Gaynor on Wednesday: Big dry a bad break for NGC

By BRIAN GAYNOR

Natural Gas Corporation/NGC/TrustPower

John Barton, the managing director of Natural Gas Corporation (NGC), is in the hot seat. His company is at the forefront of the electricity crisis and since taking up his new position in November, NGC's share price has dropped by one-third, its profit performance has slumped and the company's electricity customers are up in arms over price rises.

At the root of his problems is last year's acquisition of TransAlta New Zealand, an electricity retailer with limited generation capacity but with more than 500,000 customers in Wellington and Christchurch and on the North Shore.

In March 2000, NGC bought 75.8 per cent of TransAlta from TransAlta Canada for $824 million, or $2.79 a share. The purchase was partly financed by a four for five rights issue at $1.16 a share, which raised $366 million.

The memorandum sent to NGC's shareholders was extremely optimistic, particularly in terms of the company's purchasing power.

The report said that NGC would be the largest energy retailer in New Zealand, with more than 670,000 customers (574,000 electricity and 96,000 natural gas) and "the increased electricity purchasing power of the combined NGC/TransAlta customer bases should provide the opportunity to put in place attractively priced long-term supply arrangements with generators."

Later in the year, NGC acquired the remaining 24.2 per cent at $2.79 a share and TransAlta shareholders were offered either cash or NGC shares. (NGC's share price was set at $1.50 to determine the number of shares issued to TransAlta shareholders.)

Grant Samuels' appraisal report concluded that TransAlta's shares were worth between $2.29 and $2.60 each and the offer was fair.

But TransAlta's structural flaws were well documented in the Grant Samuels report. The company has generation capacity of 3600 Gigawatt hours (GWh) a year but 2700 GWh is committed to outside parties on long-term contracts. This leaves only 900 GWh available for TransAlta's retail customers, well short of its annual requirement of about 7400 GWh. The shortfall of 6500 GWh is provided by medium-term agreements, hedge contracts and the purchase of wholesale electricity on the spot market.

The generation shortage has not been a problem in recent years because there has been significant overcapacity and spot prices have been low. But TransAlta has always been vulnerable to a rise in wholesale electricity prices, although it told shareholders "[we] have in place risk-management policies to ensure this risk is appropriately monitored and managed."

These comments have come back to haunt Mr Barton and his management team. It is quite clear that its risk management strategies were woefully inadequate and the company has been badly affected by the low water levels in the South Island hydro lakes, reduced output and the sharp increase in wholesale spot prices.

NGC has had to raise electricity prices for its small-business and residential electricity customers by an average of 16 per cent. This will hurt consumers on the North Shore, but Mercury Energy customers in Auckland are safe because it is owned by Mighty River Power, a company with surplus generation capacity.

TrustPower also has a net generation deficit with annual sales of about 4000 GWh and generation output of 1750 GWh.

The Tauranga-based company has been affected by the rise in spot prices and announced on Friday that net profit for the six months to September 30 would be more than 50 per cent below the same period last year.

By contrast, Contact Energy is the big winner among listed companies. It has a huge generation surplus and is able to take advantage of the sharp increase in spot prices. According to Grant Samuels' recent appraisal report on the company, the high spot prices in April 2001, primarily through drought, brought record revenue for Contact Energy.

In light of this it is not surprising that Edison Mission Energy of the United States recently raised its Contact shareholding from 40.7 to 47.9 per cent, paying $3.10 a share.

Contact Energy is now in a very strong position to take advantage of the electricity price increase and grab retail customers from NGC, TrustPower and other retailers with generation deficits.

Although the two companies are close neighbours in Wellington, Stephen Barrett of Contact can turn up the heat on John Barton and take advantage of NGC's poor strategic position.

The sharp decline in NGC's share price has been a big shock to shareholders, as most of them believed that the company had secure earnings and cash flow. Many had not realised that NGC had bought a relatively high-risk electricity company that is vulnerable to a dry and cold winter.

The big lesson from the electricity crisis is that investors need to keep a close eye on South Island rainfall and hydro-lake water levels. A dry and cold winter suits Contact Energy, whereas NGC and TrustPower are best served by a wet and cold April to September. But in the longer term, Contact Energy has the best strategic position because it can adopt more aggressive pricing policies to attract new retail customers.

* Disclosure of interest: none.

* bgaynor@xtra.co.nz