Court clash on the cards for Contact

In the first of a two-part series examining New Zealand's largest ever public share issue, MARK REYNOLDS looks at some of the risks associated with Contact Energy's business.

One of the first things Contact Energy is likely to do when it is sold to the public is to issue court proceedings against its previous owner - the Government.

Contact Energy is seriously contemplating taking the Government to court over the value of its contracts to buy gas from the huge Maui oil and gas field off the Taranaki coast.

This dispute over gas values is just one of many risks that people wanting to invest in Contact will need to consider before they send in a cheque to buy shares in the electricity and gas company.

Other complications include increased competition in the electricity sector following law changes from April 1, a dispute with the contractor for a huge new power station in South Auckland, potential for earthquakes or landslides to damage the company's hydro power stations in the South Island, Contact's dependence on a few key managers to run its complex business, and its extensive exposure to the vagaries of the overall economy.

The gas contracts are probably the most difficult risk for everyday investors in Contact to come to grips with. They are important because the cost of Maui gas is a key component of Contact Energy's business. To begin with, the cost of Maui gas sets the price that Contact's 105,000 retail gas customers will pay for gas.

That includes customers of Enerco in Auckland who have just been taken over by Contact.

Maui gas is also the main fuel for many of Contact Energy's electricity generation plants. If the company can reduce the price of gas, it will be able to sell electricity more cheaply and therefore compete more effectively against other electricity suppliers such as TransAlta and the three companies formed from the split of ECNZ.

Contact buys Maui gas from the Government under a contract which does not expire until 2009. The Government, in turn, buys the gas from the field's owners, Fletcher Challenge, Shell Petroleum and the family-owned Todd Corporation.

There is a lot of uncertainty about how much gas is left in the Maui field, and consequently unexpected failure or reduction of gas supply from the field could have a major impact on the company's ability to continue business.

But more important for people considering buying shares in Contact are the financial obligations the company has under the Maui gas contracts. The obligations are to take or pay for gas each year until 2009. That means that even if Contact does not want all of the gas it is contracted to buy, it must pay for it.

At present, the Maui contracts provide more gas than Contact actually needs to run its electricity operations and supply its gas customers.


Therefore it is paying for gas it has not yet used. Contact currently writes off the cost of those prepayments - which amounted to nearly $20 million in the company's latest financial year.

The amount of gas Contact is forced to buy is determined in part by how much gas remains in the Maui field. Contact has received a report from an independent consultant that the remaining reserves in the Maui field are fewer than the Government says is in the field.

The court case Contact is considering would pit the Government's assessment of the size of Maui against Contact's independent report.

The prospectus for the sale of shares in Contact points out that if Contact wins such a case, its take-or-pay obligations could decline substantially.

Those obligations stand at nearly $1.4 billion, so it is easy to see why Contact is considering the legal action against the Crown.

While a drop in the price it pays for gas could have significant benefits for Contact, the company's prospectus points out that its business is also facing pressure from electricity market prices.

The electricity market is changing following the split of ECNZ into three competing companies. The split is expected to see the ECNZ companies undercut each other to sell bulk electricity on the wholesale energy market. Because Contact produces more than a quarter of the electricity in New Zealand it will be caught up in the price war.

"There is potential for extreme price competition on a sustained basis, which would have a material adverse effect on Contact's future results of operations," the prospectus warns.

The company forecasts extreme volatility in the wholesale market over the next three months, but that is expected to settle down toward the end of this year.

Overall prices for this financial year are nevertheless expected to be substantially lower than last year.

At the same time as the pressure comes on wholesale prices, Contact will face increasing competition from retail electricity companies. The industry is forecast to hot up following changes in energy laws that have made the retail market more open to competition from April 1.

Contact is also exposed to competition in both the wholesale and retail gas markets and that is expected to increase following a split later this year of Contact's main gas competitor, the Natural Gas Corporation. NGC will set up a separate gas retailing company to compete with Contact and that is expected to push down retail gas prices.

Contact can manage the gas-price pressure to some extent by producing power from its hydro-powered generators in the South Island, like the Clyde and Roxburgh dams. But, as the Contact Energy prospectus points out, that puts the company at the mercy of weather conditions.

Contact's hydro-facilities are also susceptible to other natural phenomena. The Roxburgh Dam, for example, is having $3 million in repairs made to it to bring it into line with current earthquake standards.

All of the risks mentioned above can be managed by Contact, and to some extent have been since the company was split off from ECNZ three years ago.

But even the people who have managed Contact over those years are one of its business risks now.

As the company's prospectus says: "Contact's business and its development has, to a significant extent, depended over the past three years on the efforts and abilities of keep certain management personnel, in particular Paul Anthony, the managing director and chief executive officer."

Mr Anthony has a clause in his employment contract that was designed to make sure he stayed with the company at least until it was privatised. But that clause also means he would receive an attractive settlement if he left the company within 12 months of its privatisation.

Settling that management risk is just one of the many risks that Contact Energy's new owners are going to have to look at closely.

* Tomorrow: The rewards - how Contact Energy will manage its risks.