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OGE Energy Corp. (NYSE:OGE)

Q3 2011 Earnings Conference Call

November 3, 2011 9:00 AM ET

Executives

Todd Tidwell – Director, IR

Pete Delaney – Chairman and CEO

Sean Trauschke – VP and CFO

Keith Mitchell – President, Enogex

Analysts

Brian Russo – Ladenburg

Operator

Good day, ladies and gentlemen and welcome to the Third Quarter 2011 OGE Energy Earnings Conference Call. My name is Kiana, and I’ll be your coordinator today. At this time, all participants are in a listen-only mode and we will accept your questions at the end of this conference. (Operator instructions) I would now like to turn the call over to Mr. Todd Tidwell. Please proceed, sir.

Todd Tidwell

Thank you. Good morning, everyone and welcome to OGE Energy Corp’s third quarter 2011 earnings call. I am Todd Tidwell, Director of Investor Relations. With me today I have Pete Delaney, Chairman and CEO of OGE Energy Corp; Sean Trauschke, Vice President and CFO of OGE Energy Corp and several other members of the management team to address any questions that you may have.

In terms of the call today, we will first hear from Pete followed by an explanation of the third quarter results and an overview of the Oklahoma rate filing from Sean, and as always, we will answer your questions.

I would like to remind you that the conference is being webcast and you may follow along on our website at, www.oge.com.

In addition, the conference call and accompanying slides will be archived following the call on that same website. Before we begin the presentation, I would like to direct your attention to the Safe Harbor statement regarding forward-looking statements. This is an SEC requirement for financial statements and simply states that we cannot guarantee forward-looking financial results, but this is our best estimate today.

I will now turn the call over to Pete Delaney for his opening comments. Pete?

Pete Delaney

Thank you, Todd. Good morning, everyone. For the third quarter, we reported earnings of $1.80 per share, compared to $1.65 in the third quarter of 2010. As I mentioned in our last call, it was a very hot Oklahoma summer, and reported utility earnings are higher primarily due to that wrecking hot weather. And as an example, in the Oklahoma City, this summer, we experienced 63 days of daytime highs of over 100 degrees, that compares to a normal year where we would have 10 days of 100-plus weather.

Gross margins in the gathering, processing, and transportation businesses in Enogex were all up, reflecting the positive fundamentals there. However, Enogex earnings were lower compared to last year due to higher operating expenses, offsetting the increase in gross margins compared to the third quarter of last year. So, our Enogex earnings were lower quarter over quarter. Enogex is still on plan to meet their financial target.

Additionally, we continued to make steady progress on key initiatives and in managing the record capital spend. As noted in the last call about our expectations of earnings to exceed the top end of our guidance, we have increased our 2011 earnings guidance to $3.40 to $3.45 per share. Previously, we mentioned our increased O&M and capital spending related to utility infrastructure, particularly around our power generation. Those investments have proven to be timely as we maintained our high reliability standard throughout this hot summer.

When we established an all-time peak demand of over 7,000 megawatts, it was about 400 megawatts higher than the last year’s record peak demand. Recovery of these investments and others is a key component of our $73 million regulatory filing with the Oklahoma Corporation Commission we made in late July.

The rate case hearing is scheduled for December and we anticipate new rates would be effective after the first of the year. Previously mentioned, we are undertaking the largest capital spending program in our company’s history in 2011 of nearly $1.5 billion. The first nine months of this year, we’ve invested over $900 million in our businesses. Besides our base capital spending on distribution and generation infrastructure and maintenance, we have several electric transmission projects underway.

We have wind turbines being placed in service as we speak at our Crossroads Wind Farm. We now have over 400,000 smart meters installed as part of our smart grid deployment, that’s about 50,000 meters higher than the last time we spoke.

We have three processing plants under construction or under development along with additional compression and expansions on our gathering system. So, we have a lot going on this year with five major project on track to be completed and operating either in 2011 or 2012 as planned.

For the period 2012 to 2016, we have nearly $4 billion of known and committed projects. Needless to say, we remain focused on project evaluation, planning, integration and operations.

Investment is, of course, only one part of the equation and we remain focused on mitigating cost pressures associated with the increased investment by focusing on the productivity of our operations. We believe our automated metering infrastructure investment will provide a platform for improving our productivity. Additionally, we are planning through our home-area network initiatives to provide customers with tools to manage to lower monthly bills, despite higher rates.

