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Executives

Timothy Silverstein

Ronald J. Tanski - Chief Executive Officer, President and Chief Operating Officer

Matthew D. Cabell - Senior Vice President and President of Seneca Resources Corporation

David P. Bauer - Principal Financial Officer and Treasurer

Analysts

Andrea Sharkey - Gabelli & Company, Inc.

Timothy M. Winter - Gabelli & Company, Inc.

National Fuel Gas (NFG) Q2 2013 Earnings Call May 3, 2013 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2013 National Fuel Gas Company Earnings Conference Call. My name is Katina, and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Tim Silverstein, Director of Investor Relations. Please proceed.

Timothy Silverstein

Thank you, Katina, and good morning, everyone. We appreciate you joining us on today's conference call for a discussion of last evening's earnings release. With us on the call from National Fuel Gas Company are: Ron Tanski, President and Chief Executive Officer; Dave Bauer, Treasurer and Principal Financial Officer; and Matt Cabell, President of Seneca Resources Corporation. At the end of the prepared remarks, we will open the discussion to questions. Also a new slide deck was recently posted to our Investor Relations website, which we may refer to during today's call.

We would like to remind you that today's teleconference will contain forward-looking statements. While National Fuel's expectations, beliefs and projections are made in good faith and are believed to have a reasonable basis, actual results may differ materially. These statements speak only as of the date on which they are made, and you may refer to last evening's earnings release for a listing of certain specific risk factors.

With that, we will begin with Ron Tanski.

Ronald J. Tanski

Thanks, Tim. Good morning, everyone. As you saw in our earnings release, we had a really good quarter both financially and operationally. Consolidated earnings per share were up nearly 20%, helped by a 30% increase in earnings in our Pipeline and Storage segment. Additionally, total production increased 57% as a result of several exceptional new Marcellus wells turned online during the quarter. Once again, we believe that our diversified yet integrated structure helped to drive our performance with improved results coming from each of our operating segments.

Before I move on with the rest of the call, I want to remind everyone that Dave Smith has moved up to the role of Executive Chairman of the Board. Therefore, he won't be participating in these call or the day-to-day details of the business. However, don't expect any major change in the strategic course of the company. Dave and I have spent a lot of years together here at National Fuel and have viewed the growth opportunities of the company in much the same way.

Under Dave's leadership during the last 3 years, National Fuel has invested more than $300 million on interstate pipeline projects and we've increased our contracted transportation capacity by 1 billion cubic feet per day. Over the same 3 years, in the Exploration and Production business, we've grown our Marcellus production from 0 to nearly 100 Bcf this fiscal year. And we've built a Midstream business of smaller-diameter, higher-pressure gathering pipeline from the ground-up.

Looking forward, Seneca will continue to focus on the Marcellus, where our results continue to improve as evidenced by the outstanding performance of our Tract 100 wells in Lycoming County, Pennsylvania, with several wells achieving peak production rates north of 20 million cubic feet per day. These wells continue to exceed our initial expectations, prompting us to again increase our production guidance.

In addition to Lycoming County, Seneca's other main priority this fiscal year is the delineation of our Pennsylvania legacy acreage in our Western development area. We're increasingly optimistic about the potential of this acreage, where initial results in the Rich Valley prospect area are extremely encouraging. We've kicked off a multiwell pilot development program across the acreage. And assuming we see results that are consistent with our initial well, we could be looking at hundreds of new well locations across this area.

In addition to our Exploration and Production activities, we'll continue to focus on ways to expand our Midstream businesses. In this quarter's results, you can see the year-over-year earnings impact that our new pipeline projects can have. Today, between our various FERC-regulated pipeline expansion projects and our 2 nonregulated gathering projects, National Fuel's system pipeline moved just about 1.4 billion cubic feet a day of Marcellus production.

Each of the projects we placed in service is expandable and our project development team is actively marketing new projects to producers. Some of these projects will be smaller in size, costing $10 million to $30 million, such as the modest expansion store Line N system that we have planned for later this year and in fiscal 2014. Others, like the Central Tioga Extension Project, will be larger, in the $150 million range, and consequently have a longer lead time. Nevertheless, this is a long-term business and we firmly believe the strategic location of our system and our ability to efficiently and timely complete the project to meet the needs of shippers will lead to continued growth.

The Utility business is the only segment that did not have any organic growth. We did have improved results this year because we had more normal winter compared to the last year that was 26% warmer than normal. We've continually done a great job in this business, controlling costs and delivering great service to our customers. Our delivery rates are among the lowest in the state. And our gas costs are generally either the lowest or among the lowest in the state.

