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WGL > SEC Filings for WGL > Form 10-K on 23-Nov-2012All Recent SEC Filings

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Form 10-K for WGL HOLDINGS INC


23-Nov-2012

Annual Report


Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTRODUCTION

This Management's Discussion and Analysis of Financial Condition and Results of Operations (Management's Discussion) analyzes the financial condition, results of operations and cash flows of WGL Holdings and its subsidiaries. It also includes management's analysis of past financial results and potential factors that may affect future results, potential future risks and approaches that may be used to manage them. Except where the content clearly indicates otherwise, "WGL Holdings," "we," "us" or "our" refers to the holding company or the consolidated entity of WGL Holdings and all of its subsidiaries.

Management's Discussion is divided into the following two major sections:

WGL Holdings-This section describes the financial condition and results of operations of WGL Holdings and its subsidiaries on a consolidated basis. It includes discussions of our regulated operations, including Washington Gas and Hampshire, and our non-utility operations.

Washington Gas-This section describes the financial condition and results of operations of Washington Gas, a wholly owned subsidiary of WGL Holdings, which comprises the majority of the regulated utility segment.

Both sections of Management's Discussion-WGL Holdings and Washington Gas-are designed to provide an understanding of our operations and financial performance and should be read in conjunction with the respective company's financial statements and the combined Notes to Consolidated Financial Statements in this annual report.

Unless otherwise noted, earnings per share amounts are presented on a diluted basis, and are based on weighted average common and common equivalent shares outstanding.


Table of Contents

WGL Holdings, Inc.

Washington Gas Light Company

Part II

Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations (continued)

Management's Discussion Table of Contents

Page Executive Overview 27 Primary Factors Affecting WGL Holdings and Washington Gas 27 Critical Accounting Policies 32 Stock Based Compensation 35 WGL Holdings, Inc.
Results of Operations 36 Liquidity and Capital Resources 43

Contractual Obligations, Off-Balance Sheet Arrangements and Other Commercial Commitments 49 Credit Risk 52 Market Risk 53 Washington Gas Light Company
Results of Operations 60 Liquidity and Capital Resources 62 Rates and Regulatory Matters 63

EXECUTIVE OVERVIEW

Introduction

WGL Holdings, through its wholly owned subsidiaries, sells and delivers natural gas and provides a variety of energy-related products and services to customers primarily in the District of Columbia and the surrounding metropolitan areas in Maryland and Virginia.

WGL Holdings has four operating segments:

regulated utility;

retail energy-marketing;

commercial energy systems and

wholesale energy solutions.

Our core subsidiary, Washington Gas, engages in the delivery and sale of natural gas that is regulated by regulatory commissions in the District of Columbia, Maryland and Virginia. Through the wholly owned unregulated subsidiaries of Washington Gas Resources, we offer energy-related products and services. We offer competitively priced natural gas, electricity and energy from renewable sources to customers through WGEServices, our non-utility retail energy-marketing subsidiary. We offer efficient and sustainable commercial energy solutions focused on upgrading energy related systems of large government and commercial facilities through WGESystems. Capitol Energy Ventures performs natural gas and asset optimization activities.

Activities and transactions that are not significant enough on a stand-alone basis to warrant treatment as an operating segment, and that do not fit into one of our four operating segments, are aggregated as "Other Activities" and are included as part of non-utility operations. These activities include the operations of WGSW which was formed to invest in certain renewable energy projects. WGSW is a wholly owned subsidiary of Washington Gas Resources. Administrative costs associated with WGL Holdings and Washington Gas Resources are also included in "Other activities."

Refer to the Business section under Item 1 of this report for further discussion of our regulated utility and non-utility business segments. For further discussion of our financial performance by operating segment, refer to Note 15 -Operating Segment Reporting of the Notes to Consolidated Financial Statements.

PRIMARY FACTORS AFFECTING WGL HOLDINGS AND WASHINGTON GAS

The following is a summary of the primary factors that affect the operations and/or financial performance of our regulated and unregulated businesses. Refer to the sections entitled "Business" and "Risk Factors" under Item 1 and Item 1A, respectively, of this report for additional discussion of these and other factors that affect the operations and/or financial performance of WGL Holdings and Washington Gas.


Table of Contents

WGL Holdings, Inc.

