National Fuel Gas Co Q3 FY2021 Earnings Call

Thank you, Celine, and good morning. We appreciate you joining us on today's conference call for a discussion of last evening's earnings release. With us on the call from National Fuel Gas Company are Dave Bauer, President and Chief Executive Officer; Karen Camiolo, Treasurer and Principal Financial Officer; and Justin Loweth, President of Seneca Resources. At the end of the prepared remarks, we will open the discussion to questions. The third quarter fiscal 2021 earnings release and August Investor Presentation have been posted on our Investor Relations website. We may refer to these materials during today's call. We would like to remind you that today's teleconference will contain forward-looking statements. While National Fuel's expectations, beliefs, and projections are made in good faith and are believed to have a reasonable basis, actual results may differ materially. These statements speak only as of the date on which they are made, and you may refer to last evening's earnings release for a listing of certain specific Risk Factors. With that, I'll turn it over to Dave Bauer.

Thanks, Ken. Good morning, everyone. The third quarter was another strong one for National Fuel, with our Upstream and Midstream businesses continuing the positive momentum they established during the first half of the year. Seneca had a great quarter, with production up nearly 50% on the strength of last year's acquisition and its 2021 drilling program. That growth in production, along with higher commodity prices, grew over nearly a 70% increase in EBITDA from combining our Upstream and Gathering operations. The acquisition continues to impress with both production and operating costs better than we expected. With the near-term run up in winter natural gas prices, along with increased confidence around the online date for Leidy South, we've decided to move up some completion connectivity at Seneca. This will allow us to more fully utilize our Leidy South capacity from the start and capture some of the valuable winter premiums in the Transco Zone 6 market. As a result, we expect to shift them forward a few months. And while we aren't raising the upper end of guidance, it's now likely that Seneca's capital spending for 2021 will be closer to the high-end of our previous range. Justin will have a full update on Seneca's operations later on the call. At the pipeline storage business, construction of the FM100 project has been going well despite a very rainy month of July. At this point, everything remains on schedule for a late calendar 2021 in-service date. Pipeline construction is well underway; almost 90% of the pipe has been strung on the right-of-way and nearly 40% is in the ground. The two compressor stations are nearing mechanical completion, and once automation and electrical work is complete, commissioning will begin. I took a tour of the construction site a couple of weeks ago and was really impressed with what the team and our contractors have accomplished in such a short period of time. Truly a great job by all. As I've said in the past, this is a great project for National Fuel; it increases revenues on our regulated pipelines by $50 million a year, and when combined with Seneca fastly on Transco's companion Leidy South project, it will allow for higher E&P production volumes and gathering throughput. The perfect example of the power of our integrated approach to the business positions National Fuel to deliver solid near-term growth and sustainable free cash flow. Turning to the utility, our summer construction program is well underway. Consistent with prior years, our goal is to replace 150 miles of older pipeline. The team is right on track to hit that mark. Replacing older pipe goes a long way to reducing methane emissions on our system. To date, our program has been the driver of a 64% reduction in emissions from our delivery system compared to 1990 levels. Earlier this year, we filed for an extension of our system modernization tracking mechanism in our New York division, which makes up a little more than two-thirds of our replacement program. As you recall, that mechanism allows us to recover in near real-time the costs associated with our modernization spending. It’s a great program in that we're able to lower emissions on our system and make it more reliable, all without the need to file annual rate cases. We expect the New York Commission will act on this petition during our fiscal