Speaking of cost pressure, of course, we expect several final rulings at year end from the EPA regarding regional haze and utility Mac. As you know, the EPA rejected our state plan to comply with regional haze regulations and expect a federal plan to be issued for Oklahoma that will require four scrubbers to be installed over a very short period of time.

We remain opposed to EPA’s plan because of the potential harm to customers and potentially, the state’s economy and in our analysis, their failure to follow the regulations. The Oklahoma Attorney General has filed suit questioning the EPA’s procedures regarding the rejection of the state plan and that lawsuit is currently in Federal Court.

If the settlement implementation plan is not changed from their initial proposal, another legal action would likely be our next step.

In addition to these regulations, we are evaluating the impact of the Cross-State Air Pollution Rule. Oklahoma, as you probably know, was not included in the recent final rule, but it is one of the supplemental state proposed to be added for reductions of NOx in the ozone season.

EPA has indicated it will be determining if Oklahoma will be included in the supplemental Casper sometime later this month. Mac has been postponed until December, as both Casper and Mac have nationwide implications. It is unclear when these rules become effective, because of the litigation opposing the rules by various states, but we continue to work on a comprehensive solution to all these regulations with an objective of minimizing the burden placed on our customers. We would, of course, like to see some more clarity in the rules to be able to invest wisely.

The economic front, Oklahoma City and the state continued to perform well. The unemployment rate in the metro area is about 5%, probably the lowest in the nation from large metro areas. State unemployment is higher at 5.9%. We are continuing to add customers, 7,000, to the systems, compared to third quarter of 2010.

Industrial and oil field sales continue to do well, driven primarily by the robust energy sector. That said, we continue to be aware that several manufacturers continue to struggle. Whirlpool announced plant closing in Arkansas, but on a normalized weather basis, megawatt sales are up over 2% year to date.

Turning to Enogex, earnings were lower quarter over quarter and Sean will discuss the drivers in more detail. Gross margins were higher as volume growth continues on the system in the gather segment, along with increased transportation revenues. Operating expenses were the main driver for lower earnings as we are hiring aggressively to build the capacity to manage the projected growth in volumes.

In addition, the Cox City processing plant was not back on service until mid-September which depressed processing margins, approximately $5 million in the quarter. NGL pricing remain strong and we expect additional value capture in the fourth quarter with Cox City already back in operation; the South Canadian processing plant is scheduled for service in mid-November.

Since the second quarter call, we’ve completed several initiatives in the Enogex business. We announced the conversion of a major customer from (inaudible) to fixed fee in return for long-term acreage dedications. The margins were negatively impacted in the short term from this agreement. We believe this is in the best interest of shareholders in the long term, as earnings volatility is reduced, our positioning for long-term growth is improved.

Our hedges roll off this year. The conversion to fixed fee agreements will work as a more cost effective hedge against commodity price volatility.

In addition to the contract conversion, we announced expansion of 120 million a day wheeler plant to $200 million [ph] a day which we should have completed by the first half of 2012. And now, the construction of the 200 million a day McLare [ph] plant will be operational in 2013.

These plant announcements further enhance our commitment to the area, ensuring producers that we will have the capacity to process their gas. With South Canadian and these other plants, we are increasing our endless [ph] processing capacity by over 60%.

Further positioning Enogex for sustained growth, we completed on Tuesday, our previously announced $200 million mid-stream asset and contract acquisition that provides a long-term acreage dedication of approximately 100,000 net acres in the heart of the Granite Wash region. There is substantial infrastructure build-out required over many years to meet projected producer requirements and this position should create synergies with other opportunities in the most profitable natural gas basin in the country.

This acquisition, Enogex will have over a million gross acres of dedication in the Granite Wash and Cana regions providing the growth potential for many years to come.

In closing, I want to thank our members for the dedication and hard work that suppliers (inaudible) executed all these important initiatives. As I said before, we have much hard work in front of us, but we keep working our plan, executing on our key initiatives and delivering value to customers and shareholders. Now, I would like to turn the call over to Sean to review our financial performance in more detail. Sean?

Sean Trauschke

Thanks, Pete and good morning. For the third quarter, our net income was $179 million, or a $1.80 per average diluted share, as compared to net income of $163 million or $1.65 per share for the third quarter of 2010. Contribution by business unit on a comparative basis is listed on the slide.