Washington Gas Light Company

Part II

Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations (continued)

Weather Conditions and Weather Patterns

Washington Gas. Washington Gas' operations are seasonal, with a significant portion of its revenues derived from the delivery of natural gas to residential and commercial heating customers during the winter heating season. Weather conditions directly influence the volume of natural gas delivered by Washington Gas. Weather patterns tend to be more volatile during "shoulder" months within our fiscal year in which Washington Gas is going into or coming out of the primary portion of its winter heating season. During the shoulder months within quarters ending December 31 (particularly in October and November) and June 30 (particularly in April and May), customer heating usage may not correlate highly with historical levels or with the level of heating degree days (HDDs) that occur, particularly when weather patterns experienced are not consistently cold or warm.

Washington Gas' rates are determined on the basis of expected normal weather conditions. Washington Gas has a weather protection strategy that is designed to neutralize the estimated financial effects of variations from normal weather. Refer to the section entitled "Market Risk-Weather Risk" for a further discussion of Washington Gas' weather protection strategies.

WGEServices. The financial results of our retail energy-marketing subsidiary, WGEServices, are also affected by deviations in weather from normal levels and abnormal customer usage during the shoulder months described above. Since WGEServices sells both natural gas and electricity, WGEServices' financial results may fluctuate due to unpredictable deviations in weather during the winter heating and summer cooling seasons. WGEServices purchases weather-related instruments to help manage this risk. Refer to the section entitled "Market Risk-Weather Risk" for further discussion of WGEServices' weather-related instruments.

CEV. Variations from normal weather may also affect the financial results of our wholesale energy business, CEV, primarily with regards to summer - winter storage spreads and in transportation spreads throughout the fiscal year. CEV manages these weather risks with, among other things, physical and financial basis hedging. Refer to the section entitled "Market Risk-Weather Risk" for further discussion of CEV's weather-related instruments.

Regulatory Environment, Regulatory Decisions and Changes in Legislation

Washington Gas is regulated by the PSC of DC, the PSC of MD and the SCC of VA. These regulatory commissions approve the terms and conditions of service and the rates that Washington Gas can charge customers for its rate-regulated services in their respective jurisdictions. Changes in these rates as ordered by regulatory commissions affect Washington Gas' financial performance.

Washington Gas expects that regulatory commissions will continue to set the prices and terms for delivery service that give it an opportunity to recover reasonable operating expenses and earn a just and reasonable rate of return on the capital invested in its distribution system.

WGEServices is subject to the jurisdictional requirements of the public service regulatory commissions of the states in which the company is authorized as a competitive service provider. These regulatory commissions: (i) authorize WGEServices to provide service, review certain terms and conditions of service and (ii) establish the regulatory rules for interactions between the utility and the competitive service provider. In addition these regulatory commissions issue orders and promulgate rules that establish the broad structure and conduct of retail energy markets. Changes to the rules and orders by the regulatory commissions may affect WGEServices' financial performance.

WGL Holdings has completed an internal assessment in preparation for the Dodd-Frank Act (the Act) legislation and requirements. The Company's preliminary determination is that none of its entities, either separately or in the aggregate, will be classified as swap dealers or major swap participants under the Act.

Availability of Natural Gas Supply and Pipeline Transportation and Storage Capacity

Natural Gas Supply and Capacity Requirements

Washington Gas. Washington Gas is responsible for acquiring sufficient natural gas supplies, interstate pipeline capacity and storage capacity to meet its customer requirements. As such, Washington Gas must contract for both reliable and adequate supplies and delivery capacity to its distribution system, while considering: (i) the dynamics of the commodity supply and interstate pipeline and storage capacity markets; (ii) its own on-system natural gas peaking facilities and (iii) the characteristics of its customer base. Energy-marketing companies that sell natural gas to customers located within Washington Gas' service territory are responsible for acquiring natural gas for their customers; however, Washington Gas allocates certain storage and pipeline capacity related to these customers in accordance with regulatory requirements.

The increase in demand for pipeline and storage capacity compared to the available capacity is a business issue for local distribution companies, such as Washington Gas. Aside from the economic recession, historically, Washington Gas' customer base has grown at an annual rate of approximately two percent. It is expected to return to this historical growth rate


Table of Contents

WGL Holdings, Inc.

Washington Gas Light Company

Part II

Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations (continued)

over the next few years as the new housing market recovers. To help maintain the adequacy of pipeline and storage capacity for its growing customer base, Washington Gas has contracted with various interstate pipeline and storage companies to expand its transportation and storage capacity services to Washington Gas. The last of these capacity expansion projects is expected to be placed into service during fiscal year 2016. Washington Gas will continue to monitor other opportunities to acquire or participate in additional pipeline and storage capacity that will support customer growth and improve or maintain the high level of service expected by its customer base.