We've done such a great job that we caught the attention of the New York Public Service Commission, who thought our earnings were too high and seemed interested in having us incorporate an earnings sharing mechanism in our rate, along the lines of the mechanism that we had in place a number of years ago. In March, we submitted a proposal with the commission that included just such a mechanism to become effective June 1. In April, however, the commission commenced a new proceeding, ordering the company to make a filing by May 8 and show cause why our rates should not be made temporary and subject to refund until the staff had time to more fully review these rates.

Now we've dealt with show cause orders before and they're a typical aspect of our regulated operations. So litigating with the commission for months and months is not out of the ordinary. What makes this particular order troubling, however, is that the commission is suggesting that they will invoke Section 66(20) of the Public Service Law to reach back and recover what they consider to be passed-over earnings. I think this is a terrible signal from a regulatory policy point of view and it discourages utilities and investors from making discretionary investment in New York State.

In the Exploration and Production business, however, we're continuing to invest heavily. And I'll turn the call over to Matt Cabell to update you on those operations.

Matthew D. Cabell

Thanks, Ron. Good morning, everyone. Seneca produced 28.8 Bcfe in the second quarter of fiscal 2013, a 57% increase over last year's second quarter. Since our last earnings call, we brought on 7 new wells at Tract 100 in Lycoming County, Pennsylvania. 2 of these wells came on at rates in excess of 20 million cubic feet per day. And of the 14 wells that we brought on since mid-January, 6 have exceeded 20 million a day. The average 7-day rate for all 21 wells on Tract 100 is 13.3 million cubic feet per day. We expect to add 4 more Tract 100 wells this summer and another 5 well pads this fall.

On our Western Pennsylvania legacy acreage, the Rich Valley well has been online now for a little more than a month. It hit a peak 24-hour rate of 8.1 million cubic feet per day and averaged 6.7 million over its first 30 days. Consequently, we are now estimating an EUR of 7 Bcf. We feel good about the potential of this area and are beginning the first phase of a development program with 2 wells drilled but not yet frac-ed and 7 more planned to be drilled and frac-ed in fiscal 2014. Given our fee ownership of the gas rights and consequent lack of royalty, we believe this area may have economics that are better than our successful Covington development in Tioga County.

We've drilled 6 Marcellus wells in the Western development area since the beginning of the fiscal year, including the aforementioned 2 Rich Valley/Clermont wells and have begun to complete them. Most of these wells are in areas where the Marcellus has a very low water saturation. So we will be soaking each of them for at least 30 days. In addition to Rich Valley, we have 2 wet gas wells at Owl's Nest, 1 at Church Run and a dry gas well in a prospect that we call Ridgway. We will begin seeing test results this summer.

Looking at our current drilling activity. We have 2 rigs at Tract 100 and our third rig is moving to Mount Jewett, preparing to drill a Utica delineation well. This well will be completed in September and tested in the first or second quarter of fiscal '14.

In California, production for the quarter was down about 6% versus last year, primarily due to expected natural decline at North Midway Sunset. In addition to production growth -- in addition, production growth at the CESP field was limited by a gas transportation issue. While the CESP bottleneck is related to gas, it has a more meaningful impact on oil production since the wells we have shut in are oil producers with only a modest amount of associated gas. We expect to have the transportation issue solved very soon. And we'll see an increase in West division production for the balance of the year as we bring all CESP wells back up to full production and bring on new wells at CESP, South Lost Hills and South Midway Sunset. Second half production for the West division should exceed production from last year's second half and full year production is anticipated to be similar to fiscal 2012.

We've taken over as operator at the East Coalinga Field and have begun reactivating idle wells. So far, 20 wells have been returned to production. And we have increased overall production from 230 barrels of oil per day to approximately 350 barrels of oil per day. We have also begun our evaluation drilling program. We have 12 Coalinga wells planned for the fiscal year, which will include a comprehensive suite of logs and whole cores through key producing intervals.

At our last earnings call in February, we raised our production guidance by 6 Bcf. This quarter, we're raising it again, this time by another 7 Bcfe and narrowing the range slightly to a new range of 110 to 118 Bcfe. The midpoint of the range is now 36% higher than our production volume in fiscal '12. The bottom of the range is now higher than what we projected as the top of the range early in the fiscal year. This is not because we are poor forecasters, but rather it's because we are drilling and completing some outstanding wells and bringing them online ahead of schedule.

