Filed On 3/2/98 · SEC File 1-10070 · Accession Number 950124-98-1026
As Of Filer Filing On/For/As Docs:Pgs Issuer Agent
3/02/98 MCN Energy Group Inc 10-K405 12/31/97 18:169 Bowne of Detroit...01/FA
Annual Report -- [X] Reg. S-K Item 405 · Form 10-K
Filing Table of Contents
Document/Exhibit Description Pages Size
1: 10-K405 Annual Report -- [X] Reg. S-K Item 405 36 219K
2: EX-3.2 Articles of Incorporation/Organization or By-Laws 17 55K
3: EX-4.2 Instrument Defining the Rights of Security Holders 8 33K
4: EX-12.1 Statement re: Computation of Ratios 2± 12K
5: EX-12.2 Statement re: Computation of Ratios 2± 12K
6: EX-12.3 Statement re: Computation of Ratios 1 11K
7: EX-12.4 Statement re: Computation of Ratios 1 10K
8: EX-13.1 Annual or Quarterly Report to Security Holders 76± 351K
9: EX-21.1 Subsidiaries of the Registrant 7 33K
10: EX-23.1 Consent of Experts or Counsel 1 9K
11: EX-23.2 Consent of Experts or Counsel 1 10K
12: EX-23.3 Consent of Experts or Counsel 1 10K
13: EX-23.4 Consent of Experts or Counsel 1 10K
14: EX-23.5 Consent of Experts or Counsel 1 10K
15: EX-23.6 Consent of Experts or Counsel 1 10K
16: EX-23.7 Consent of Experts or Counsel 1 10K
17: EX-24.1 Power of Attorney 11 25K
18: EX-27.1 Financial Data Schedule 1 10K
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-------------------
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 COMMISSION FILE NUMBER 1-10070
MCN ENERGY GROUP INC.
(Exact name of registrant as specified in its charter)
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38-2820658
(I.R.S.
MICHIGAN Employer
(State or other jurisdiction of Identification
incorporation or organization) No.)
500 GRISWOLD STREET, DETROIT, MICHIGAN 48226
(Address of principal executive offices) (Zip Code)
313-256-5500
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
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NAME OF EACH EXCHANGE
ON WHICH REGISTERED
TITLE OF EACH CLASS ---------------------
Common Stock, $.01 Par Value Per Share New York Stock Exchange
9 3/8% Cumulative Preferred Securities, Series A* New York Stock Exchange
8 5/8% Trust Originated Preferred Securities** New York Stock Exchange
8 3/4% Preferred Redeemable Increased Dividend Equity
Securities New York Stock Exchange
8% FELINE PRIDES New York Stock Exchange
-------------------
* Issued by MCN Michigan Limited Partnership. The payments of dividends and
payments on liquidation or redemption are guaranteed by MCN Energy Group Inc.
** Issued by MCN Financing I. The payments of dividends and payments on
liquidation or redemption are guaranteed by MCN Energy Group Inc.
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SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendments to
this Form 10-K. X
The aggregate market value of MCN Energy Group Inc. Common Stock, $.01 par
value per share, held by non-affiliates as of February 24, 1998 was $2.896
billion based on 78,270,811 outstanding shares and the closing price on that day
(New York Stock Exchange Composite Transactions).
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of MCN's 1997 Annual Report to Shareholders are incorporated by
reference in Part II, Items 5,6,7 and 8 and portions of MCN's February 1998
definitive Proxy Statement are incorporated by reference in Part III.
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KEY TO ABBREVIATED TERMS
Antrim Gas............................ Natural gas produced from shallow
wells in the Devonian (Antrim) shale
formations.
Capital Investments................... MCN's consolidated capital
expenditures plus acquisitions and
MCN's share of capital expenditures
of joint ventures, less the minority
partners' share of consolidated
capital expenditures.
Citizens.............................. Citizens Gas Fuel Company; a wholly
owned natural gas distribution
subsidiary of MCN.
Coalbed Methane....................... Natural gas formed during the
transformation of plant material into
coal. Drilling a well into the coal
and dewatering the coal seam will
cause a reduction in pressure,
releasing natural gas.
Cogeneration.......................... The production of two forms of
energy, usually steam and
electricity, from a single fuel
source such as natural gas.
Degree Days........................... A measure of the coldness of the
weather based on how much the day's
average temperature is below 65
degrees Fahrenheit.
Diversified Energy group.............. MCN's exploration and production,
pipeline and processing, gas storage,
energy marketing, and electric power
businesses.
End User Transportation............... A gas delivery service provided to
large-volume commercial and
industrial customers who purchase
natural gas directly from producers
or brokerage companies.
FERC.................................. Federal Energy Regulatory Commission;
a federal agency that determines the
interstate rates and regulations of
interstate pipelines.
Gas Gathering......................... The process of collecting natural gas
from gas wells and then transporting
the gas through pipelines to
processing plants or major pipelines.
Gas Processing........................ For MCN, the removal of carbon
dioxide and petroleum liquids from
natural gas so it meets market
quality standards.
Gas Storage........................... The process of injecting, storing and
withdrawing natural gas from a
depleted underground natural gas
field or salt cavern.
GCR................................... Gas Cost Recovery; a process by which
MichCon, through annual gas cost
proceedings before the Michigan
Public Service Commission, is allowed
to recover its reasonable and prudent
cost of gas sold.
Intermediate Transportation........... A gas delivery service provided to
producers, brokers and other gas
companies that own the natural gas,
but are not the ultimate consumers.
ii
KEY TO ABBREVIATED TERMS
(concluded)
Methanol.............................. A form of alcohol manufactured from
various feedstocks, including natural
gas, and used as a solvent,
antifreeze and high octane fuel.
MCN................................... MCN Energy Group Inc. and its
subsidiaries.
MCNIC................................. MCN Investment Corporation, a wholly
owned subsidiary of MCN and the
holding company of MCN's Diversified
Energy group subsidiaries.
MichCon............................... Michigan Consolidated Gas Company; a
wholly owned natural gas distribution
and intrastate transmission
subsidiary of MCN.
MichCon Pipeline Co. ................. A wholly-owned subsidiary of MichCon
that engages in pipeline projects
through its subsidiaries.
MPSC.................................. Michigan Public Service Commission;
the regulator of intrastate aspects
of the natural gas industry within
the State of Michigan.
Normal Weather........................ The average daily temperature within
MCN's Gas Distribution service area
during a recent 30-year period.
Spot Market........................... Buying and selling natural gas on a
short-term basis, typically month to
month.
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Units of Measurement
--------------------
Bcf..................................................... One billion cubic feet of natural gas.
Mbbl.................................................... One thousand barrels, which is a unit of
measurement of oil and other petroleum
liquids.
Mcf..................................................... One thousand cubic feet of natural gas.
MMcf.................................................... One million cubic feet of natural gas.
MW...................................................... One million watts of electricity.
Tcf..................................................... One trillion cubic feet of natural gas.
/d...................................................... Added to MMcf or Bcf to denote average
volumes per day.
/e...................................................... Added to other units of measurement to
provide a consolidated measure of equivalent
natural gas, crude oil and condensate at a
rate of 6 Mcf per barrel of oil or
condensate.
iii
TABLE OF CONTENTS
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PAGE
CONTENTS NUMBER
-------- ------
Part I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 18
Item 3. Legal Proceedings........................................... 20
Item 4. Submission of Matters to a Vote of Security Holders......... 20
Executive Officers of the Registrant........................ 21
Part II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 22
Item 6. Selected Financial Data..................................... 22
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 22
Item 8. Financial Statements and Supplementary Data................. 22
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 22
Part III
Item 10. Directors and Executive Officers of the Registrant.......... 23
Item 11. Executive Compensation...................................... 23
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 23
Item 13. Certain Relationships and Related Transactions.............. 23
Part IV
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form
8-K......................................................... 23
Signatures.............................................................. 29
iv
PART I
ITEM 1. BUSINESS
MCN Energy Group Inc. (MCN), is a diversified energy holding company with
markets and investments throughout North America and in Asia. The operating
revenues, operating income, and identifiable assets of MCN's business segments
are included in the financial statements, incorporated by reference in Item 8,
"Financial Statements and Supplementary Data," on page 22. At December 31, 1997,
MCN and its subsidiaries had 3,209 employees.
MCN operates through two major business groups, Diversified Energy and Gas
Distribution.
