MOODY'S DOWNGRADES THE RATINGS OF QUESTAR CORP. AND ITS SUBSIDIARIES (QUESTAR GAS COMPANY AND QUESTAR PIPELINE COMPANY TO A2 SENIOR UNSECURED)
Approximately $965 Million of Debt Securities Affected.
New York, November 12, 2002 -- Moody's Investors Service downgraded the ratings of Questar Corporation
(Questar, the parent) and its subsidiaries Questar Gas Company,
Questar Pipeline Company, and Questar Market Resources. The
rating outlook is stable for all rated Questar entities. The following
ratings were downgraded with a stable outlook:
Questar Corp.: Commercial paper rating from Prime-1
Questar Gas Co.: Senior unsecured rating from A1 to A2;
Questar Pipeline Co.: Senior unsecured rating from A1 to
Questar Market Resources: Senior unsecured rating from Baa2 to Baa3.
These rating actions reflect: 1) the weaker debt coverage measures
of its regulated businesses compared to its peers'; 2) increasing
exposure to the risks of non-regulated oil and gas exploration
and production (E&P); 3) moderately high leverage and future
capital needs that may forestall further debt reduction; and 4) the
challenges of being geographically concentrated in the Rocky Mountain
region, where gas production activity and prices are prone to boom-and-bust
The stable outlook assumes that Questar will use the proceeds received
from recently announced events ($105.5 million of proceeds
from the favorable resolution of the TransColorado litigation and $106.5
million from the sale of Canadian E&P assets) to moderate its leverage.
The outlook also assumes Questar Gas's ongoing rate case will be settled
within expected ranges. Moody's expects that Questar's capital
spending will moderate after the record hit in 2001. However,
the company's ratings may be pressured if capital expenditures remain
significantly higher than internally generated cash flows, deterring
a reduction in leverage. Questar's ratings anticipate event risk
longer term. Every few years in its recent history, Questar
has made a sizable E&P acquisition. That pattern may well continue,
so that its leverage could stay above its long-term target of 40%-45%
Questar Corporation is a holding company with no operating assets of its
own. Questar serves as a vehicle to provide short-term loans
and equity to help finance the operations and investments of its subsidiaries.
However, its material subsidiaries are largely self-financing
for regulatory clarity. They include two regulated subsidiaries
-- Questar Gas Company, engaged in gas distribution,
and Questar Pipeline Company, engaged in interstate gas transmission.
Questar's unregulated businesses are housed primarily in Questar Market
Resources (QMR), an intermediate holding company, whose subsidiaries
engage in both E&P, gas gathering and processing, and
energy marketing. Another subsidiary Wexpro develops and produces
reserves owned by Questar Gas pursuant to a contractual agreement.
Questar provides no guarantee or any other form of explicit support for
any of these fully owned subsidiaries.
On a consolidated basis, Questar Corporation's leverage is moderately
high (52% pro forma at September 30, 2002, adjusted
for over $200 million of expected near-term debt reduction).
Cash flow is sound (21% retained cash flow-to-debt
for last twelve months ended September 30), reflecting in large
part the cash flows generated by its regulated and unregulated E&P
businesses. Similarly, the ratio of funds flow from operations-to-fixed
charges was over five times. Moody's notes however that,
while Questar's E&P operations generate flush cash flow, they
also require heavy ongoing reinvestment to offset the natural decline
in its reserve base.
The Prime-2 commercial paper rating of the Questar parent company
factors in the credit strength of its operating subsidiaries and the structural
subordination to $1.3 billion of their external debt.
On a standalone basis, each of Questar's operating subsidiaries
is modestly sized and has credit qualities that are below industry averages
in some respects. However, their ratings reflect the benefit
of integration with each other.
The A2 rating of Questar Pipeline (25% of last twelve months' consolidated
operating income as of September 30) reflects its high leverage and weak
debt coverage measures. Although these risks are mitigated by the
imminent debt paydown and earnings pressure elimination from its sale
of its underperforming TransColorado joint venture, Moody's expects
that its interest coverage and cash flow coverage of debt will be weaker
than many of its peers'. For the last twelve months ended September
30, pro forma the $105.5 million TransColorado sale,
its EBITDA-to-gross interest was 3.2 times,
retained cash flow-to-debt was 11%, and debt-to-capital
In recent years, Questar Pipeline undertook a number of expansion
projects that entailed large outlays. These large projects burdened
the Pipeline with debt, while lower than expected earnings from
these investments (including the TransColorado and Southern Trail projects)
have caused its return-on-assets to erode from 10%
a few years ago to 8.5% currently. The sale of Questar's
interests in TransColorado under the above-mentioned settlement
will lessen the pressure on returns. Capital expenditures are expected
to decrease following the completion of its $100 million Southern
Trail project this past June. However, the magnitude of the
spending reduction is uncertain, as the Pipeline has numerous smaller
projects that could be undertaken if there is enough shipper interest.