WGEServices. WGEServices contracts for storage and pipeline capacity to meet its customers' needs primarily through transportation releases and storage services allocated from the utility companies in the various service territories in which it provides retail energy commodity.

CEV. CEV contracts for storage and pipeline capacity in its asset optimization activities through both long term contracts and short term transportation releases. CEV also contracts for physical natural gas supply on both a long term and short term basis.

Diversity of Natural Gas Supply

Washington Gas. An objective of Washington Gas' supply sourcing strategy is to diversify receipts from multiple production areas to meet all firm customers' natural gas supply requirements. This strategy is designed to protect Washington Gas' receipt of supply from being curtailed by possible financial difficulties of a single supplier, natural disasters and other unforeseen events, and to take advantage of competitive commodity prices associated with natural gas supplies.

WGEServices. WGEServices diversifies its wholesale supplier base in order to minimize its supply costs and avoid the negative impacts of relying on any single provider for its natural gas supply. To supplement WGEServices' natural gas supplies during periods of high customer demand, WGEServices maintains gas inventories in storage facilities that are allocated by natural gas utilities such as Washington Gas.

CEV. CEV buys and sells wholesale natural gas across a diversified base of counterparties. CEV's activities are also diversified across many liquid regional markets across the eastern United States.

Volatility of Natural Gas and Electricity Prices

Volatility of natural gas prices impacts customer usage and has different short-term and long-term effects on our business. The impact is also different between the regulated utility segment and the non-utility retail energy-marketing segment as described below.

Washington Gas. Under its regulated gas cost recovery mechanisms, Washington Gas records cost of gas expense equal to revenue from customers associated with this cost for each period reported. Consequently, an increase in the cost of gas due to an increase in the purchase price of the natural gas commodity generally has no short-term direct effect on Washington Gas' net income.

However, to the extent Washington Gas does not have regulatory mechanisms in place to mitigate the indirect effects of higher gas prices, its net income may decrease for factors such as: (i) lower natural gas consumption caused by customer conservation; (ii) increased short-term interest expense to finance a higher natural gas storage and accounts receivables balances and (iii) higher expenses for uncollectible accounts.

Various regulatory mechanisms help to mitigate these effects on Washington Gas' revenue and net income. The RNA is a billing mechanism that decouples Washington Gas' non-gas revenues from actual delivered volumes of gas in Maryland. In addition, Virginia has two additional regulatory mechanisms, the WNA and CRA that collectively eliminate the effect of weather and other factors such as conservation (refer to the section entitled "Rates and Regulatory Matters" for further discussion of Washington Gas' RNA, WNA and CRA application).

Long term, volatility in natural gas prices is affected by the relative cost of natural gas service compared to available substitute products such as electricity, propane and fuel oil. An increase in the relative price of substitute products generally produces an increase in demand for natural gas services. Conversely, a decrease in the relative price generally results in lower demand.

WGEServices. WGEServices may be negatively affected indirectly by significant changes in the wholesale price of natural gas. WGEServices' risk management policies and procedures are designed to minimize the risk that WGEServices' purchase commitments and the related sales commitments do not closely match (refer to the section entitled "Market Risk" for further discussion of WGEServices' mitigation of commodity price risk). Additionally, in the short-term, higher energy prices may increase the costs associated with uncollectible accounts, borrowing costs, certain fees paid to public service commissions and other costs. To the extent that these costs cannot be recovered from retail customers due to competitive factors, WGEServices' operating results would be negatively affected.

CEV. CEV can be positively affected by significant changes in the wholesale price of natural gas. In general, opportunities for asset optimization activities are increased for CEV with increased volatility in natural gas prices. These opportunities are primarily in short term transportation and storage spreads, seasonal storage spreads and long term supply or basis transactions.


Table of Contents

WGL Holdings, Inc.

Washington Gas Light Company

Part II

Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations (continued)

Non-Weather Related Changes in Natural Gas Consumption Patterns

Natural gas supply requirements are affected by changes in the natural gas consumption patterns of our customers that are driven by factors other than weather. Natural gas usage per customer may decline as customers change their consumption patterns in response to: (i) more volatile and higher natural gas prices, as discussed above; (ii) customer upgrades to energy efficient appliances and (iii) a decline in the economy in the region in which we operate.