- Diversified Energy, operating through MCN Investment Corporation (MCNIC), is
involved in the following businesses: Exploration & Production (E&P), with 1.3
trillion cubic feet equivalent (Tcfe) of proved gas and oil reserves at
December 31, 1997 in the Midwest/Appalachia, Midcontinent/Gulf Coast and
Western regions of the United States; Pipelines & Processing, with gathering,
processing and transmission facilities near areas of rapid reserve development
and growing consumer markets; Energy Marketing, with total gas sales and
exchange gas delivery markets of 358.8 billion cubic feet (Bcf) for 1997;
Electric Power, with investments in electric generation facilities in
operation and under development with a combined 2,804 megawatts (MW) of gross
capacity and investments in electric distribution facilities; and Gas Storage,
with investments in storage facilities that have 52 Bcf of storage capacity,
42 Bcf of which is currently under development.
- Gas Distribution consists principally of Michigan Consolidated Gas Company
(MichCon), a natural gas distribution and intrastate transmission company
serving 1.2 million customers in more than 500 communities throughout
Michigan. MichCon is subject to the accounting requirements and rate
regulation of the Michigan Public Service Commission (MPSC) with respect to
the distribution and intrastate transportation of natural gas. Slightly less
than half of MichCon's labor force is covered by collective bargaining
agreements. In June 1998, bargaining agreements covering approximately 15% of
the labor force are due to expire.
1
DIVERSIFIED ENERGY
Diversified Energy's operating revenues for 1997 totaled $951.3 million
(including intercompany transactions), while operating and joint venture income
was $112.7 million in 1997, nearly double 1996 operating and joint venture
income. Diversified Energy contributed 43% of the company's earnings, up from
28% in 1996. The growth in earnings was driven primarily by increased operating
and joint venture income as all of MCN's Diversified Energy business units
turned in exceptional performances. Partially offsetting the growth in earnings
were increased financing costs resulting from additional capital needed to fund
investments.
Diversified Energy -- Operating Statistics
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1997 1996 1995
------- ------- -------
Exploration & Production
Gas Production (MMcf)..................................... 78,218 57,202 31,420
Oil Production (Mbbl)..................................... 3,346 1,086 388
Gas and Oil Production (MMcf Equivalent).................. 98,294 63,718 33,748
Pipelines & Processing*
Gas Processed (MMcf)...................................... 42,761 44,223 14,588
Methanol Produced (Thousand Gallons)...................... 60,810 10,545 --
Transportation (MMcf)..................................... 115,975 86,391 4,994
Energy Marketing, Gas Storage & Electric Power*
Gas Sales (MMcf).......................................... 343,719 218,952 170,668
Exchange Gas Deliveries (MMcf)............................ 15,109 22,586 16,462
------- ------- -------
358,828 241,538 187,130
======= ======= =======
Electricity sales (thousands of MW hours)................. 1,843 709 272
======= ======= =======
* Includes MCN's share of joint ventures
EXPLORATION & PRODUCTION
MCNIC is engaged in natural gas and oil exploration, development and
production through its wholly owned subsidiary, MCNIC Oil & Gas Company (MOG).
At December 31, 1997, proved gas reserves totaled 1,166.2 Bcf and proved oil
reserves were 155.1 Bcfe, up a combined 80.2 Bcfe, or 7%, from December 1996
levels. The increase in gas and oil reserves during 1997 was tempered by the
sale of properties with 57.6 Bcfe of proved reserves and net downward reserve
revisions of 32.8 Bcfe. Operating and joint venture income for 1997 increased by
$24.9 million over 1996 to $58.1 million, reflecting a significant increase in
gas and oil production during 1997 to 98.3 Bcfe from 63.7 Bcfe in 1996.
Approximately $17.8 million in federal tax credits were generated in 1997
related to gas production from certain Antrim and coalbed methane gas wells. E&P
operating results for 1997 reflect a $1.95 average gas sales rate per thousand
cubic feet (Mcf), which declined $.01 per Mcf compared to 1996. Operating
results for 1996 reflect a gas sales rate of $1.96 per Mcf, compared to $2.02
per Mcf in 1995. The average sales rates include the effect of hedging with
commodity swap and futures agreements, which are used to manage Diversified
Energy's exposure to the risk of market price fluctuations. As a result of
strong gas prices in the marketplace, hedging agreements had the effect of
reducing the average sales rate for 1997 by $.40 per Mcf and for 1996 by $.35
per Mcf. Conversely, hedging agreements increased the average sales rates for
1995 by $.51 per Mcf in a less favorable gas market. E&P operating results also
reflect an average oil sales rate of $16.87 per barrel, which decreased by $3.31
per barrel compared to 1996. The average oil sales rate for 1996 increased by
$3.94 per barrel compared to 1995.
MOG's strategy is to continue to grow its U.S. gas reserve base and
production in known producing areas through drilling and acquisition, generating
attractive returns. MOG is also pursuing international opportunities in areas
with known hydrocarbons involving both lower risk, unconventional long-life
reserves and higher risk conventional exploration and development prospects with
substantial upside potential. Although MOG may increase its operating role in
the future, currently it takes mainly a non-operated, but active role, investing
2
with operators with local expertise in each play. MOG anticipates that
production will increase in the future through the continued development of its
large inventory of unconventional and conventional drilling locations and from
additional exploration and development of MOG's approximately 1.2 million net
(2.6 million gross) acres of undeveloped property.
In 1997, MOG participated in the drilling of 696 wells (412 net), bringing
the total drilled to 2,273 wells (1,477 net) since it began operations in 1992.
The 1997 drilling program achieved an overall drilling success rate of 91% and
added approximately 269 Bcfe of proved reserves. MOG's success rate in its
drilling program since its inception in 1992 has averaged approximately 91%. In
1997, about 26% of these wells were drilled in Michigan Devonian (Antrim) shale
formations. Even though the potential natural gas recovery from an average
Antrim well is less than the recovery from wells drilled in other types of
formations, wells drilled in the Antrim shale formations have a high success
rate and are therefore considered relatively low risk. MOG's average working
interest in Antrim shale E&P wells is approximately 80%. Exploratory activities
in the Midcontinent/Gulf Coast and Western regions involve greater risk of dry
holes or unproductive wells, but there is also a greater potential for finding
larger gas reserves. MOG's average working interest in these wells is
approximately 30%. Average finding cost in 1997 was $.90 per Mcfe, up from $.83
per Mcfe in 1996. Average production cost in 1997 was $.70 per Mcfe, down from
$.76 in 1996.
Approximately 42% of MOG's production and 71% of its proved reserves were
associated with the Midwest/Appalachia region in 1997, as MOG added 257 net
wells in the region. MOG continued as the largest Antrim producer, holding
interests in approximately 20% of the area's estimated 5,950 producing wells.
MOG's success in the Antrim shale formation provided them with the foundation to
begin a thorough evaluation of similar nonconventional reservoirs (fractured
shales, coal seams and tight sands) throughout the United States. Coalbed
methane production from MOG's CONSOL properties and partnership with Equitable
Resources, Inc. continued to place it among the largest players in the region.
MOG participated in 162 coalbed wells in this area during 1997.
About 33% of production and 14% of reserves were from the Midcontinent/Gulf
Coast in 1997. MOG owns a 41% working interest in the Broughton Joint Venture, a
partnership that is actively drilling in the Cotton Valley pinnacle reef play in
east Texas. The partnership made a significant natural gas discovery during the
third quarter 1997. The Camp Cooley #2R natural gas well, in which MOG holds a
24% net interest, has been producing since October at rates in excess of 30
million cubic feet per day (MMcf/d). With an absolute open flow potential
calculated at 48 MMcf/d, it is one of the largest discoveries in the play to
date. The Cotton Valley pinnacle reef play continues to attract national
attention for its high-potential drilling prospects despite difficult drilling
and completion conditions that have driven up exploration costs. Broughton holds
one of the biggest positions in this major play, with numerous large anomalies
identified through three-dimensional (3-D) seismic on its more than 300,000
gross acres concentrated within the three-county heart of the known producing
area. As a result, Broughton can be selective in choosing only the largest and
most prospective reef targets. The Broughton partnership participated in the
drilling of 10 wells during 1997, and 18 since entering the play in 1996.
Also on the Gulf Coast, MOG is involved in a number of high-potential 3-D
seismic plays that appear promising. These include a 17.7% working interest in a
120,000-acre Sligo reef play and a 47% working interest in a 29,500-acre project
in the successful Yegua and Wilcox plays, both in Texas, as well as a 43.8%
interest in a 154,000-acre project in Louisiana.