Moody's notes that while Pipeline's budget is largely discretionary (its
maintenance capex is in line with its depreciation expense), spending
could remain high if those proposed projects are undertaken, and
this could delay strengthening in the company's leverage and return measures.
The A2 rating of Questar Gas (25% of last twelve months' operating
income as of September 30) reflects returns that are below its authorized
returns and also the industry average; it also reflects weak earnings
coverages. However, its has maintained leverage at about
50%, in line with industry norms and at about its allowed
equity ratio. Questar Gas is relatively mature compared to its
sister companies. Nevertheless, it has a higher customer
growth rate than the average US gas distribution company. Although
the growth is moderating, it has made regulatory lag a persistent
issue. Its return-on-equity was 9% for the
last twelve months ended September 30, well below its 11%
authorized return and average for the industry. It has filed for
a general rate increase in Utah with settlement expected to be announced
in the near-term. We assume in our rating that the settlement
results in a revenue increase that would at minimum help to prevent a
further weakening in its returns and coverages (EBIT/interest at 2.8
times for the last twelve months ended September 30).
The Baa3 rating of QMR (roughly 50% of last twelve months' operating
income) reflects the depleting nature of its oil and gas reserve assets
and the substantial reinvestment they require; the regional commodity
price risks related to its non-regulated E&P business as well
as the gathering/processing and marketing businesses that support it;
the modest size of its reserve base; and the risk from being geographically
concentrated in the Rockies. QMR's investment grade rating,
however, also takes into consideration a measure of stability provided
by the regulated E&P business of its Wexpro subsidiary and the benefit
of its affiliation with the Questar organization through various commercial
Non-regulated E&P comprises over half of QMR's operating income
and over a quarter of Questar's consolidated. With proved reserves
of 184 MMBOE (non-regulated reserves, pro forma the sale
of Canadian assets), QMR is the smallest among investment grade-rated
independent E&P companies. QMR's three-year average
finding and development costs ($4/BOE range, for all sources)
are competitive against other independent E&P companies. However,
reserve replacement costs have been rising. This trend may continue
as the company develops its substantial inventory of proven undeveloped
reserves. However, QMR is moderately leveraged compared to
reserves (debt/total proved BOE at about $2 and debt/proved developed
reserves at about $3.50, excluding Wexpro and pro
forma the sale of the Canadian assets); has a relatively long reserve
life (12 years total proved and 7 years proved developed); has consistently
replaced at least 100% of its reserves through the drillbit;
and has enjoyed a high drilling success rate.
Located far from major consuming markets and having limited pipeline takeaway
capacity, Rockies gas production tends to be particularly prone
to boom-and-bust cycles. In the second and third
quarters of 2002, basis differentials in the Rockies widened to
a record high in seven years. Questar's recent results have been
suppressed by lower realized prices on unhedged production and curtailed
production from wells that were shut in. Promising developments
are attracting more producers to this region. This may fuel gas-on-gas
competition that could cause the chronic regional oversupply and weak
prices to persist. Moody's notes that 26% of QMR's non-regulated
reserves and 37% of non-regulated production are located
in the Mid-Continent where price volatility is more moderate.
Questar's practice of hedging the majority of its production from proven
developed wells helps to mitigate its price risk (about 40% of
its forecast non-regulated proven developed gas production is hedged
at prices above recent depressed Rockies spot prices through 2003).
Moody's will monitor QMR's ability to weather the low Rockies gas prices
that it has experienced recently and which could recur, and also
its ability to better realize the value of the company's inventory of
proved undeveloped reserves in the Uinta Basin and the Pinedale Anticline
in the Rockies, where the company has been devoting much of its
resources. As Questar's vehicle for earnings growth, QMR
will continue to be the focus of Moody's scrutiny. Acquisition
event risk is most likely at QMR, as the company may consider stepping
out from its existing reserve holdings in the Rockies.
Moody's notes that about 40% of QMR's operating income and 20%
of Questar's consolidated are generated by E&P operations that are
governed by the Wexpro Settlement Agreement. Wexpro adds a measure
of stability to QMR's credit profile and provides strong cash flows and
returns. Under this agreement, Wexpro (a subsidiary of QMR)
is allowed to recover operating expenses related to producing oil and
gas from certain properties formerly owned by Questar Gas Company.
In a utility-like fashion, Wexpro earns a specified return
on its investment base. This return calculation includes no commodity
price factor; rather, it is based on a basket of regulated
utilities' returns. In 2001, Wexpro's after-tax return
was 19.7%, much higher than its sister companies'.