Now, turning to OG&E. Net income for the quarter was a $159 million, or $1.60 per share as compared to net income of $142 million or $1.43 per share, 2010. Gross margin increased $28.3 million or nearly 7% and I’ll touch on gross margin on the next slide.

Other primary drivers are as follows. Operating expenses were relatively flat quarter over quarter. O&M declined primarily as a result of a change we made to the post retirement medical plan earlier this year to stabilize the rising retiree medical costs. Lower O&M costs were offset partially by higher depreciation and ad valorem expenses associated with additional assets being placed in the service.

Net other income decreased by $1.6 million for a couple of reasons. First, we had increased losses associated with the guaranteed flat bill program, which works as a hedge against weather. And second, we increased our charitable contributions compared to the third quarter of 2010. This decrease was partially offset by an increase in equity AFUDC funds primarily attributed to construction costs associated with the Crossroads Wind Farm.

And finally, interest expense increased $1.4 million primarily due to an increase in interest on long-term debt issued in May of this year. Gross margin increased $28.3 million compared to the same period in 2010. Main driver for the higher gross margin was the weather. As Pete mentioned in his opening remarks, 2011 was an all-time record summer in Oklahoma. Cooling degree days were 14% higher than last year and 36% above normal.

The average daily temperature in July and August was approximately 89 degrees which was 7 degrees higher than average. Hot weather increased gross margin by $10.2 million and net gross margin by $7.3 million when taking into account the impact of the guaranteed flat bill program, compared to last year.

Year to date, earnings per share have been positively impacted $0.30 compared to normal and $0.14 compared to last year. Higher transmission revenues increased the gross margin by nearly $7 million. Once we received the FERC order, we began to include CWIT [ph] and transmission gross margin instead of booking AFUDC. New customer growth increased gross margin by $5.7 million and the increase in Arkansas rates, riders and other items also positively impacted gross margin by $5.7 million.

Before moving on to Enogex, I would like to point out that in the third quarter, we booked a credit to customers relating to fuel expense in the amount of $5.1 million as a result of a settlement agreement with the Oklahoma Commission regarding the 2009 fuel adjustment costs. This $5.1 million reduction in the gross margin is included in the riders and other category above.

Now turning to Enogex, OGE’s share of net income for the quarter was $19 million or $0.19 per share as compared to net income of $23 million, or $0.23 per share in 2010. Gross margin increased by $11.4 million. And I’ll discuss those drivers in a moment. The other drivers are as follows. Operation and maintenance expense increased by $8.7 million in 2011, as we began building out our plant [ph] system growth.

Interest expense was $2.3 million lower compared to 2010, primarily due to an increase in capitalized interest as a result on increased construction activity on the system. Finally ArcLight’s 13.3% ownership reduced pretax earnings by approximately $5 million.

Now, turning to gross margin. Gross margins at Enogex increased $11.4 million in the third quarter of 2011 compared to 2010. Transportation, gathering and processing were all left [ph] this quarter compared to last year. Transportation gross margin increased $6.8 million, primarily resulting from higher demand fees on the MEP and Gulf Crossing capacity leases.

You’ll also recall that last year, capacity payments were reduced while the system was undergoing pipeline integrity work. In addition, the transportation business benefitted from natural gas sales along with new contracts and more favorable rates. Gathering gross margins also improved as volumes increased nearly 7% quarter over quarter. Processing business continues to benefit higher commodity prices and higher condensate volumes and prices.

Partially offsetting the higher processing gross margins were lower process volumes due to the outage at the Cox City plant which was not back in the show [ph] until mid-September. Average natural gas liquids prices increased from $0.92 to a $1.24 per gallon or 35%.

One quick comment on processing volumes. We do expect our processing volumes to increase year over year; however, we believe the growth will be just shy of 3%. A lot of this change has to do with the richness of the gas coming into our system and then falling out as condensate before reaching the processing plants.

Year to date, condensate volumes are up 9% and the margins are up $9.8 million. In addition, we’ve had some operational constraints due to Cox City outage. With that being said, Cox City is now in full operation and we expect the new South Canadian plant to be operational t his month. As a result, we expect volumes to increase significantly in the fourth quarter.

For a more detailed explanation of the earnings drivers for OGE, I would refer you to the company’s third quarter 10-Q filed with the SEC this morning.