In the Midcontinent, development drilling continued in the Anadarko and
Permian Basins as MOG participated in 135 wells. Most notable were the 35 wells
completed in the Delaware Sands play in southeast New Mexico. These wells
boosted MOG's net production from the play and set up a number of development
locations for future drilling. In 1997, MOG added 65 net wells in the
Midcontinent/Gulf Coast region, while divesting of its interests in more than
500 mature Midcontinent wells and selling its ownership interest in an offshore
Gulf of Mexico venture.
The Western region became a significantly larger piece of the business in
1997, accounting for 25% of production and 15% of reserves, compared with only
6% and 9%, respectively, in 1996. In the Western region during 1997, MOG
participated in 200 wells and achieved a 93% drilling success rate that resulted
in the
3
addition of 51 net wells. Production from the region is expected to increase at
double-digit rates again in 1998 with about 250 new wells planned for drilling.
Western region production has grown rapidly due to the Venoco and Jonah Field
partnerships.
MOG continues to develop its one-third partnership interest in a
52,000-acre block in and around the Jonah Field, located in the Green River
Basin of Wyoming. This partnership, which originally began in May 1996, included
12 existing gas wells and a 42 MMcf/d gathering system. Through the end of 1997,
MOG had drilled 28 additional wells, all of which were successful. As a result,
total field production tripled to 54 MMcf/d and the gathering system was
expanded to 65 MMcf/d. With 65 proved undeveloped locations identified and ready
to drill, MOG's net proved reserves from this field are approximately 104 Bcfe.
MOG's net natural gas volumes grew from 1.4 Bcfe of partial-year production in
1996 to 8.9 Bcfe in 1997.
In December 1996, MOG added California oil-producing acreage to the Western
region through the formation of Venoco L.L.C. Development drilling and
installation of secondary oil recovery facilities have increased the
partnership's production as much as 5,300 Bbls per day during 1997 to over 7,000
Bbls per day. The Venoco venture contributed 11.7 Bcfe of oil and gas production
in this region. In addition, the partnership acquired the South Ellwood
properties that have provided MOG with 4,000 Bbls per day of production in 1997.
Other areas of interest within MOG's Western region include the Powder
River Basin in Wyoming, where MOG has a 35% working interest in a coalbed
methane project that drilled 61 wells during 1997, bringing the well count to
118. In the Uinta Basin in Utah, MOG has 50% interests in both a secondary oil
recovery venture that drilled 50 successful producing wells in 1997 and a
coalbed methane project that has begun a five-well pilot program in anticipation
of full-scale development starting in 1999.
In 1997, MOG made significant investments in natural gas reserves,
acquiring interests in more than 32 producing wells. At December 31, 1997, 2,917
wells were producing. An additional 384 wells were in various stages of
completion and are expected to begin producing in 1998. Additional information
on MOG's exploration and production activities is reported under Item 2.
Properties, located on pages 20 and 21 under this section.
MOG anticipates that oil will become a larger percentage of total reserves
and production in order to achieve a more balanced portfolio. In addition to
producing increasing quantities of oil through traditional methods, MCN expects
increased production from enhanced oil recovery investments. In Michigan's
Niagaran Reef formation, carbon dioxide extracted from Antrim natural gas
production is being injected into existing oil reservoirs. Production began in
1997. MOG is also participating in a number of secondary recovery water-flood
projects, designed to increase the flow rate and overall production of MCN's oil
wells.
The natural gas industry is very competitive, especially when it comes to
obtaining desirable properties and projects for the production of natural gas
and oil. The successful relationships MOG has developed with its various joint
venture partners has created a unique network through which many potential E&P
investments have been, and will continue to be, presented to MOG for
consideration. MOG's primary focus is in known areas of gas production where the
chances of finding gas are high, although high-potential exploratory projects
will also be pursued. Additional investments in natural gas reserves will be
made in areas that offer proved reserves and an acceptable success rate. MOG's
investment portfolio is built on a diversification strategy intended to manage
risk: geographically, with investments in the Midwest/Appalachia,
Midcontinent/Gulf Coast and Western regions; geologically, with formation depths
ranging from less than 400 feet to more than 18,000 feet; and technologically,
with investments in both conventional and unconventional gas and oil projects.
Key to its strategy is also to significantly hedge the commodity price exposure
of its gas and oil portfolio long-term. Competition ranges from the major oil
companies to numerous small independent gas and oil companies.
It is anticipated that MCN will invest in excess of $400 million in
exploration and production activities in each of 1998 and 1999.
4
PIPELINES & PROCESSING
Operating and joint venture income nearly tripled from $10.7 million in
1996 to $29.1 million in 1997 due to full-year contributions from projects added
in 1996 and strong growth across the range of its businesses. Also,
transportation volumes increased in 1997 to 116.0 Bcf from 86.4 Bcf in 1996,
while there was a slight decrease in processing volumes in 1997 to 42.8 Bcf from
44.2 Bcf in 1996. Results also reflect a significant contribution of methanol
production totaling 60.8 million gallons, compared with initial 1996 production
of 10.5 million gallons, from MCNIC's partnership with Lyondell Petrochemical
Co., formed in late 1996. Earnings from Lyondell also benefited from higher than
expected methanol prices during 1997.
Pipelines & Processing's expansion strategy is to own interests in natural
gas and gas liquid gathering, processing and transmission facilities near areas
of rapid reserve development or growing consumer markets. This strategy includes
working with other Diversified Energy businesses that complement Pipelines &
Processing's operations. Operating responsibilities for these facilities are
generally assigned to our partners.
The Dauphin Island Gathering Partners (DIGP) have approved expansion plans
to construct approximately 78 miles of gas gathering lines to provide an
incremental 500 MMcf/d of capacity. At year-end 1997 DIGP completed the first
phase of its planned expansion, adding 63 miles of pipe to interconnect its
existing 400 MMcf/d Mobile Bay and 300 MMcf/d Main Pass systems and to add more
than 200 MMcf/d of additional capacity. The result of the two-phase expansion
will be a 229-mile system that can deliver up to 1.1 Bcf/d of gas from more than
70 committed blocks that represent approximately 60% of the 5 Tcf of reserves
estimated to be in this part of the Gulf of Mexico. Pipelines & Processing's
share of this partnership is 34.6%.
Closely related to the DIGP project is the Mobile Bay Processing
partnership, formed during 1997 to build a major liquids handling and gas
processing facility, primarily for gas coming onshore from the Dauphin Island
system. MCNIC holds a 42.8% share of this venture, which began construction in
November 1997 and is scheduled to be in service in summer 1998 with a processing
capacity of 600 MMcf/d. Producer contracts are in place that commit sufficient
gas volumes to the plant to warrant its full design capacity. The partnership
intends to connect other sources of gas to the plant inlet, which would allow
for its expansion to 900 MMcf/d of capacity. MCNIC Power Company also has become
associated with this project by entering into a separate venture to construct a
40 MW cogeneration plant to meet the facility's electricity and thermal heating
requirements. Duke Energy Corp. is MCNIC's primary partner in this power
facility, as well as in the Dauphin Island Gathering and Mobile Bay Processing
ventures.
MCNIC's other offshore gathering system, the one-third owned 40-mile Blue
Dolphin Pipeline, increased its throughput 38% during 1997 to average 92
MMcfe/d. Strong leasing and drilling activity in the area indicates potential to
continue increasing this system's throughput during 1998 and beyond.
Elsewhere in the Midcontinent/Gulf Coast region, MCNIC formed two gathering
ventures with American Central Gas Companies, Inc. MCNIC holds a 40% interest in
each. In July 1997 the Foss Lake Gathering System venture was created to own and
operate a 76-mile low-pressure system in the Anadarko Basin of western Oklahoma.
This system currently gathers approximately 40 MMcf/d of natural gas and has a
design capacity of 60 MMcf/d, a level of service the partnership intends to
achieve during 1998 by attracting additional area producers to the system. In
December 1997 the second venture was formed to own and operate the East Texas
Gathering system. This system primarily consists of 68 miles of gas gathering
lines with throughput capacity of about 150 MMcf/d. It is located in an area of
significant drilling activity, providing opportunity for rapid expansion.
In September 1997 MCNIC created a partnership with Petro Source Corporation
to develop CO2 pipeline, processing plant and marketing projects in support of
enhanced oil recovery projects. As its first initiative, the partnership has
begun construction of an 82-mile, 100 MMcf/d CO2 pipeline that will connect four
gas treating plants to a distribution system servicing enhanced oil recovery
projects in the Permian Basin of west Texas. MCNIC Pipeline & Processing has a
33% interest in the pipeline, which is expected to be placed in service during
the second quarter of 1998.