Income from oil sales in excess of cost recovery and return on investment
is shared by Wexpro and Questar Gas, which uses those amounts to
reduce its customers' natural gas costs.
Moody's notes that, longer term, the Wexpro Agreement may
subject to legislative and regulatory risk. There could be a reconsideration
of the provisions under that Agreement, for example, if market
prices for gas persist at lower levels than prices provided by Wexpro
for an extended period of time. Moody's views this risk as low,
given Wexpro's long history of providing low-cost gas supply and
satisfactory reviews by regulatory agencies.
Although not explicitly supported, QMR's investment grade rating
assumes that Questar will support QMR as a strategic growth vehicle and
a key component of its integrated business model. Covenants in
QMR's bank agreement and bond indenture ensure Questar's support.
Questar ceasing to fully own QMR constitutes an event of default under
QMR's bank agreement. QMR's indenture allows bondholders to put
their bonds to the company should QMR be downgraded to below investment
grade after Questar ceases to be its majority owner.
While the ratings of Questar entities reflect their individual credit
qualities, they also reflect their interdependence on one another.
Much of the Questar organization - in particular, Questar
Gas, Questar Pipeline, Wexpro, and Questar Gas Management
(a small gathering and processing subsidiary of QMR) --
operates as an integrated unit, with each subsidiary representing
a link in the gas value chain. These subsidiaries benefit from
this vertical integration by drawing much of their revenues from each
other. Except for its non-regulated E&P subsidiaries,
the affiliates are the largest customers of the major Questar subsidiaries.
For example, Questar Gas is by far the largest shipper on Questar
Pipeline. Questar Gas purchases about half of its gas supply from
Wexpro. Affiliates account for roughly two-thirds of the
revenues at QMR's gathering and processing affiliate. QMR's small
marketing operations also exist primarily to sell its affiliates' oil
and gas production.
Much of affiliate revenues is underpinned by long-term contracts.
Two such contracts - the Wexpro agreement (between Questar Gas
and Wexpro) and the gas gathering agreement (between Questar Gas and Questar
Gas Management) -- have been sanctioned by state regulators
to help supply Questar Gas with natural gas. These agreements allow
these QMR subsidiaries to earn a regulated return on certain E&P and
gathering and processing activities and provide a platform of stable earnings
on which QMR can build its unregulated E&P business.
The significant amount of capital required by each of Questar's major
subsidiaries could deter debt reduction. Questar Gas must extend
mains to meet customer growth, which, at above 2%,
exceeds the national average. Questar Pipeline has invested heavily
in recent years to build pipeline infrastructure to support the recent
development activity in the Rockies. Although Questar Pipeline
has no large capital projects on the horizon, meaningful amounts
may still be spent on a number of smaller projects to better capture the
value of its existing assets. QMR will account for most of Questar's
capital expenditures. It has a large portfolio of undeveloped gas
reserves (roughly 40% of non-regulated E&P proven reserves
is undeveloped, pro forma the Canadian asset sale), which
require upfront investment before they become productive.
Absent another major acquisition, Questar has no plans to issue
common stock in the near-term. (Questar has a universal
shelf registration that would enable it to issue equity to help finance
such an acquisition.) The company is likely to favor means other
than equity issuances -- asset sales, capex reduction,
internal equity formation - to reduce its debt. For example,
Questar's goal to reduce the debt incurred in its $403 million
acquisition of Shenandoah Energy, Inc. in 2001 (Questar's
biggest acquisition to date) will be met over the coming months by the
sale of its E&P assets in Canada and elsewhere and proceeds won in
the TransColorado litigation. The application of these proceeds
toward debt reduction will reduce its leverage from the high of 59%
at year-end 2001 to about 52% pro forma based on its September
30, 2002 balance sheet. This is a meaningful reduction;
however, additional measures would need to be taken to reach debt
levels within its target debt range and that are more in line with its
Questar's business risks have grown along with large investments in businesses
outside its regulated gas distribution and transmissions businesses.
Over the past few years, regulated assets have declined slightly
as a percentage of Questar's consolidated assets, but they still
comprise a majority 58%, including 24% for Questar
Gas, 27% for Questar Pipeline, and 7% for Wexpro.
On the other hand, investment in non-regulated businesses
at QMR (most of which is E&P) has increased faster than any other
segment, much of it due to Questar's Shenandoah Energy acquisition.
Increased investment in less stable businesses, in particular non-regulated
E&P, presages more volatility in future earnings.
Questar Corporation is a diversified natural gas company headquartered
in Salt Lake City, Utah.
Moody's Investors Service
Vice President - Senior Analyst
Moody's Investors Service