fourth quarter. Looking to next year, on the strength of the FM100 project, our preliminary guidance for fiscal 2022 is $4.40 to $4.80 per share; at the midpoint, a 12% increase from our expected 2021 earnings. In addition, at NYMEX pricing of $3.50 million, we expect about $250 million in free cash flow, which is well in excess of our expected dividend payments and which positions us well to continue improving our investment-grade balance sheet. For those of you who have followed us for a while, we have a disciplined hedging program designed to mitigate price volatility and protect the returns on our upstream and gathering investments. We call that program to be between 60% and 80% hedged at the beginning of a fiscal year, and we typically layer in those hedges over the preceding three to five years. Our fiscal 2022 hedging program is right on track with those targets through a combination of fiscal firm sales and financial instruments. We have hedges on roughly three-quarters of our expected fiscal 2022 Appalachian production, so we're well ahead. We still have considerable upside from natural gas prices. Every $0.25 change in realized prices impacts cash flows by about $20 million and earnings by about $0.15 per share. Switching gears, as we all know, natural gas has been a significant, if not the biggest driver of greenhouse gas emissions reductions since 2005. In addition, natural gas and its related delivery systems have consistently proved their reliability, resilience, and affordability. Without a doubt, consumers recognize and appreciate those benefits. Notwithstanding the anti-fossil fuel commentary from Washington and Albany, we continue to add customers to our utility system year in and year out. But in spite of these obvious benefits, our policymakers, particularly on the coast, are pursuing avenues to restrict consumers' access to natural gas, including in some cases outright bans. Taking an electrify-everything approach is neither rational nor practical. The natural gas delivery system is safe and largely underground, ensuring greater reliability and resilience compared with above-ground electric infrastructure. This past winter was a textbook example of the importance of resilience. Unlike the tens of thousands of windmills and millions of solar panels that would be needed to electrify the country heating load, the natural gas delivery system already exists and is largely paid for. Abandoning it makes little sense, especially when you consider that aggressive emissions reduction targets can be met through a mix of energy efficiency measures, hybrid heating technologies, and low-carbon fuels like renewable natural gas and hydrogen. I'm all in favor of reducing emissions. So then an all-of-the-above approach is necessary if we're to have reliable, affordable energy in this country. Before I close, I'd like to give you a heads up on the second annual edition of our Corporate Responsibility Report, which will be published early next month. Last year's report was a great first start to our efforts to enhance our ESG-related disclosures. We look to build on it in several important ways this year. In addition to reporting under the Sustainability Accounting Standards Board framework, we'll also include disclosures under the Task Force on Climate-related Financial Disclosures (TCFD) framework. We're also enhancing our emissions disclosures to include full Scope 1 and 2 CO2 and methane emissions. Importantly, we'll be using this data to establish what we think are very credible and realistic methane and greenhouse gas emissions reduction targets. Lastly, we're expanding our diversity disclosures using the E01 framework. Overall, it's a great report that's responsive to the disclosure requests our shareholders had asked for. I'd like to send a big thank you to the team that made it a reality. In closing, this is an exciting time for National Fuel. Construction of the largest pipeline in our company's history is on time and on budget. Seneca's production is at an all-time high and will continue to increase as new capacity on Leidy South and FM100 becomes available. At the same time, the stability of our utility business adds to our financial strength. All the while, we remain committed to reducing the emissions profile of our operations. When you bring it all together, National Fuel is in a great position to deliver significant earnings and free cash flow to our shareholders. With that, I'll turn it over to Justin.