5
In early 1996, Pipelines & Processing joined a partnership to construct the
Portland Natural Gas Transmission System (PNGTS) as a shipper and a 20% equity
partner. As proposed in an amended regulatory filing made in late 1996, this
292-mile, $340 million pipeline would connect with the TransCanada PipeLines
system at the Vermont border and with the Tennessee Gas Pipeline system in
Massachusetts and would be in service in late 1998. PNGTS is proceeding on
schedule toward construction and is expected to begin providing up to 210 MMcf/d
of transportation service in late 1998. This system will transport gas from
pipeline interconnections in Quebec to markets as far south as Boston.
In April 1997 MCNIC agreed in principle to participate in the Millennium
Pipeline project as a 10.5% equity partner. This is a proposed $680 million
project to carry up to 700 MMcf/d of western Canadian and U.S. natural gas to
New York and other northeastern markets, with deliveries beginning in time for
the 1999-2000 winter heating season. The pipeline would originate at an
interconnection with the TransCanada PipeLines Ltd. system in Lake Erie and
primarily follow existing Columbia Gas Transmission rights-of-way to pipeline
interconnections in Westchester County, N.Y. An application seeking Federal
Energy Regulatory Commission (FERC) approval of the project was filed in
December 1997.
In August 1997 MCNIC joined the Vector Pipeline project with a 25% equity
interest. The $450 million project, which will transport up to 1 Bcf/d of
natural gas from the Chicago area, through Michigan and into the Dawn, Ontario
gas hub for ultimate redelivery in various U.S. and Canadian markets. Since the
Dawn hub will be readily accessible to Millennium, these two projects provide a
potential direct link from the Chicago hub to Northeast markets. This link is
becoming crucial as significant new pipeline capacity is being developed to move
western Canadian gas to the Chicago hub, with limited existing take-away
capacity, and as gas demand in the Northeast continues to grow at rates far
higher than the national average. Vector also filed a FERC application in
December 1997 with service proposed to begin in time for the 1999-2000 winter
heating season.
Both Millennium and Vector have conducted open seasons, in which customers
expressed interest in contracting for capacity in excess of the proposed
amounts. Subsequently, each of the pipelines has obtained binding precedent
agreements for transportation service that represent sufficient capacity to
proceed with development.
Pipelines & Processing is a 50% partner in Copano Field Services L.P.,
which continued its growth in 1997 primarily through strategic acquisitions. In
early 1997, Copano acquired a 25 MMcf/d gas processing facility attached to one
of its systems and reached an agreement with KCS Energy, Inc. to purchase a
150-mile, 150 MMcf/d intrastate gas pipeline system in south Texas. Throughput
capacity doubled to 290 MMcf/d while gas processing capacity was added, totaling
25 MMcf/d. The system now has 621 miles of pipe. Efforts are underway to acquire
or build new pipeline sections to link the various Copano systems.
In December 1996 Pipelines & Processing acquired a 25% interest in Lyondell
Methanol Company, L.P., a limited partnership that owns and operates a 248
million gallon-per-year methanol processing plant in Texas. MCNIC will supply
natural gas to the methanol plant and will have the opportunity to participate
with the other partner in future electric power generation projects during the
next five years. MCNIC's share of methanol production in 1997 was 60.8 million
gallons, compared with initial production of 10.6 million gallons. Higher than
expected methanol prices provided a large boost to joint venture income.
In September 1997 Pipelines & Processing announced an asphalt manufacturing
partnership. The asphalt venture is with Crown Energy Corporation and was
created to develop the Asphalt Ridge oil sand project in northeast Utah. The
first phase of this project includes construction of a $15 million manufacturing
facility designed to produce approximately 100,000 tons of premium-quality
asphalt annually. It is expected to begin delivering product in summer 1998. A
second facility is expected to be built in 1999 and a third in 2000, if market
conditions warrant. The project benefits from the unique, abundant oil sands
found at the plant's site, as well as new federal standards favoring the use of
premium-grade asphalt such as that to be produced by the facility.
In November 1997 Pipelines & Processing announced a coal fines venture
project to recover fine particles of coal that have been a wasted by-product of
coal mining, then chemically process the fines through a
6
procedure to produce coal briquettes for resale into existing coal markets. MCN
has filed for and expects to receive from the Internal Revenue Service a
determination that production from the plants will qualify for synthetic fuel
tax credits, estimated to range from $20 to $25 per ton. MCN anticipates
constructing up to six plants, each of which would have a rated capacity to
produce one million tons of coal briquettes annually, although actual production
levels may vary significantly depending upon actual site conditions, including
coal fines quality and quantity, equipment performance and other factors. Having
the plants in service by June 30, 1998 is essential to the project, since they
must be operational by that date to qualify for tax credits.
In Michigan and Indiana, gas processing capacity was expanded 20% to 185
MMcf/d, primarily due to the acquisition of a new plant. Pipelines & Processing
now has an average interest of 89% in seven such plants that extract CO2 from
Antrim gas production.
MCN's strategy to grow its pipelines and processing operations is to take
equity positions, usually in partnerships owning natural gas gathering,
processing and transmission facilities near areas of either rapid reserve
development or growing consumer markets. It is anticipated that in excess of
$350 million will be invested in pipelines and processing facilities in 1998, a
level of investment that could rise significantly in future years based on the
numerous potential domestic and international projects currently being pursued.
ENERGY MARKETING, GAS STORAGE & ELECTRIC POWER
Operating and joint venture income for 1997 for the combined results of
these three businesses more than doubled to $29.8 million from $14.0 million in
1996. The improvement reflects the acquisition in May of an interest in the
Midland Cogeneration Venture in Michigan, as well as gas sales and exchange
deliveries that increased 49% to 359 Bcf in 1997 from 242 Bcf in 1996. These
volumes include 61.4 Bcf of supply-area sales added due to the marketing
alliance with Torch Energy Advisors of Houston, which began operations in early
1997.
Capital investments for the combined marketing, storage and electric power
units during 1997 totaled approximately $250 million, compared with $21 million
in 1996, and are anticipated to exceed $250 million in 1998. These capital
investments primarily target electric power generation projects.
ENERGY MARKETING
MCN's non-regulated energy marketing activities are directed by CoEnergy
Trading Company (CTC). CTC, a wholly owned subsidiary of MCNIC, is engaged in
the purchase and sale of natural gas to over 700 commercial and industrial
users, as well as gas and electric utilities and other large-volume customers
throughout the Midwest, Gulf Coast and Northeast regions of the United States
and Eastern Canada. Through its offices located in Hartford, Connecticut and
Detroit and Grand Rapids, Michigan, CTC is able to offer buyers a bundled
service by making arrangements for the acquisition of the required gas volumes
and delivery to customers' facilities, and for all the necessary services in
between. This bundled service is more in demand during the winter months, when
interstate pipeline capacity in certain areas of the Northeast and Midwest is
either constrained or uneconomical. CTC is able to better meet this demand
through the use of gas production and access to storage fields and other
physical assets owned by affiliates.
CTC competes against numerous marketing companies. A diverse portfolio of
short-, medium- and long-term sales and supply contracts combined with access to
reliable gas suppliers, storage facilities and multiple pipeline connections
enhances its competitive position. In 1996, CTC entered into a marketing
alliance with Torch Energy Advisors of Houston that began contributing to
results in early 1997. This alliance links Torch's supply-aggregation and
marketing strengths in the Gulf Coast region with CTC's strong presence in high-
consumption markets. In June 1997, CTC and Gulf Canada Resources Limited signed
a letter of intent to form Gulf-CoEnergy Services, an alliance combining their
expertise to market North American natural gas. Gulf will hold 60 percent and
CTC will hold 40 percent in this new venture. Gulf-CoEnergy Services will have
more than 500 MMcf/d of committed natural gas supply and utilize Gulf's strong
position in gathering and processing in western Canada and gas marketing in the
western United States. CTC uses its competitive position in both the market and
production regions to identify and complement business opportunities for MCNIC's
various businesses.
7
Also assisting MCNIC's marketing efforts is strategically selected pipeline
capacity that is used to deliver gas to Midwest, Northeast and Canadian
customers. In support of the gas marketing function, MCNIC has firm
transportation service contracts on various pipeline systems totaling
approximately 250 MMcf/d, which is supplemented by interruptible service as
needed. MCNIC expects to increase its reserved pipeline capacity, particularly
on recently proposed west-to-east systems, to help meet customers' needs. In
addition to MCNIC's anticipated equity interests in three of these projects, CTC
expects to capture significant marketing opportunities utilizing the new
pipelines.
