable trends. The ratings reflect Union’s low business risk operations within a stable regulatory environment, dominant position within a strong franchise area, sound financial profile and credit metrics as well as earnings growth from its storage facilities and transmission system. The ratings also reflect the Company’s exposure to ongoing volume risk and a continued modest decline in customer consumption, as well as cash flow deficits due principally to working capital changes, growing contribution of revenues from the unregulated portion of its business and the low allowed ROE under which Union must operate until 2012.

The regulatory environment for Union remains stable and continues to allow the Company to recover prudently incurred operating expenses and capital expenditures in a timely fashion. Union is currently operating under an Ontario Energy Board (OEB) approved five-year incentive regulation (IR) plan wherein the Company’s distribution rates are adjusted annually based on the previous year’s revenue and a number of adjustment factors. Union’s allowed ROE of 8.54% is applicable for the duration of the IR framework until 2012 and its next cost-of-service rebasing for the subsequent period will be in 2013.

The IR framework provides a measure of regulatory stability that underpins Union’s predictable cash flow. However, DBRS notes that the original IR mechanism initially included a provision under which the Company was required to file for a review of the IR if its actual ROE was above/below 300 basis points of the expected level. Subsequently, when Union achieved normalized earnings for 2008 that exceeded the 300 basis point limit, it complied and filed for a review with the OEB. In June 2009, as a result of this application, an OEB approved agreement between Union and its stakeholders replaced the mandatory review provision with a 90/10 cost-sharing mechanism (in favour of customers).

More recently, in September 2010, Union applied for approval of 2011 regulated distribution, storage and transmission rates, effective January 1, 2011. The proposed delivery rate increase of less than 1% for typical residential customers is predominantly attributable to the removal of long term storage revenues from delivery rates pursuant to the OEB’s Natural Gas Electricity Interface Review decision.

Union continues to benefit from a large customer base that generates strong and stable cash flows, however, the Company remains exposed to a degree of demand risk since its rates are based on forecast volumes that are sensitive to changes in weather, economic conditions, pricing of competitive energy sources and declines in customer usage. The downturn in the Ontario manufacturing sector and overall economy will continue to place downward pressure on volumes in Union’s franchise area. However, this is partially mitigated by the relatively low price of gas which supports its competitiveness relative to other energy sources (e.g., electricity). The Company has stated that it expects a continued reduction in industrial demand for natural gas as a result of industrial and commercial production slowdowns and industrial plant closures in Ontario.

Union’s storage facilities continue to benefit from its strategic location at Dawn, the major natural gas hub in Ontario, which is connected to key pipelines and allows the Company to access other major Canadian and U.S. markets. The Company is expected to continue to expand its unregulated storage and regulated transmission businesses in the near- to medium-term and as such, DBRS expects earnings growth in this segment to outpace growth in the Company’s gas distribution segment as it experiences overall decline in total gas consumption in its service area due to energy conservation. DBRS notes that natural gas continues to enjoy a competitive advantage in Ontario relative to alternative sources of energy, notably electricity which is more costly.

The Company will likely experience negative free cash flow for the year ending 2010 as a result of higher capital expenditures and working capital changes, the latter driven in part by gas cost deferrals. Although Union is not presently engaged in any major expansion projects, DBRS believes that should the Company embark on any sizable undertakings that it will finance its capital projects in a manner that will ensure that it maintains a stable balance sheet and credit metrics appropriate for its rating category. Furthermore, DBRS anticipates that, if necessary, Union’s parent company, Westcoast Energy Inc., will provide financial support to the Company in the form of equity injections and/or reduced dividends to maintain its capital structure at the approved levels. Accordingly, overall, DBRS views Union’s liquidity level as sufficient for its external funding requirements and current ratings.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating North American Energy Utilities (Electric, Natural Gas and Pipelines), which can be found on our website under Methodologies.