Thanks, Dave, and good morning, everyone. Seneca had a strong third quarter with operational results slightly ahead of our expectations. We produced 83.1 Bcfe, an almost 50% increase from last year, driven by increased Tioga County volumes from our acquisition, which closed in late July 2020, combined with solid results from our Appalachian development program. We continue to see the benefits of our increased scale, with per unit cash operating expenses dropping $0.06 per Mcfe versus the prior year to $1.13 per Mcfe driven by a significant year-over-year decrease in our per unit G&A expense. During the quarter, we drilled 12 new wells, five in the WDA and another seven in the EDA. Notably this included the commencement of drilling on our first Tioga County pad from our acquisition. Similar to our activity in the WDA over the past few years, the Tioga pad will be a return trip. It allows us to utilize existing roads, pads, and gathering infrastructure, which significantly enhances our consolidated E&P and gathering returns. We have approximately 10 additional pads within the acquired acreage footprint, where we believe we can take advantage of similar capital efficiencies. Given the continuous nature of this acreage and continued operational success, we expect most of our wells will exceed 10,000 feet treated lateral length, generating outstanding returns. For the remainder of the year, we are on track with our plans to ramp up production to fill Leidy South and capture premium winter pricing. We have begun the process of accelerating our completion phase and now have two active completion crews, which is a level of activity we expect to continue throughout the first half of fiscal 2022. This will drive our production cadence in the coming quarters, with most of our new production coming online towards the end of our current fiscal year and in the first half of next year. As a result, we expect modestly lower sequential production in Q4 of fiscal 2021. Later this quarter, we plan to turn in line one operated pad within our Western Development Area. Additionally, in the next few weeks, we expect to see a production pad online for a six-well non-operated pad in Lycoming County. Seneca holds a 25% working interest in this pad; however, 100% of the production will flow through National Fuel's wholly-owned gathering system, driving throughput growth and revenues for our sister company. Moving to fiscal 2022, our operations plan is right on track. We expect to turn in line about 40 wells during the first half of the fiscal year and another 10 or so wells over the balance of the year. As a result, we expect sequential quarter-over-quarter production growth in the first three quarters of the year, with production leveling out in our fourth quarter. Our increased completion base, along with our plans to operate two drilling rigs throughout fiscal 2022, is projected to drive an increase in our capital expenditures by $45 million year-over-year, consistent with our prior expectations. Looking beyond next year, we expect capital to trend downward as we decrease our activity levels and move to a maintenance to low growth mode. On the marketing front, Seneca's Appalachian production is well protected in fiscal 2022, with current sales contracts in place for approximately 93% of our expected fiscal 2022 production volumes, minimizing our exposure to invasive spot pricing. We also have hedges in place on approximately three-quarters of our expected Appalachian production. Overall, the setup remains very constructive for natural gas prices, with Appalachian producers currently exercising capital discipline, LNG and Mexico exports near all-time highs, and storage levels remaining below both last year and five-year inventories. However, with prices north of $3.50 per MMBtu for our fiscal 2022 and $3 for fiscal 2023, the caveat will be whether this capital constraint will continue over the coming months and whether producers will stick to their current focus on free cash flow generation and maintenance production levels. While I'm cautiously optimistic that newfound discipline will hold, at Seneca, we expect to continue adhering to our longstanding methodical approach to risk management by layering in additional hedges over the coming quarters. At current quarter prices, our program will continue to generate attractive returns and significant free cash flow. Looking out beyond fiscal 2022, our activity level will be geared towards generating sustainable free cash flow. Absent the ability to enter into significant additional long-term firm sales or acquire firm capacity that would result in strong realized prices, Seneca expects to shift into a maintenance to low growth production mode focused on fully utilizing our existing and diverse marketing portfolio. Moving to California, we expect to invest $10 million to $15 million a year, generating substantial free cash flow or moderating production declines, and we'll look for ways to increase our activity to the extent oil prices remain at current levels. That said, our opportunities to increase our activity levels remain limited by the challenging regulatory environment and tempered by the lengthy timeline to obtain new permits. On the renewable side, we're making excellent progress on our new solar plant at our South Midway Sunset field in California, which is expected to be completed later this year. We are also moving forward on an additional solar plant at our South Lost Hills production field, which we expect to complete in fiscal 2022. With the ability to generate California low carbon fuel standard credits and reduce grid power consumption, these projects are not only highly economic but also reduce our emissions. Upon completion of these projects, approximately 20% of our power needs in California will be met with solar. We continue to make considerable strides in our sustainability initiatives in Appalachia. Last month, we commenced a comprehensive real-time in-field study evaluating the emissions generated by various types of completion equipment. Last week, we announced that we are in the process of completing a six-well EDA pad using e-frac technology. The results of these field trials will provide Seneca with high-quality comparative data on the emissions profile of these completion technologies, supporting our efforts to select equipment that aligns with our long-term sustainability goals. Additionally, we are also actively evaluating various responsibly sourced gas initiatives and expect to move toward one or more of these frameworks over the coming months. As a best-in-class operator and the lowest carbon intensity field based in the United States, we are well-positioned to be an upstream leader in ESG. And with that, I'll turn it over to Karen.