An alliance formed in June 1997 added electricity to CTC's marketing
portfolio. DTE-CoEnergy L.L.C. is jointly owned with DTE Energy Co., parent of
Detroit Edison, and markets a wide range of energy services to industrial,
commercial and institutional customers. The alliance's target market area spans
the Great Lakes and Mid-Atlantic states, as well as the Province of Ontario.
Offerings include electricity and natural gas supplies, plus associated energy
and risk management services required to create cost-effective, bundled energy
packages tailored to meet individual customers' needs in a non-regulated
environment.
It is expected that electricity sales volumes initially will be slow to
develop, since this business relies on the restructuring of the retail
electricity industry. Restructuring is being pursued at the state level
nationwide, so marketing opportunities will open only gradually. Within
DTE-CoEnergy's target market area, Pennsylvania has opened limited access to the
retail electricity market through pilot programs. DTE-CoEnergy is one of 25
suppliers participating in a 14-month, 1,200 MW Pennsylvania pilot that began in
November 1997. Initial sales volumes from this pilot, although modest, have
provided important experience that will assist future efforts as additional
states open the electricity sector to competition. Within the target region,
Michigan, Indiana, Maryland, New Jersey, New York and Ohio are developing plans
to open portions of their retail markets to competition beginning in 1998 or
1999, with most planning to be fully restructured by 2002.
GAS STORAGE
MCNIC, through its subsidiary MCNIC Gas Storage Company (MCNIC Gas
Storage), has adopted a strategy of using joint ventures and strategic
partnerships to provide gas storage services, either as a separate service or
bundled with full gas service, to other gas utilities, pipeline companies and
large-volume gas users. Storage facilities near major consuming markets provide
supply flexibility, improve reliability of deliveries and help reduce gas costs.
MCNIC's 35 Bcf of owned and leased storage capacity in Michigan allows the
company to flow gas into storage at relatively steady rates during off-peak
periods, and to draw upon this storage for delivery during peak-demand periods.
This strategy allows for a very reliable service while keeping operating costs
low.
The gas industry's changing operating environment has resulted in more
efficient use of existing storage facilities and a reduced immediate need for
additional capacity. However, growing markets will require expanded storage
capabilities in selected areas in the long-term. This future need, together with
Michigan's pivotal geographic location and favorable geology, presents a
significant opportunity for MCN's storage services.
During August 1997 MCNIC began developing the $160 million Washington 10
storage field project that will significantly increase the amount of gas storage
capacity available to CoEnergy for its markets. The Washington 10 project is
converting a depleted gas reservoir in southeast Michigan to a 42 Bcf storage
facility, capable of delivering approximately 400 MMcf of natural gas on an
average winter day and much higher volumes during peak-demand periods. Initial
gas injection is scheduled for the spring of 1999, with the facility expected to
be fully operational in time for the 1999-2000 winter heating season.
MCNIC Gas Storage also has a 50% interest in the Washington 28 storage
field, located northeast of Detroit in Macomb County. This 10 Bcf field provides
storage to MCNIC's Energy Marketing operations. MCNIC Gas Storage sold its 25%
share of the Blue Lake gas storage project in December 1997. MCN's Gas
Distribution segment also owns a 25% interest in the Blue Lake and will maintain
its share of the venture.
8
ELECTRIC POWER
MCNIC's Electric Power unit operates through MCNIC Power Company (MCNIC
Power), MCNIC International Holdings and MCNIC-GP International Holdings, wholly
owned subsidiaries of MCNIC, to pursue domestic and international power
generation-related opportunities. Power generation projects offer the potential
for multiple sources of income, such as long-term gas sales, transportation
services and a return on the investment in the facility, particularly in the
U.S.
In recent years, an increasing amount of new electric generating capacity
has been fueled by natural gas because of the lower capital costs, lower
emissions and other advantages associated with natural gas-fueled facilities. In
addition, many states have passed regulations requiring electric utilities to
consider bids from third parties to meet new electric generation needs. MCNIC
Power has the capacity to provide long-term gas supplies at known prices to
power generation facilities.
MCNIC Power's strategy is to capture synergies among MCN's businesses and
to profitably apply the expertise they have gained in managing energy-related
projects. The gas-fueled power generation industry has seen an increase in the
number of participants, many of whom are willing to accept returns on power
generation projects that are considerably below MCNIC Power's threshold. The
restructuring of the electric utility industry could increase the long-term
opportunities for MCNIC Power. MCN's experience in the natural gas industry's
transition to a more competitive environment, combined with our success as a
partner in several independent power projects, should enable us to capture such
opportunities.
Electric Power sales increased 160% to 1.8 million MW hours (MWh) in 1997
from 700,000 MWh in 1996, primarily due to the addition of interests in the
Midland Cogeneration Venture (MCV) in April 1997 and a power generation and
distribution partnership in India in March 1997. Net generating capacity climbed
to 506 MW from 91 MW.
MCNIC's experience and relationships in the energy business have provided a
solid base with which to pursue opportunities internationally. India holds
significant investment potential, where there is tremendous demand for
additional power generation capacity and the business environment remains
conducive to attractive returns on investment. The strategy in India is to
partner with others who bring expertise and capital to the venture, including an
experienced Indian partner.
In March 1997, MCNIC made its first international investment with the
formation of Torrent Power Ltd. (Torrent), a venture with Torrent Exports Ltd.
of Ahmedabad, India. MCNIC's investment of approximately $173 million gives it a
40% interest in Torrent and its growing electricity generation and distribution
business in the state of Gujarat in western India. Torrent consists of: a 36%
interest in Ahmedabad Electricity Company (AEC), an electric utility with 550 MW
of generating capacity and the exclusive franchise to operate in the city of
Ahmedabad, which has a population of about 5 million; a 43% interest in Surat
Electricity Company, an electric utility with the exclusive franchise to operate
in the city of Surat, which has a population of about 3.5 million; and a 42%
interest in Gujarat Torrent Energy Corporation (GTEC), a project company set up
to build, own and operate a 655 MW dual-fuel (natural gas and liquid fuel)
facility near the city of Bharuch. Torrent continues to pursue opportunities to
purchase additional interests in these companies.
The first of GTEC's three 138 MW gas-turbine generators was placed on
commercial production in January 1998. The other two, followed by the facility's
241 MW steam-turbine generator, are expected to be placed into service
approximately three months apart, such that the full 655 MW of generating
capacity should be commercially on-line in late 1998. GTEC is considering an
expansion that could double the facility's capacity, if conditions warrant.
Entering 1998, MCN is pursuing opportunities to participate in the
construction of more than 5,000 additional gross MW of generating capacity in
India. Among them is a 525 MW coal-fired facility in the state of Tamil Nadu and
a 347 MW dual-fuel project in the state of Madhya Pradesh, as well as several
captive power projects ranging from 20 MW to 210 MW in various locations.
In December 1997, MCNIC made another international power investment with
the acquisition of an approximate 65% interest in a 36 MW hydroelectric power
project in Nepal. The $98 million Upper Bhote
9
Koshi Hydroelectric Project began construction in 1997 and is scheduled to be
placed into commercial operation in late 1999. The power project, located
approximately 60 miles northeast of Kathmandu, will boost Nepal's existing
electric power generation capacity by more than 10% and play a vital role in
Nepal's emerging economy. Electricity production from the facility will be sold
under long-term firm contract to state-owned Nepal Electricity Authority.
Also in 1997, MCNIC made an approximate $46 million advance to fund power
generation projects already under construction in the Philippines. MCNIC has the
option to convert this advance into an equity interest in either the overall
independent power company or specific power generation assets.
Potential future additions to the Electric Power unit continued to multiply
during 1997. Domestically, projects representing almost 1,000 gross MW of
capacity are being pursued, including the 40 MW unit associated with MCNIC
Pipeline & Processing Company's Mobile Bay, Alabama, gas processing project. The
$28 million Mobile Bay cogeneration project is expected to provide electric
power and thermal energy to the processing plant beginning in third quarter 1998
utilizing 10 natural gas-fired electric generators and a hot oil recovery
system. MCN anticipates expanding the power facility up to 60 MW as the energy
needs of the processing plant increase. Other potential domestic power projects
include facilities in Ohio, Virginia, West Virginia and New Mexico.
In April 1997, MCNIC invested approximately $55 million for an 18% general
partnership interest in Midland Cogeneration Venture Limited Partnership, which
operates the MCV facility in Midland, Michigan. MCV, the nation's largest
cogeneration facility, can produce up to 1,370 MW of electricity and 1.35
million pounds per hour of process steam for industrial use. It sells
electricity to Consumers Energy Co. and The Dow Chemical Co. under long-term
contracts. Dow Chemical and Dow Corning Corp. also purchase process steam from
the facility under long-term contracts. In addition to MCNIC's share of the
partnership's income, the interest in MCV may provide significant growth
opportunities through incremental energy marketing and gas services that
CoEnergy could provide for the facility.