Gas prices have improved substantially in the past few months as gas supply has tightened and storage has been depleted to normal levels. Subsequently, we are now planning to complete a Tract 595 pad in Tioga County that we had temporarily delayed last year when prices were weak. The sixth well, Pad C, will be completed in September and brought online in the first quarter of fiscal 2014. This adds about $25 million to $30 million for our fiscal '13 spending plan. Therefore, we are revising our guidance and narrowing the range to $525 million to $585 million. With this acceleration and the excellent results we have been having lately, we are also prepared to revise our 2014 production guidance to a new range of 132 to 142 Bcfe.

Let me close with a few comments about Seneca's longer-term plans for the Marcellus. We will be drilling and completing wells on Tracts 100 and 595 for another 2 years. As I mentioned, we are also beginning development of our Rich Valley area and could possibly have multiple rigs running in that area in fiscal 2015. The immediate Rich Valley/Clermont area has about 180 well locations. Current and future delineation work could very possibly extend this area into a larger trend and add another 300 to 500 locations. We've also drilled 3 delineation wells in the wet gas portion of our acreage, which will be tested this summer and fall. Positive results from wet gas region could lead to another significant development area with hundreds of well locations.

So while our immediate focus remains Lycoming and Tioga Counties, you should all understand that we are becoming increasingly confident of our continued robust production growth for the rest of this decade or longer. With that, I'll turn it over to Dave Bauer.

David P. Bauer

Thank you, Matt, and good morning, everyone. The second quarter was another outstanding quarter for National Fuel. Consolidated earnings of $1.02 per share were up $0.16 or almost 20% over the prior year's adjusted operating result. And that's in spite of a $0.66 per Mcf drop in the average after hedging natural gas price realized by Seneca.

Colder weather on the Pennsylvania service territory of our utility was the biggest driver behind the earnings increase. If you recall, the winter of 2012 was the warmest on record in our service territory, which weighed heavily on last year's earnings. The weather this year was much closer to normal, which allowed our Utility earnings and cash flows to return to more historic levels. Earnings in the Pipeline and Storage segment were up almost 1/3 on the back of our recent Line N 2012 and Northern Access expansion projects. Consistent with our prior forecast, these projects will add $23 million in annual revenues per year, about $21 million of which will fall within fiscal '13.

Seneca had another great quarter with adjusted EBITDA up by $23 million or 25%. And again, that's after a $0.66 per Mcf drop in realized natural gas prices, which impacted Seneca's cash flows by about $16 million. Operationally, all of Seneca performance metrics, including DD&A, LOEs and G&A in particular, showed significant improvements during the quarter. These cost structure improvements, which will drive enhanced profitability for Seneca in the future, reflect the evolution of Seneca's Marcellus program from the initial ramp-up phase to our current high-growth mode.

Starting with DD&A. Seneca's per unit DD&A expense of $2.05 per Mcfe dropped significantly from both the $2.30 rate from last year and the $2.12 rate in the first quarter. This decrease was caused by a combination of better-than-expected reserve adds and our continued focus on driving down drilling and completion costs, particularly at Tract 100. As a result, we're revising our full year DD&A guidance to a range of $2.05 to $2.15 per Mcfe.

Seneca's $0.97 per Mcfe of LOE expense for the quarter was down $0.17 year-over-year or about 15% and down $0.08 compared to the first quarter. This decrease is reflective of our growing base of low-cost Marcellus production. However, the drop from the first quarter is also partially a timing issue. You'll recall that a number of well workovers in California were front-loaded in the first quarter. I expect our full year LOE will be in the middle of the range of $0.95 to $1.05 per Mcfe.

When evaluating Seneca's LOE expense, it's important to remember that the $0.97 per Mcfe for the quarter includes gathering cost that are paid to Seneca's sister company, NFG Midstream, which is included in the all other category in our earnings release. The growth in Seneca's production has started to make a meaningful impact on Midstream's bottom line, approximately $0.04 per share of earnings and over $7 million of adjusted EBITDA for the quarter.

Seneca's G&A expense was $0.59 per Mcfe, an impressive $0.19 lower than the prior year's quarter. In nominal dollars, the nearly $17 million of G&A expense for the quarter was a little higher than you might have expected, given our guidance. But this is largely a timing issue associated with how we record certain expenses across the fiscal year. I expect our full year G&A will be in the range of $60 million to $62 million.