Turning to the 2011 outlook, we are increasing our guidance to $3.40 to $3.45 per share. Has been a very hot summer and as I said it earlier, earnings have been positively impacted $0.30 per share year to date from the weather. On the second quarter call, I mentioned that because of the hot summer weather, we expected delays in our guidance.

Looking at the utility and based on the weather impact, we are projecting 2011 earnings to be between $2.50 and $2.55 per share, up from the previous guidance of $2.10 to $2.20 per share. At Enogex, taking into consideration the higher margins in the transportation business, higher natural gas liquids prices in the processing business partially offset by the fixed fee contract conversion, we have narrowed our range to $0.90 to $0.95 per share. Other key assumptions have been included in the 10-Q filed this morning.

Before answering your questions, I did want to remind you that we will provide 2012 guidance in February. In addition, I wanted to mention our updated CapEx table in the 10-Q and appendix of this presentation. You’ll notice that we’ve accelerated the Enogex investments to meet the growing demand for gathering and processing services. As a result of the increasing growth opportunities at Enogex, our projected capital expenditures for 2011 are now more than the previous year’s combined. Consistent with that, ArcLight investment will increase and we are now projecting they will own nearly 19% of Enogex by the end of 2011.

Lastly, I’m pleased to report that we have two transmission projects, the Sunny Side-the Hugo and Sooner the Rose Hill lines that will be in service in 2012. You will notice in the CapEx table that the total cost of these projects is now forecasted to be approximately $50 million lower versus what we estimated at the beginning of the year, certainly good for our customers.

With that, this concludes our prepared remarks. We’ll now open it up for your questions.

Question-and-Answer Session

Operator

(Operator instructions) And our first question comes from the line of Brian Russo with Ladenburg. Please proceed.

Brian Russo

Hi, good morning.

Pete Delaney

Hi, good morning Brian.

Brian Russo

Just at the utility, the EPA and FIP status, what are some of the upcoming dates that we should be aware of? And then just could you follow up on your comment that you might be presuming maybe an alternative field if the EPA rejects your previous proposal?

Peter Delaney

Yes, Brian. It’s Pete. In December, the EPA, it’s regional haze and we are expecting in mid-December, I think it’s around 18th, the Federal Implementation Plan from the EPA. Right now, on procedural grounds, the Attorney General has a lawsuit against the EPA on that, which is sitting in Federal Court, and we don’t know when that action will be taken. So that’s the key day. We anticipate it’ll probably be much in the form of their preliminary view we got of the Federal Implementation Plan.

We are – what I reference to is, should that be very close to that in final form, we believe – we filed comments on that as well, but we have a subset of case as opposed to a procedural case, particularly as it relates to the cost effectiveness standard which they are supposed to apply in regards to regional haze as it is not a health based standard, but a visibility standard.

We believe they aired greatly in their analysis and what I was refereeing to is that we will appeal to Federal Court that that Federal Implementation Plan.

Brian Russo

Okay, great. And just on figures [ph] to Enogex, could you remind me what you said about your processing volume growth, I think you said 3%. That’s for 2011, correct?

Peter Delaney

Yes, that’s correct.

Brian Russo

Okay. And anyway you can kind of translate into accelerating volume growth in ’12 and beyond as your capacity is increasing 50% with, I think, the South Canadian plant? And then if you could just run through, of course, with the new projects and the specific timing that those are the projects come on line?

Sean Trauschke

Okay. Why don’t I address the new process and projects first and then we will get to your volume growth question? So, as you well know, we have the South Canadian plant coming on line later this year, and that’s 200 million a day. And we previously announced the Wheeler plant, which originally was a 120 million a day, that 120 million will be available in the second quarter of 2012.

We’ve subsequently increased the capacity of that plant by additional 80 million a day and that additional 80 million will be available to us in the third quarter of ‘12 and then we announced that we are going to precede with a third plant being the core plant for 200 million a day which will be available, I mean, operational in the second quarter of 2013.

So, the way I think about that, Brian, is we are going to be adding 200 million a day this year, next year and in ’13. Now, as far as volume growth, we’ve not provided ‘12 or ‘13 volume growth, we will certainly lay that out for you in February, but I think it’s safe to say that with our commitment to build these plants that we are bullish on the volumes.

Brian Russo

Okay. And just the end, ArcLight’s ownership increasing to 19% by year-end, does that include their participation in these new projects or these new projects that have been announced, would that be incremental to the 19% if they choose to participate?