MCNIC Power's business also includes a number of small cogeneration units
located at the operating facilities of large commercial and industrial
customers. MCNIC Power has long-term agreements for the sale and transportation
of natural gas to these units.
RISK MANAGEMENT STRATEGY
MCN primarily manages commodity price risk by utilizing futures, options
and swap contracts to more fully balance its portfolio of gas and oil supply and
sales agreements. MCN has hedged through long-term financial swaps most of its
anticipated future gas production not covered by long-term, fixed-price sales
obligations. MCN's Energy Marketing group coordinates all of MCN's hedging
activities. A management committee ensures compliance with risk management
policies and periodically reports to MCN's board of directors. Certain hedging
gains or losses related to gas and oil production are recorded by MCN's E&P
operations. Gains and losses on gas hedging transactions that are not recorded
by MCN's E&P group are absorbed by Energy Marketing.
10
GAS DISTRIBUTION
GAS SALES AND TRANSPORTATION
Gas Distribution serves customers in the Detroit, Grand Rapids, Ann Arbor,
Traverse City, Muskegon and Adrian metropolitan areas and in various other
communities throughout the State of Michigan. The following services are
provided by Gas Distribution:
- Gas Sales -- Includes the sale and delivery of natural gas to residential
and small-volume commercial customers.
- End User Transportation -- Through this service, large-volume commercial
and industrial customers that purchase natural gas directly from
producers or brokerage companies utilize the company's network to
transport the gas to their facilities.
- Intermediate Transportation -- Provides transportation service through
the company's gathering and high pressure transmission system to
producers, brokers and other local distribution companies that own the
natural gas, but are not the ultimate consumer.
In January 1996, MCN consolidated its Michigan pipeline operations through
the transfer of its Michigan gathering and transportation network from its
Diversified Energy group to its Gas Distribution group. The transfer was made in
order to consolidate MCN's Michigan gathering pipeline activities within one
business unit. The segment information included herein is reported as though the
combined intrastate pipeline operations were part of Gas Distribution for all
periods presented.
· Enlarge/Download Table
1997 1996 1995
-------- -------- --------
REVENUES (In millions of dollars)
Gas Sales................................................... $1,080.1 $1,102.9 $ 931.9
End User Transportation..................................... 84.7 82.5 80.8
Intermediate Transportation................................. 55.2 48.6 42.0
-------- -------- --------
Total Sales and Transportation............................ 1,220.0 1,234.0 1,054.7
-------- -------- --------
Other....................................................... 51.3 42.3 52.9
-------- -------- --------
Total Operating Revenues.................................. $1,271.3 $1,276.3 $1,107.6
======== ======== ========
MARKETS (Bcf)
Gas Sales................................................... 209.1 221.0 209.8
End User Transportation..................................... 145.1 146.9 145.8
Intermediate Transportation................................. 586.5 527.5 374.4
-------- -------- --------
Total Sales and Transportation............................ 940.7 895.4 730.0
======== ======== ========
NOTE: Intermediate transportation volumes include intercompany transactions.
EFFECT OF WEATHER: Gas Distribution's sales and end user transportation
volumes, revenues and net income are impacted by weather. Given the seasonal
nature of the business, revenues and net income tend to be higher in the first
and fourth quarters of the calendar year.
Effect of Weather on Gas Markets and Earnings
--------------------------------------------------------------------------------
· Download Table
1997 1996 1995
---- ---- ----
Percentage Colder Than Normal............................... 0.8% 5.4% 0.3%
Increase From Normal in:
Gas Markets (in Bcf)...................................... 0.6 10.9 1.5
Net Income (in Millions).................................. $0.5 $ 9.9 $1.4
11
GAS SALES: Revenues decreased $22.8 million in 1997 due primarily to
weather which was 4.6% warmer than in 1996, partially offset by higher prices to
recover gas costs. This market represents 22% of total deliveries and produced
76% of Gas Distribution's gross profit margin from sales and transportation
services (gross profit margin). The average margin per Mcf from gas sales was
$2.09 in 1997 and $2.07 in 1996.
Competition in the gas sales market from alternative energy sources is
minimal, coming primarily from sources such as electricity, propane, and to a
lesser degree, oil and wood. Natural gas continues to be the preferred fuel for
Michigan residences and businesses. Nearly every residential and commercial
developer in MichCon's service territories selects natural gas in new
construction because of the convenience, cleanliness and price advantage of
natural gas compared to propane, fuel oil and other alternative fuels. Service
and price are the primary factors affecting this market.
Gas Distribution continues to take steps to become the preferred provider
of natural gas and high-value energy services within Michigan and to maintain
strong financial results. To accomplish this, MichCon will increase penetration
of existing markets by focusing on meeting the needs of customers and the
marketplace, will increase efforts to reduce cost of gas and operating costs,
and will take advantage of growth opportunities to expand to new geographic
areas. There continue to be opportunities to grow residential markets through
the conversion of existing homes, as well as from new construction. Gas
Distribution continues to grow industrial and commercial markets by aggressively
facilitating the use of existing gas technologies and equipment.
Gas Distribution's Market Expansion Program is intended to spur demand for
natural gas in areas currently not served, primarily targeted at residential and
small-volume commercial markets. By financing the cost of main extensions, this
program makes it easier for users of other higher-cost fuels, such as propane
and fuel oil, to switch to natural gas for space heat and other applications.
This program has contributed 15% of the 74,150 new customers added during the
past 3 years. In 1997, 9 new areas of Michigan were served by MichCon, bringing
the total number of new areas added since the program's inception in 1984 to
137.
Cost of gas sold per Mcf for 1997 was $3.11, an increase of $.19 (7%) over
1996. Cost of gas sold per Mcf for 1996 increased from 1995 by $.56 (24%).
MCN owns a 47.5% interest in Southern Missouri Gas Company, L.P. which was
formed in November 1996. The initial phase of system construction was completed
in 1997 at a cost of approximately $40 million. As of December 31, 1997 the
system was comprised of a 441 mile pipeline system and served approximately
6,000 customers.
END USER TRANSPORTATION: End user transportation deliveries decreased
slightly to 145 Bcf in 1997 due to warmer weather. In 1997, this market
accounted for 15% of total gas deliveries and produced 15% of gross profit
margin.
At December 31, 1997, Gas Distribution had end user transportation
agreements representing annual volumes of 151 Bcf, up from 146 Bcf a year
before. Approximately 56% of these volumes are under contracts that extend to
1999 or beyond and include the majority of the large, and most price-sensitive,
customers.
Through technical and financial assistance, industrial and commercial
customers have been encouraged to increase the use of natural gas. The natural
gas-fueled power generation accounted for approximately 31 Bcf of gas deliveries
in both 1996 and 1997. Air compressors and other small engines in certain
commercial applications also provide possibilities for conversion to natural
gas-powered equipment. The efficiencies and price competitiveness of natural gas
can significantly reduce operating costs for customers, even though a higher
initial outlay for gas-burning equipment may be required.
The primary focus of competition in this market is total cost of fuel. Some
large commercial and industrial customers have the capability to switch to
alternative fuel sources such as coal, electricity, oil and steam. In addition,
some of these customers could bypass Gas Distribution's system and obtain gas
directly from a pipeline company. However, cost differentials must be sufficient
to offset the substantial investment costs and risks associated with fuel
switching or bypass. Gas Distribution competes against alternative fuel sources
by providing competitive pricing and reliability of supply, through the use of
the company's extensive
12
storage capacity and multiple supply sources. Almost all significant customers
that are in proximity to other company's pipeline facilities are under long-term
contracts.
In the past several years, Gas Distribution has been successful in
converting many customers' facilities to natural gas from alternative fuels and
in retaining those customers after conversion. Also, in the past several years,
Gas Distribution has not experienced any significant fuel switching of any
significance by its customers. In 1997, approximately 22 Bcf of MichCon's
transportation deliveries were to customers who displaced coal with natural gas.
Although the MPSC has approved a direct access program for the state's two
largest electric utilities which will allow large electric users to directly
purchase lower priced electricity, beginning in mid-1998, this program is not
expected to materially impact the competitiveness of natural gas.
INTERMEDIATE TRANSPORTATION: This service accounts for about 63% of total
gas deliveries, but, due to the lower rates applicable to this service,
represents only 9% of gross profit margin. The increases in intermediate
transportation deliveries in 1997 and 1996 are due primarily to additional
volumes transported for two major fixed-fee customers and increased
transportation of Antrim gas for Michigan gas producers and brokers.