Thank you, Justin, and good morning, everyone. National Fuel’s third-quarter GAAP earnings were $0.94 per share, and after adjusting for an unrealized gain on our non-qualified benefit plan investments, operating results were $0.92 per share. Last night's release explained the major drivers for the quarter, so I'll focus on our guidance updates for the remainder of the year and our initial projections for next year. Starting with fiscal 2021, we're increasing and tightening our earnings guidance to a range of $4.05 to $4.15 per share. In addition to the strong results from the third quarter, we've incorporated the significant strengthening of natural gas prices for the remainder of the year. Moving into fiscal 2022, we are projecting a 12% increase in earnings at the midpoint, with our preliminary guidance in the range of $4.40 to $4.80 per share. At a high level, the increase in earnings relative to fiscal 2021 can be boiled down to three main drivers. The first two are related to integrated upstream and midstream development tied to the FM100 expansion and modernization project. Starting with the Pipeline and Storage segment, the direct benefit of the project will be approximately $50 million per year of incremental revenues. Given the late calendar startup, we expect approximately $30 million to $35 million of revenue from this project during fiscal 2022. A large portion of this revenue will flow through to the bottom line but will be partially offset by the associated operating costs and depreciation expense. Additionally, in fiscal 2022, we expect a decrease in AFUDC that was accrued during the FM100 construction period. This project, along with its companion Leidy South expansion, will provide Seneca with a key outlet for growing natural gas production. Seneca’s expected production range for next year is 335 to 365 Bcfe. This nearly 8% increase relative to fiscal 2021 will also benefit our gathering business, driving higher throughput and related revenue. While there is a modest amount of associated expected gathering segment expense, the vast majority of this incremental revenue will flow through to the bottom line. The third major driver is higher commodity price expectations. For fiscal 2022, we're assuming $3.50 per MMBtu with spot prices of $2.85 in the winter months and $2.25 in the summer period. On the oil side, we're assuming $65 per barrel. As Dave mentioned, we're well hedged going into next year, but for reference, even with the level of hedges we have, given our base of production, changes in pricing could impact earnings for the year. For reference, a $0.25 change in natural gas prices is expected to impact earnings by $0.15 per share, while a $5 change in oil could affect earnings by $0.03 per share. While those are the major drivers year-over-year, I’ll touch on a few other smaller assumptions around our guidance range. In our utility for the first three quarters of this year, we averaged about 13% warmer than normal weather. For fiscal 2022, we're forecasting a return to normal weather, and as a result, we expect margins to be higher by approximately $10 million year-over-year, particularly in our Pennsylvania jurisdiction where we don't have a weather normalization clause. This will be largely offset by modestly higher expected O&M expense, which we anticipate to increase by 3% to 4% compared to fiscal 2021, driven by higher personnel costs, principally related to negotiated wage increases with our collective bargaining units along with normal inflationary increases to labor and other items that we see each year. In the Pipeline and Storage business, we expect O&M to increase by 4% to 5% versus fiscal 2021. This was principally driven by a one-time favorable benefit to O&M expense of approximately $4 million in fiscal 2021 that will not recur in fiscal 2022. Outside of this item, and operating expenses related to FM100, underlying costs in this business will be relatively flat year-over-year. Lastly, from a guidance standpoint, we're expecting a modestly lower effective tax rate next year at 25% to 26%, stemming from our ability to take advantage of tax credits related to our enhanced oil recovery activities at our California facilities for fiscal 2022. These credits are available based upon historical oil prices and, given the low pricing environment in calendar 2020, we expect to be able to take advantage of this credit next year. However, with oil prices where they are today, we expect this to phase out again for fiscal 2023. Turning to our capital plans for next year, we're projecting a roughly 10% decrease relative to fiscal 2021. This is driven by the completion of the $280 million FM100 project early in the year. We expect that reduction would be somewhat offset by modestly higher upstream and associated gathering spending that we had been planning for over the past year. As a reminder, Seneca added a second drilling rig in January, and we expect to see an increase in our completion phase this fall in advance of new transportation capacity. With respect to our cash position, as we discussed previously, we expect to live within cash flow this year when you consider the proceeds of our timber sale and our dividend payments. This hasn't changed as a slightly higher expected spending at the midpoint of our updated guidance is largely offset by higher cash flows from the expected increase in earnings for the year. We started the year with a modest amount of short-term borrowings, and while we've had roughly $120 million of cash on hand at the end of June, we expect to be back in a borrowing position as we continue to spend on the FM100 project. As we look to fiscal 2022, assuming a $3.50 NYMEX natural gas price, we expect funds from operations to exceed capital expenditures by roughly $250 million. This more than covers our dividend and is expected to leave us with nearly $100 million of excess cash flow positioning as we go into fiscal 2023. While our balance sheet is already in a good spot, we expect the combination of higher EBITDA and increased cash flows along with lower leverage to lead to continued improvement in our investment-grade credit metrics. We would have stepped over the course of fiscal 2022 to trend towards a 2.5 times debt to EBITDA, and with sustainable free cash flow beyond next year, seek further improvement beyond that level. With this leverage trajectory, we will have significant flexibility to deploy capital, whether that be making growth investments or returning cash to shareholders. We will look to deploy capital in the most value-creative manner for our shareholders. With that, I'll close and ask the operator to open the line for questions.