Sean Trauschke

Yeah. The 19% just pertains to the capital that would be extended this year, okay, and we will treat the capital contributions for 2012. We will incorporate that into our guidance, but we’ve not made that decision, OGE hasn’t decided at what level we are going to participate and then subsequently that will drive our clients [ph] participation.

Brian Russo

When is that – that kind of an analysis concluded or when is the participation breakdown finalized for the projects?

Sean Trauschke

Well, we do it in the aggregate, Brian, we don’t do it on a project by project basis. And so, we will lay that out for you when we provide the 2012 guidance and then any subsequent projects that come forward, we will deal with those on an independent basis – individual basis. Does that make sense?

Brian Russo

Yes, it does. And then I guess just on the cash flow statement, the nine-months ended, the $73 million contribution from non-controlling interest, does that bring ArcLight to the 19% or is that kind of a year to date and maybe still at 16%?

Sean Trauschke

That’s a year-to-date number that was through September 30th and we have subsequent contribution that occurred October 3rd and then November 1st which will bring them to a total contribution of $217 million for the year or roughly 19% ownership.

Brian Russo

Okay, great. And maybe, you could just talk about what you are seeing with pension expense?

Sean Trauschke

Sure, so we – we have roughly, in round numbers for forecasting pension expenses to be roughly $33 million this year. And a couple of things to keep in mind when you think about that pension expense. We take that pension expense and 85% of that – let me back up, 75% of that is designated towards the utility and of that amount 85% is designated to Oklahoma, and the reason that’s important is because in Oklahoma we have a pension tracker. And so to the extent that the Oklahoma portion of that pension expense is greater than $28.3 million, that will be –any excess will be classified as a regulatory liability going forward, conversely if it’s less than $28.3 million, that will be an asset.

We’ve made great strides in our pension plan. We’ve been funding that roughly $50 million a year for the last couple of years. We’ve reallocated our assets to really more of a 50/50 and we have long-term plan to get to the point where we match our liabilities and our assets closer together.

If you are looking at where we expect that to go and we’ve made considerable progress, unfortunately, it seems like we continue to lower the discount rate which changes our funded status on [ph] basis but we are very comfortable with where we are.

Brian Russo

Alright, great.

Sean Trauschke

(inaudible)

Brian Russo

Yes, it does. Thank you very much.

Peter Delaney

Alright. Thanks, Brain.

Operator

(Operator instructions) We have a question from the line of Brian Russo with Ladenburg again. Please proceed.

Brian Russo

Hi. I might as well ask another question since I might be the only one on the queue. Anyway, just, I was wondering if you just talk a little bit broadly speaking about the industry trends. In the mid-stream energy infrastructure business, we’ve seen a lot of consolidation announcements and some transferred assets into MLPs and I just wanted to get kind of your broader picture thoughts of how Enogex is positioned?

Peter Delaney

Well, I will start and Keith Mitchell, the President of Enogex, has any thoughts. From – we’ve continued to look long-term and the forecast and how – I know you are referring to some of the M&A activity that’s taking place, maybe on a long haul side, we’ve seen some there.

As we know, most gathering assets are held in MLPs and that’s been that way for quite some time. So I don’t rally see any change there. From our position, I think we’ve discussed pretty clearly why we went into our partnership with ArcLight and I think it’s coming to fruition in terms of the growth potential we’ve seen and how we position for that.

I talked about the acquisition we’ve made and the long-term acreage dedications that we have, and our position within our Mid-Continent is that we see with the economics a lot of continued drilling and we believe that we can, for the most part, meet our objectives focused on where we are today and we haven’t really seen any change in our forecast and what producers are going to be doing. And so, we feel well positioned to accomplish what we are trying to accomplish here. Keith, do you have any other observations?

Keith Mitchell

No, just reiterate what you said, Pete, and that is that we feel very well positioned, the areas that we are getting the dedications and we see our growth, our liquid rich areas with great drilling, economic fundamentals that exist today and we see continuing.

Brian Russo

Alright, great. I appreciate the comments. Thank you.

Operator

(Operator instructions) As we have no further questions, I’ll turn it over to Pete Delaney for any closing remarks.

Peter Delaney

Thank you, operator. Well, thank you all for your continued interest in OGE Energy and have a great day. We are adjourned.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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