Gas Distribution's extensive transmission pipeline system has enabled it to
increase the volumes transported for Michigan gas producers, ANR Pipeline
Company (ANR) and other shippers. Gas Distribution operates in a pivotal
geographic location with links to major interstate pipelines that reach markets
elsewhere in the Midwest, the eastern United States and eastern Canada.
There has been a significant increase in Michigan Antrim gas production
over the past few years, resulting in a growing demand by gas producers and
brokers for intermediate transportation services. In order to meet the growing
demand for the transportation of Antrim gas, MichCon recently completed the
expansion of the transportation capacity of its northern Michigan gathering
system, which is owned by MichCon Pipeline Company (MichCon Pipeline). Pipeline
expansion enabled MichCon to transport an additional 53.5 Bcf in 1997.
MichCon Pipeline, a wholly-owned, non-utility subsidiary of MichCon, is
involved in ventures that transport natural gas and natural gas liquids from
northern and east-central Michigan gas fields to processing plants in the
northern part of the state. In December 1997, MichCon Pipeline purchased a
pipeline to expand the transportation capacity of its northern Michigan
gathering system. The cost of the pipeline was approximately $13 million and is
expected to transport approximately 44 Bcf of Antrim gas annually. During 1997,
MichCon Pipeline transported an average of 646 MMcf/d of natural gas and related
liquids. The transportation rate of one customer on the Saginaw Bay Pipeline,
which was to decrease 40% in accordance with the terms of a contract that
reduces the transportation rate for the last 10 years of the agreement, was
successfully renegotiated at the maximum MPSC approved rate during 1997.
Moreover, Saginaw Bay was successful in restructuring all transportation
contracts relating to the Saginaw Bay Pipeline to the maximum tariff rates.
In January 1997, MichCon placed into service a 59-mile loop of its existing
Milford to Belle River Pipeline at a cost of approximately $91 million. The
pipeline has improved the overall reliability and efficiency of MichCon's gas
storage and transmission system by mitigating the risk of disruption in the
operation of the existing pipeline or other facilities used to supply gas to
MichCon's customers. In addition, the pipeline provides significant off-system
transportation opportunities as discussed below.
With significant new supplies of western Canadian gas projected into the
Chicago area beginning in November 1998, MichCon is in an excellent position to
increase revenues through transportation to growing markets in eastern Canada
and the Northeast U.S. In December 1997, MichCon entered into a long-term lease
of capacity on its Milford to Belle River Pipeline with Vector Pipeline to
effectuate transportation from Chicago supplies to Dawn, Ontario if and when
Vector is constructed and placed in service, potentially in late 1999 or 2000.
Additional opportunities for transportation services are being pursued which
will further maximize the use of MichCon's existing transmission infrastructure.
13
In 1998 MichCon expects to exercise its option to purchase a 50% interest
in an additional pipeline under the St. Clair River to link MichCon's system
with Consumers' Gas of Toronto's pipeline facilities. This project will further
enhance MichCon's ability to transport gas bound for both Canadian and Northeast
U.S. markets.
ENERGY ASSISTANCE AND CONSERVATION PROGRAMS
Energy assistance programs funded by the federal government and the State
of Michigan, including the Home Heating Credit for low-income customers and the
Family Independence Agencys' State Emergency Relief Program, remain critical to
MichCon's ability to control its uncollectible expenses. MichCon has
historically obtained favorable regulatory treatment of its uncollectible costs,
including those related to these energy assistance programs.
MichCon receives a significant amount of its heating assistance funding
from the federal Low-Income Home Energy Assistance Program (LIHEAP) which funds
the State of Michigan's Home Heating Credit program. In 1997 Congress provided
$1.0 billion for LIHEAP and supplemented it with a $300 million emergency fund
that could be tapped only upon order of the President. The State of Michigan
received $64 million of the total $1.2 billion that was released in 1997. The
bulk of this money was passed on to qualified taxpayers in the form of Michigan
Home Heating Credits. MichCon received $12.7 million through this program in
1997. Home Heating Credits assisted 83,000 MichCon customers in 1997. Congress
voted to continue LIHEAP in 1998 and 1999. For federal Fiscal Year 1998, which
began October 1, 1997, Congress continued funding at the $1.0 billion level and
again authorized a $300 million emergency fund. In addition, it appropriated
$1.1 billion for federal Fiscal Year 1999 subject to revision as part of
Congress' 1999 budget deliberations. MichCon is currently working with federal
and state officials to identify other ways to obtain energy assistance for
low-income customers, and is taking actions to minimize the impact a reduction
in LIHEAP funds could have on MichCon's financial position.
GAS SUPPLY
MichCon obtains its natural gas supply from various sources in different
geographic areas under agreements that vary in both pricing and terms. This
geographic and contractual diversity of supply ensures that MichCon will be able
to meet the requirements of its present and future customers with reliable
supplies of natural gas at competitive, market responsive prices. Citizens
serves approximately 14,000 customers and is served by two interstate pipelines,
Panhandle Eastern Pipe Line Company (Panhandle) and ANR. MCNIC Michigan
Holdings, Inc., an affiliate intrastate pipeline company, connects ANR to
Citizens' distribution system. During 1997, nearly all of Citizens' purchases
were from CTC, an affiliated company.
One of the objectives of the Gas Distribution business is to rank in the
lowest quartile for cost of gas in Michigan as well as neighboring states.
Although Gas Distribution's gas costs rose approximately 7% during the year to
$3.11 per Mcf, they remained in the lowest quartile among a group of 22
utilities in the region, having decreased 15% over the last 10 years. Cost of
gas sold decreased in 1997 as a result of lower sales volumes, due primarily to
warmer weather as well as supplier refunds. Under its gas cost recovery
mechanism, MichCon expects to continue to collect all of its cost of gas sold.
Gas Distribution -- Sources of Gas Supply (Bcf)
--------------------------------------------------------------------------------
· Download Table
1997 1996 1995
---- ---- ----
Long-term Supply:
Michigan Producers........................................ 66.0 86.3 90.9
Interstate Suppliers...................................... 13.8 14.5 18.2
Canadian Suppliers........................................ 31.3 37.3 31.5
Spot Market................................................. 89.1 94.0 55.1
----- ----- -----
200.2 232.1 195.7
===== ===== =====
14
Gas Distribution purchased 33% of its 1997 supply from Michigan producers,
51% from producers in the southern and midcontinent regions of the United States
and 16% from Canadian producers. These supplies are complemented by 130 Bcf of
working storage capacity from storage fields owned and operated by MichCon in
Michigan, of which 25 Bcf is leased to others.
MichCon has long-term firm transportation agreements with ANR and Great
Lakes Gas Transmission Limited Partnership (Great Lakes). Under these agreements
ANR is obligated to transport approximately 375 MMcf per day of supply during
the summer months and 310 MMcf per day of supply during the winter months for
MichCon, while Great Lakes is obligated to transport 30 MMcf per day. These
transportation agreements expire on various dates between 1999 and 2011.
MichCon also has contracts with independent Michigan producers that expire
on various dates through 2011. MichCon's continues its supply strategy of
purchasing gas under contracts that tie purchase prices to spot market prices.
To mitigate price volatility related to spot market prices for sales customers,
MichCon has been authorized by the MPSC to change its supply strategy to
purchase up to one-third of its gas under fixed price contracts.
At December 31, 1997, MichCon owned and operated five natural gas storage
fields in Michigan with a working storage capacity of approximately 130 Bcf.
These facilities play an important role in providing reliable and cost-effective
service. MichCon uses its storage capacity to supplement its supply during the
winter months, replacing the gas in April through October when demand is at its
lowest. The use of this storage capacity also allows MichCon to lower its
peak-day entitlement, thereby reducing interstate pipeline costs. During 1997,
MichCon's maximum one-day sendout exceeded 2.3 Bcf, of which approximately 70%
came from its underground storage fields. MichCon's gas distribution system has
a maximum daily sendout capability of 2.8 Bcf, with approximately 70% coming
from underground storage. MichCon also leases 25 Bcf of its natural gas storage
capacity to an affiliated company and to third parties.
REGULATION AND RATES
MichCon is subject to the jurisdiction of the MPSC as to various phases of
its operations, including gas sales and transportation rates, service and
accounting. Citizens' rates are set by the Adrian Gas Rate Commission, a
municipal commission. Other various phases of its operations are subject to the
jurisdiction of the MPSC. Both MichCon and Citizens are subject to the
requirements of other regulatory agencies with respect to safety, the
environment and health.