Thank you. We have our first question coming from Holly Stewart. Your line is open.

Maybe we'll start with either Dave or Karen just on the free cash flow guidance, appreciate the details that at different commodity prices. Maybe on that $250 million target since that's kind of where we're trending right now. Can you just give some of the detailed assumptions behind that, meaning which of the different business units are contributing what to that total?

Yes. If you want to divide it between our regulated and non-regulated segments, it's 60% from non-regulated and about 40% from regulated. On the regulated side, our pipeline and storage are contributing a larger amount than our utility, but that's essentially the breakdown. Does that help?

Yes, thanks. Got it. Okay. If you consider the production ramp-up with the Leidy South project, how should we view the distribution going forward between WDA and EDA?

Holly, you cut out a fair amount while you were asking that second question. It might be best to say it again if you don't mind.

Okay. Is that better?

Much better. Thank you.

Yes.

Okay. Sorry about that.

Yes. All right.

Justin, regarding Leidy South and the integration of that volume into the pipeline, as we look at 2022 and beyond, how should we consider the division between WDA and EDA?

Sure. So we've really one of the best benefits of the Leidy South project is we're able to utilize it with all three of our major operating production areas. So generally speaking, we intend to keep a pretty balanced plan between the EDA and the WDA. I think you should expect that we're going to be utilizing that and our other capacity kind of from all three production areas, maybe weighted a little bit more between Tioga development and the WDA versus Lycoming, just given our significant inventory in both Tioga and the WDA. So that's how I would kind of best position it, but relatively balanced between EDA and WDA.

Okay. That's helpful. Maybe just a follow-up on your comment in your prepared remarks about a non-operating package. You mentioned a 25% working interest, but a 100% working interest on the gathering side. Can I ask who that producer is and if there is a change in activity? I don't recall you discussing such a split in the past.

Sure. So this is something that we've been working on for a long time, a great project for the company, where we had worked with Alta to extend our trout run and this is Lycoming County. It's our trout run gathering system, which extends into some acreage that they have to the north and to the east of our existing track 100 area. We were not only able to gather all of this and extend our gathering system to leverage that, but at Seneca, we executed a joint operating agreement and effectively farmed in to a chunk of acres there as well. Similarly, we have another area outside or adjacent to our track 100 gamble area where we're the operator. So it's a good relationship. One that we expect to continue here with EQT and a great kind of synergy for two companies working together to create a one plus one equals three approach.

Yes, yes. Okay. That's great. And then maybe the last one for me, just one on California, you talked about trying to maintain production there. I think historically you've been able to do some bolt-ons as well, but obviously the environment kind of continues to become more difficult. Just wondering maybe this is even for Dave to just bigger picture, how you're thinking about Seneca's future in California.

Sure. I mean a couple of things. One is that we did successfully kind of farm-in/acquire areas in Coalinga, North Midway, and South Midway over the last several years. We've got quite a bit of development to still do across those three areas. It just takes a really long time to permit wells and get all that done. Fortunately, we've got a great team out there; they were able to navigate that process where we're planning out two or three years in advance for our activity levels. It means we can't really ramp up quickly, but we can be thoughtful and methodical about how we develop the assets and approach those as longer-term developments. It just doesn't have the cycle time. As we think about the division, California has been a great business for us and we've got a great team out there that manages the day-to-day very autonomously. We've generated historically a tremendous amount of free cash flow. We're continuing to do that and will continue to look for opportunities to differentiate ourselves across other California operators with some of our sustainability initiatives, including our solar investments that we've been making since 2016. So that's how we're approaching that. It's been a good place for us.

We have our next question coming from Umang Choudhary with Goldman Sachs & Co. Your line is open.

I appreciate all the details on 2022 and the quarterly run rate expected for the next fiscal year. I would like to hear more about what lies beyond 2022. I am interested in your thoughts on the projects currently under evaluation that could support sustained earnings growth. Additionally, any insights on potential organic opportunities including RNG or inorganic opportunities through consolidation would be appreciated.