As you saw in last night's release, we're increasing our fiscal '13 earnings guidance to a range of $2.95 to $3.10 per share, at the midpoint, a $0.15 per share increase. The increase reflects our strong second quarter results and assumes Seneca's updated production guidance of 110 to 118 Bcfe and a flat $4 per MMBtu NYMEX price for our unhedged production for the remainder of the fiscal year. Our $85 crude oil price assumption is unchanged. Our guidance also assumes a full fiscal year effective income tax rate in the range of 40% to 41%. As you can see in last night's release, our effective rate for both the quarter and 6 months was a little more than 39%. During the quarter, we had 2 adjustments that served to lower the effective rate for the first 6 months of the year. We don't expect any similar items in the second half of the year.

With regard to capital spending, our consolidated capital budget for 2013 is now a range of $710 million to $820 million, which reflects the new Seneca budget that Matt described earlier. Our capital budgets for the other segments have not changed from our previous guidance. In terms of cash flows, we expect the incremental net revenues from Seneca's increased production forecast should fund most of its increased capital budget. Therefore, assuming the midpoint of our earnings and capital spending guidance, we still expect our full year fiscal '13 capital spending will just about equal our cash from operations.

Turning to our hedging program. As gas prices rallied, we added positions to our hedge book for fiscal '13 and '14. For the last 6 months of fiscal '13, we're a little more than 70% hedged for natural gas at a price of $4.49 and a little less than 60% hedged for oil at a price of $94.92. For fiscal '14, we now have about 63 Bcf of gas hedged at $4.28 and 1.6 million barrels of oil hedged at $100.26. At the midpoint of our production guidance, those positions translate to an overall hedged percentage of slightly over 50%.

Switching to our financing activities. In February, we issued $500 million of new 10-year notes. The transaction went extremely well. The order book was more than 3x oversubscribed and the 3.75% interest rate on the new bond is by far the lowest in our debt portfolio. Proceeds from the issuance were used to fund the $250 million maturity that occurred on March 1. A good portion of the remainder was used to pay down short-term debt. With the March maturity behind us, we now have a nearly 5-year window until our next maturity, which occurs in April of 2018. From a liquidity perspective, we're in terrific shape. As of today, we have approximately $100 million in cash on hand and full availability under our more than $1 billion of short-term credit facilities.

In closing, it was another great quarter for National Fuel. We continue to execute on our Marcellus opportunity set and our 20% growth in earnings and cash flows for the quarter is strong evidence of our success. Operator, can we please open the line for questions?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Andrea Sharkey representing Gabelli.

Andrea Sharkey - Gabelli & Company, Inc.

I was just curious. Maybe talking about the Rich Valley, it seems like you guys are getting a lot more excited about that. And so as that ramps up, how are you planning on handling, I guess, midstream gathering, takeaway capacity, and then also the bigger pipeline capacity? Will you have to go to a third party for that? Or will you do that yourselves? And I guess, maybe help us just think about how that will progress.

Matthew D. Cabell

Yes. Andrea, I think the first thing to understand is we can probably handle about 70 million a day with only some minor gathering lines put in. The National Fuel Line FM120 runs basically right through that Clermont area. So again we can get to about 70 million a day. Beyond that, we need a line that will -- more of a trunkline built. And as we kind of get through this pilot development stage, we'll be sizing that and figuring out exactly when and where and how we want to build it. So that would likely be our Midstream [indiscernible] .

Andrea Sharkey - Gabelli & Company, Inc.

Okay, great. And then I guess, thinking about CapEx plans for -- beyond 2013 and looking at fiscal 2013, how much higher do you think it could go if this $4 or better natural gas environment holds? It will affect both your E&P Seneca spending and also maybe potentially move some pipeline projects faster. I guess, how should we maybe think about that and how you would handle funding a significant increase in '14 or beyond?

David P. Bauer

Well, I mean, certainly we could be looking at spending a good amount more than our $770 million to $945 million that we've got for our fiscal '14 forecast. Now in terms of funding it, certainly higher gas prices help with that. And I think our balance sheet in the near term certainly can take on some additional leverage. That would be the first lever that we would look to.

Operator

Your next question comes from the line of Timm Schneider [ph] representing ISI.

Unknown Analyst

First question, in Lycoming County, are you guys restricting wells at all?

Matthew D. Cabell

No. We don't bring them on as fast as possible. But we are not curtailed at all there.

Unknown Analyst

Got it. And then how many wells do guys have in inventory right now that are completed, they're just not hooked up yet?