GENERAL RATE PROCEEDINGS: MichCon received authorization to defer
manufactured gas plant (MGP) investigation and remediation costs in excess of
the $11.7 million previously reserved by MichCon. The remaining balance of this
initial reserve at December 31, 1997 is approximately $1.7 million. Any excess
costs are to be amortized over a 10 year period beginning in the year subsequent
to the year environmental investigation and remediation costs are paid. The
recovery of any remediation costs incurred will be reviewed in a future rate
case.
MichCon filed an application with the MPSC in October requesting authority
to decrease depreciation rates from the existing 4.09% to 3.44%. In December
1997 the MPSC issued an order approving a reduction in annual depreciation costs
by more than $16 million. While the Michigan Attorney General has appealed the
depreciation order, management believes the MPSC order approving the lower
depreciation rates will be upheld.
In 1994, Citizens entered into a new rate agreement with the municipal
commission that sets Citizens' rates. Under the terms of this agreement which
went into effect in January 1995, Citizens received a 3% rate increase and its
rates will be frozen for five years. The rate agreement provides Citizens'
customers with known prices and the company with an opportunity to control costs
and continue to earn a reasonable rate of return.
GAS COST RECOVERY: The GCR process allows MichCon to recover its cost of
gas sold if the MPSC determines that such costs are reasonable and prudent. This
determination includes an annual Gas Supply and Cost Review, in which the MPSC
approves maximum monthly GCR factors. A subsequent annual GCR reconciliation
proceeding provides a review of gas costs incurred during the year, determines
whether approved
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gas costs have been overcollected or undercollected and, as a result, whether a
refund or surcharge, including interest, is required to be returned to or
collected from GCR customers using the rolled-in prospective refunding
methodology approved by the MPSC on June 30, 1994.
In February 1996, MichCon filed its 1995 GCR reconciliation case indicating
an under-recovery of less than $0.1 million, including interest, which will be
collected from GCR customers using the new rolled-in prospective refunding
methodology. In February 1997, the MPSC issued an order finding that all of
MichCon's 1995 gas costs were reasonable and prudent.
In February 1997, MichCon filed its 1996 GCR reconciliation case indicating
a net under-recovery of approximately $28 million, including interest. The total
1996 underrecovery was rolled into MichCon's 1997 GCR cost recovery, pursuant to
the prospective refunding methodology discussed above. In September 1997, the
MPSC issued an order finding that all of MichCon's 1996 gas costs were
reasonable and prudent, including $4.4 million in interest costs from Panhandle
related to certain direct billings.
In July 1997, MichCon filed its 1998 GCR Plan Case. An MPSC order is
expected in May 1998.
In February 1998, MichCon filed its 1997 GCR reconciliation case indicating
a net under-recovery of approximately $13 million, including interest. An MPSC
order is expected in late 1998.
ENVIRONMENTAL MATTERS
Prior to the 1940's when major natural gas pipelines became sufficient to
meet MichCon's supply requirements, gas for heating and other uses was
manufactured from processes involving coal, coke or oil. MCN owns, or previously
owned, 17 former manufactured gas plant (MGP) sites.
During the mid-1980s, MichCon conducted preliminary environmental
investigations at former MGP sites, and some contamination related to the
by-products of gas manufacturing was discovered at each site. The existence of
these sites and the results of the environmental investigations have been
reported to the Michigan Department of Environmental Quality. None of these
former MGP sites is on the National Priorities List prepared by the U.S.
Environmental Protection Agency.
MCN is not involved in any administrative proceedings regarding these
former MGP sites, but is currently remediating four of these sites and
conducting more extensive investigations at five other former MGP sites.
In 1984, MCN established an $11.7 million reserve for environmental
investigation and remediation. During 1993, MichCon received MPSC approval of a
cost deferral and rate recovery mechanism for investigation and remediation
costs incurred at former MGP sites in excess of this reserve.
MCN employed outside consultants to evaluate remediation alternatives for
these sites, to assist in estimating its potential liabilities and to review its
archived insurance polices. The findings of these investigations indicated that
the estimated total expenditures for investigation and remediation activities
for these sites could range from $30 million to $170 million based on
undiscounted 1995 costs. As a result of these studies, MichCon accrued an
additional liability and a corresponding regulatory asset of approximately $35
million during 1995.
MCN notified more than 50 current and former insurance carriers of the
environmental conditions at these former MGP sites. MCN concluded settlement
negotiations with certain carriers in 1996 and 1997 and has received payments
from several carriers. In October 1997, MCN filed suit against major nonsettling
carriers seeking recovery of incurred costs and a declaratory judgment of the
carriers' liability for future costs of environmental investigation and
remediation costs at former MGP sites.
During 1997, 1996 and 1995, MCN spent $0.8 million, $0.9 million and $2.1
million, respectively, investigating and remediating these former MGP sites. At
December 31, 1997, the reserve balance was $36.7 million, of which $1.7 million
is classified as current. Any significant change in assumptions, such as
remediation techniques, nature and extent of contamination and regulatory
requirements, could impact the estimate of remedial action costs for the sites
and therefore have an effect on MCN's financial position and
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cash flows. However, management believes insurance coverage and the cost
deferral and rate recovery mechanism approved by the MPSC will prevent
environmental costs from having a material adverse impact on MCN's results of
operations.
FRANCHISES
MichCon operates in over 530 cities, villages and townships under
franchises or permits that typically are revocable at will and have a 30-year
maximum duration. In 1993, MichCon began a structured process to renew or
re-establish previously expired formal franchises in 233 municipalities. During
the period between 1994 and 1997 an additional 168 franchises expired. To date,
381 franchises have been renewed, 11 of which were renewed in 1997 which account
for gas sales volumes of approximately 40 Bcf annually. Additionally, two new
franchises were acquired. There were no franchises lost.
As for the 20 franchises that are currently expired, MichCon's gas
distribution systems are rightfully occupying the streets with the consent or
acquiescence of the municipalities. While MichCon could be ordered by any
municipality in which its franchise has expired to remove its property, it could
be deprived of ownership only by its consent and the payment of an agreed upon
price, or by condemnation and the payment of the fair market value of such
property. Should any of these municipalities seek to terminate MichCon's
operations therein and substitute another gas utility operation, publicly or
privately owned, the municipality must either (i) acquire and operate MichCon's
system, (ii) construct a new system or (iii) grant a franchise to another
privately owned utility to construct or acquire its own distribution system.
Public utility franchises in Michigan are non-exclusive. Construction under
a second franchise granted to another public utility requires authorization by
the MPSC, which considers, among other things, the service rendered by the
existing utility, the investment by such utility, and the benefit, if any, to
the public of having a second utility serve in the area. In June 1996, a
statutory amendment was adopted which provides that only irrevocable franchises
need municipal voter confirmation. The amendment further clarified that
franchises which are not voter confirmed are valid but revocable. In light of
that amendment, the Michigan Supreme Court dismissed an appeal involving MichCon
concerning the status of utility franchises which had not received voter
confirmation.
Citizens operates in cities and townships in and around Adrian, Michigan
under franchises or permits that are revocable, have a 30-year maximum duration,
and provide for municipal rate setting. In November 1995, the residents of
Adrian voted favorably on granting a 30-year renewal franchise to Citizens.
DISCONTINUED OPERATIONS
In June 1996, MCN completed the sale of its computer operations subsidiary,
Genix, to Affiliated Computer Services, Inc. for an initial sales price of
$137.5 million, resulting in an after-tax gain of $36.2 million. In October
1996, the initial sales price was decreased by $4.6 million to reflect the
reduction in Genix's working capital between the effective and closing dates of
the transaction. The selling price of Genix could be further adjusted downward
by as much as $26.2 million depending upon the occurrence of certain
contingencies that include, among other things, retention of certain customers
through mid-1998 and tax-related matters. Management believes that no further
adjustment to the selling price will occur. Summary statements and other
information on discontinued computer operations can be found in Note 2 to the
consolidated financial statements.
OTHER
MCNIC is involved in several residential and commercial community
development partnerships.
MCNIC Gas Storage Company, a 100% owned subsidiary of MCNIC, holds a 50%
limited partnership interest in The Orchards Golf Limited Partnership. The
Orchards golf course is above the Washington 28 storage field, which is located
north of Detroit. The partnership was formed in 1991 to develop approximately
520 acres of land in Washington Township, Michigan. The Orchards Golf Limited
Partnership entered into an agreement with Westcreek Estates to sell
approximately 70 acres. The remaining acreage consists of an 18-hole
championship golf course of approximately 200 acres and residential development
of the remaining 250 acres. 