Sure. On the regulated side, I think we're going to be able to continue to grow both the pipeline and the utility, albeit maybe not at the rate that we're going to grow from 2021 into 2022. But I think we still are going to have opportunities to do expansions on our pipeline system. As you know, we tend to wait until we have a project on file or announced before we include it in our IR decks. The team is chasing a number of opportunities that range from further expansions of our Empire line, you recall we did the Empire North project this year or excuse me, last year. We think that there's the opportunity to do another expansion there and we’re also chasing a number of expansion opportunities on the line and a portion of our system. That's the line that goes north-south along the Ohio, PA order. It ranges from a variety of opportunities there that I expect we'll be announcing in the quarters to come. At the same time, we're going to have our modernization programs, both at the pipeline companies and the utility. That'll be a modest amount of capital that'll continue to grow rate base, albeit maybe more of the low-single-digit to mid-single-digit range, but still upward sloping. So long run, I'm confident in the ability to grow the regulated side of the business. As Justin said on the non-regulated side, once we have Leidy South filled, we'll be moving to more of a low maintenance to low growth mode that I think you can count on say low, mid, single-digit growth rate. You also asked about RNG; I think whether we could be interested in that business, and the answer there is yes. I find RNG interesting. It's a good ESG story. It's good for the environment. Looking at our service territory in Western New York and Northwestern Pennsylvania, there are a lot of dairy farms. There is an opportunity to do development there. It is something that we are considering. I'll be honest, the biggest thing we've got to get our arms around is that the entire investment is supported by low carbon fuel type credits that are really a bureaucratic fiat and could go away just based on new regulations and trying to get our arms around the appropriate risk premium that we need for that kind of investment. But it's something that we're interested in and pursuing. I'm not sure if there were other elements of your question; sorry, I should have written it down.

Sorry about that, that was a long question. I also wanted to talk about any inorganic opportunities that you are also seeing or looking at which can further grow the business or improve the earnings part of the business?

Yes. I mean, we've certainly looked at assets as they come on the market, and yes, I don't want to comment on specific transactions that we've looked at. But we think on the upstream side that there are going to be opportunities for further consolidation within the basin. It’s likely that assets will become available that we chase, and if it's additive to the company, we're certainly going to pursue it.

Great. Thank you.

Okay.

And my last question was around Appalachia, like, how do we see the Appalachia business with how do you see that risk evolving over time? And one to two things which you are evaluating today beyond hedges to mitigate that risk?

Sure. Our perspective is that there is limited new takeaway capacity entering the basin. The FM100 Leidy South, which we expect to see at the end of this calendar year, is one addition, and we are pleased to have a significant portion of that. The other is MDP, which faces several challenges before it can be operational. Overall, we believe that Appalachia will remain somewhat constrained, with market conditions largely influenced by the actions of the largest producers. If capital discipline persists, the basis will widen, but we don't anticipate it reaching the extremes witnessed in the past when production surged ahead of takeaway capacity. If producers attempt to ramp up growth, they will be doing so in a market with fluctuating spot prices. For our fiscal year 2022, we have secured 93% of our projected production through firm sales, which reduces that risk for us. Going forward, we plan to leverage our diverse marketing portfolio to further minimize this risk. We have been successful in this regard for many years and aim to maintain that success with modest incremental layers of fixed price and fixed basis firm sales. Typically, we collaborate with a marketing partner that holds capacity through an AMA, allowing us to structure multi-year firm sales to shield us from basis risk. Our long-term strategy centers on this approach, and the success of our firm sales will determine whether we remain in maintenance mode or experience low growth. We expect that as long as producers act responsibly, we should see differentials that are wider than those seen recently, but not to an extreme degree.

Thank you. There are no further questions at this time. I will now turn the call back over to Ken Webster for any closing comments.

Thank you, Celine. We'd like to thank everyone for taking the time to be with us today. A replay of this call will be available this afternoon on both our website and by telephone then and will run through the close of business on Friday, August 13. To access the replay online, please visit our Investor Relations website at investor.nationalfuelgas.com and to access by telephone, call (1800) 585-8367 and enter conference ID number 1368175. This concludes our conference call for today. Thank you and goodbye.

This concludes today's conference call. Thank you for participating. You may now disconnect.