Highlights:
For the quarter ended December 31, 2008, income available for common shareholders included net after-tax non-cash accounting losses of $41.9 million, compared with net after-tax non-cash accounting gains of $47.2 million for the quarter ended December 31, 2007. This negative $89.1 million after-tax change in non-cash activity quarter-over-quarter was related to derivative and inventory accounting activities at Integrys Energy Services, Inc. Integrys Energy Services expects to recover non-cash accounting losses related to derivative fair value adjustments and inventory valuation adjustments when the related electric and natural gas transactions are physically settled.
Although not readily apparent when including the non-cash activity discussed above, Integrys Energy Services had another strong quarter from an economic value perspective, evidenced by the growth in its forward book value. Energy prices sequentially declined around 20% during the fourth quarter of 2008, following the around 40% decline in energy prices during the third quarter of 2008. The lower energy prices provided attractive risk mitigation opportunities for Integrys Energy Services’ customers, who returned to longer-term, more typical contract practices. Forward contracted retail electric volumes increased around 33%, while forward contracted retail natural gas volumes were unchanged from December 31, 2007 to December 31, 2008. When compared to previous years, these reduced retail electric and natural gas volumetric growth rates resulted from Integrys Energy Services’ focus on higher quality business within existing markets, in addition to the effect of applying high credit standards under current market conditions.
Aided by a retail natural gas distribution rate increase at The Peoples Gas Light and Coke Company (Peoples Gas), an interim retail natural gas distribution rate increase at Minnesota Energy Resources Corporation, and colder weather conditions, earnings at the natural gas segment improved $7.9 million (28.1%) quarter-over-quarter.
Higher operating and maintenance expenses in the fourth quarter of 2008, compared with the same quarter in 2007, drove a $3.9 million (21.8%) quarter-over-quarter decrease in electric segment earnings.
Significant factors impacting the change in earnings and earnings per share were as follows:
Financial results at Integrys Energy Services decreased $76.7 million, from earnings of $49.1 million for the quarter ended December 31, 2007, to a net loss of $27.6 million for the same quarter in 2008, driven by the following:
An $89.1 million after-tax decrease in Integrys Energy Services’ margin quarter-over-quarter related to non-cash activity, of which $81.8 million was related to non-cash activity associated with electric operations, with the remaining $7.3 million related to non-cash activity associated with natural gas operations. An overview of this non-cash activity has been provided below.
Non-cash electric operations:
The 20% decline in energy prices during the fourth quarter of 2008 drove a $58.0 million net after-tax non-cash loss, compared with a $23.8 million net after-tax non-cash gain recognized in the fourth quarter of 2007, related to a 5% increase in energy prices during the fourth quarter of 2007. The non-cash unrealized gains and losses recognized resulted from the application of derivative accounting rules to Integrys Energy Services’ portfolio of derivative electric customer supply contracts, requiring that these derivative instruments be adjusted to fair market value. The derivative instruments are utilized to economically hedge the price, volume, and ancillary risks associated with related electric customer sales contracts. The associated electric customer sales contracts are not adjusted to fair value, as they do not meet the definition of derivative instruments under GAAP, creating an accounting mismatch. As such, the non-cash unrealized gains and losses related to the electric customer supply contracts will vary each period, with non-cash unrealized gains being recognized in periods of increasing energy prices and non cash unrealized losses being recognized in periods of declining energy prices, and will ultimately reverse when the related customer sales contracts settle.
Non-cash natural gas operations:
The spot price of natural gas decreased significantly during the fourth quarter of 2008 (below the average cost of natural gas in inventory which Integrys Energy Services had injected into storage earlier in 2008), which resulted in a lower-of-cost-or-market adjustment, as required by GAAP. This adjustment contributed a $32.8 million quarter-over-quarter decrease in the non-cash natural gas margin, driven by non-cash inventory write-downs in the fourth quarter of 2008. The negative impact on realized margin related to these inventory adjustments was offset by $44.8 million of net after-tax non-cash unrealized gains recognized in the fourth quarter of 2008, primarily related to derivative instruments utilized to mitigate the price risk on natural gas inventory underlying natural gas storage transactions. In the fourth quarter of 2007, natural gas derivative instruments resulted in the recognition of $19.3 million of net after-tax non-cash unrealized gains. Similar to the electric operations discussed above, non-cash gains and losses related to derivative natural gas sales and customer supply contracts will vary each period, and will ultimately reverse when the physical contracts settle, or when natural gas is withdrawn from inventory.
The recognition of $5.1 million of after-tax earnings from Integrys Energy Services’ investment in a synthetic fuel production facility during the three months ended December 31, 2007. Production and sale of synthetic fuel by Integrys Energy Services ended when Section 29/45K of the Internal Revenue Code, which provided for Section 29/45K federal tax credits from the production and sale of synthetic fuel, expired effective December 31, 2007. As such, there were no earnings from this facility in the fourth quarter of 2008.
A $9.3 million ($5.6 million after-tax) increase in operating and maintenance expense, primarily due to an increase in payroll and benefits expense, increased broker commissions driven by higher transacted volumes, and an increase in bad debt expense.
The above decreases in Integrys Energy Services financial results were partially offset by the following:
A $16.7 million ($10.0 million after-tax) increase in realized natural gas margins, primarily related to realized gains on wholesale natural gas storage transactions. Quarter-over-quarter, Integrys Energy Services increased its natural gas storage withdrawals, which drove this increase in realized natural gas margins.
A $10.0 million positive year-over-year after-tax impact on earnings related to the recognition of investment tax credits on solar projects completed in the fourth quarter of 2008.
A $3.7 million after-tax increase in earnings related to discontinued operations at Integrys Energy Services. In the third quarter of 2008, Integrys Energy Services sold its Stoneman generation facility located in southwestern Wisconsin, but the transaction did not have a material impact on earnings. However, in the fourth quarter of 2008, Integrys Energy Services recognized a $3.8 million after-tax gain on the sale of this facility in discontinued operations when a previously contingent payment was paid by the buyer. This contingent payment resulted from legislation that passed in the fourth quarter of 2008, which extended the production tax credits available for certain biomass facilities.