Matthew D. Cabell

You mean specifically at 100 or everywhere?

Unknown Analyst

Everywhere.

Matthew D. Cabell

We really only have 1 pad, that Pad C that I mentioned that has just sort of been drilled and sitting there. Everything else is sort of natural inventory. So let's see, at Tract 100, there's the 4 Pad D wells. We probably drilled all 5 of the Pad E wells so that would be 9 there at Tract 100. But they're not -- it's not as though we're making a decision not to complete them, they're just -- it's just a matter of timing because as you drill the pads, you've got to wait until the whole pad is drilled before you can begin the frac-ing operation. WDA, we've got another probably 7 wells that are not producing today. It's just a matter of time before we have them frac-ed and we have the flowlines built, so we can get them into production.

Unknown Analyst

Okay. Got it. And this one's, I guess, a bigger-picture question. You guys -- for the majority of the Western acreage, you needed kind of the $4.50 -- $4.50 plus gas to really go into high ramp mode. Has that changed at all with you guys? You guys know the acreage now. You guys are becoming more efficient. Service costs are kind of trending down. Is that -- what do you think the chances are that, that $4.50 becomes a $4 or a sub $4 over the next couple of years here?

Matthew D. Cabell

Well, I guess, what I'd say, Tim, is we're feeling pretty good about this Rich Valley/Clermont area at a, let's say, a $4 gas price, particularly as we've managed to drive down our costs in a full development mode. That said, we're drilling wells -- well, we've got 2 wells that are already drilled that need to be frac-ed and put online in that area. It'd be nice to have a few more data points besides just this 1 well. Or we could say for certain that this area is going to look great at $4.

Unknown Analyst

And just real quick on the pipeline set. How much gas are you guys flowing to Canada right now or on your system, I guess?

Ronald J. Tanski

Right now, the system is only flowing minor amounts. While we've got the connection for our Northern Access moving a fair amount of gas northward, a lot of that is getting dropped off with the El Paso or the Tennessee system and some also into the Millennium system right now. The overall amount that's going to be going into Canada anytime soon, we can't say. TransCanada is working on some bottlenecks that they have up at Parkway to be able to get a bunch more of their production up further closer to Toronto.

Unknown Analyst

What do you guys think the long-term opportunity set for National Fuel Gas Company specifically is with respect to moving gas to Canada?

Ronald J. Tanski

To try to put a number over and above the capacity that we have available with our Empire system and the legacy connections at Niagara would take a major pipeline across Lake Erie or so. So I'd -- looking maximum right now with existing infrastructure, you're probably looking at 600 to 650 a day, maybe up to 700 a day with some more compression.

Operator

[Operator Instructions] Your next question comes from the line of Tim Winter representing Gabelli & Company.

Timothy M. Winter - Gabelli & Company, Inc.

I'm sorry to tag-team you here, guys, but I was wondering if we could talk a little bit more about the New York Utility and the overearning issue. What I'm trying to get to is maybe what the potential earning sensitivity is here. On Slide 38, you're showing on a trailing 12-month return of 12.6%, allowed at 9.1%, what is -- maybe what is the trailing 12 months earnings there at the New York Utility and whether the 100 basis point change in return on equity? Can you provide some color there?

David P. Bauer

Yes. Well, I mean, certainly on the 100 basis point change in return on equity would be a few cents per share for the company. I think it's -- we're probably too early in the process to really say what the -- what we think the overall impact is going to be because we haven't really even sat down to start to talk to them about what a new arrangement might look like.

Ronald J. Tanski

Yes. Tim, it's very, very early in this whole proceeding. So there's a lot of talking to be done. It's possible that we could even kick off or pick up again with the discussions regarding our settlement proposal or our earnings sharing mechanism that we had filed back in March. So it really needs to cook a little bit here with the commission. And we're going to have to wait to see what happens at their June session before they've fully reviewed our order to show cause filing.

Operator

With no further questions at this time, I would now like to turn the call back over to Mr. Tim Silverstein for any closing remarks.

Timothy Silverstein

Thank you, Katina. We'd like to thank everyone for taking the time to be with us today. A replay of this call will be available at approximately 2:00 p.m. Eastern Time on both our website and by telephone and will run through the close of business on Friday, May 10, 2013. To access the replay online, visit our Investor Relations website at investor.nationalfuelgas.com. And to access by telephone, call 1 (888) 286-8010 and enter passcode 25230200. This concludes our conference call for today. Thank you, and goodbye.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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