Each jurisdiction in which Washington Gas operates, changes in customer usage profiles are reflected in rate case proceedings where rates are adjusted to reflect current customer usage. Changes in customer usage by existing customers that occur subsequent to rate case proceedings in the Maryland jurisdiction generally will not change revenues because the RNA mechanism stabilizes the level of delivery charge revenues received from customers.

In Virginia, decoupling rate mechanisms for residential customers permit Washington Gas to adjust revenues for non-weather related changes in customer usage. The WNA and the CRA are billing mechanisms that eliminate the effects of both weather and other factors such as conservation.

In the District of Columbia, decreases in existing customer usage that occur subsequent to the company's most recent rate case proceeding will have the effect of reducing revenues, which may be offset by additions of new customers.

Maintaining the Safety and Reliability of the Natural Gas Distribution System

Maintaining and improving the public safety and reliability of Washington Gas' natural gas distribution system is our highest priority which provides benefits to both customers and investors through lower costs and improved customer service. Washington Gas continually monitors and reviews changes in the codes and regulations that govern the operation of the distribution system and refines its safety practices, with a particular focus on design, construction, maintenance, operation, replacement, inspection and monitoring practices to meet or exceed these requirements. Significant changes in regulations can impact the cost of operating and maintaining the system. Operational issues that affect public safety and the reliability of Washington Gas' natural gas distribution system that are not addressed within a timely and adequate manner could adversely affect our future earnings and cash flows, as well as result in a loss of customer confidence.

Washington Gas is experiencing operational issues associated with the receipt of low HHC gas from pipelines serving Washington Gas. Refer to the section entitled "Operating Issues Related To Changes In Natural Gas Supply" for a discussion of the specific operational issues involved.

Competitive Environment

Washington Gas. Washington Gas faces competition based on customers' preference for natural gas compared to other energy products, and the comparative prices of those products. The most significant product competition occurs between natural gas and electricity in the residential market. Changes in the competitive position of natural gas relative to electricity and other energy products have the potential of causing a decline in the number of future natural gas customers. At present, Washington Gas has seen no significant evidence that changes in the competitive position of natural gas has contributed to such a decline.

The residential market generates a significant portion of Washington Gas' net income. In its service territory, Washington Gas continues to attract the majority of the new residential construction market. Consumers' continuing preference for natural gas allows Washington Gas to maintain a strong market presence.

In each of the jurisdictions served by Washington Gas, regulators and utilities have implemented customer choice programs to purchase natural gas. These programs allow customers the choice of purchasing their natural gas from unregulated third party marketers, rather than from the local utility. There is no direct effect on Washington Gas' net income when customers purchase their natural gas commodity from unregulated third party marketers because Washington Gas charges its customers the cost of gas without any mark-up. The transfer of sales customers to third party marketers does reduce the level of investment in storage inventory, thereby lowering our recovery of carrying charges.

WGEServices. WGEServices competes with regulated utilities and other unregulated third party marketers to sell the natural gas and electric commodity to customers. Marketers of these commodities compete largely on price; therefore, gross margins are relatively small. WGEServices is exposed to certain credit and market risks associated with both its natural gas and electric supply (refer to the sections entitled "Credit Risk" and "Market Risk" for further discussion of these risk exposures and how WGEServices manages them).

WGEServices' electric sales growth opportunities are significantly affected by the price for Standard Offer Service (SOS) offered by electric utilities. These rates, often identified by customer class, are periodically reset based on the regulatory requirements in each jurisdiction. Future opportunities to add new electric customers will be dependent on the competitiveness of WGEServices' service rates relative to SOS rates offered by local electric utilities as well as the prices offered by other energy marketers.


Table of Contents

WGL Holdings, Inc.

Washington Gas Light Company

Part II

Item 7. Management's Discussion and Analysis of

Financial Condition and Results of Operations (continued)

CEV. CEV competes in the wholesale natural gas markets with other third party wholesale marketers to buy and sell natural gas as well as storage and pipeline capacity. Marketers of these commodities compete largely on price; therefore, gross margins are relatively small. CEV is exposed to certain credit and market risks associated with its asset optimization activities (refer to the sections entitled "Credit Risk" and "Market Risk" for further discussion of these risk exposures and how CEV manages them).

Environmental Matters

We are subject to federal, state and local laws and regulations related to environmental matters. These evolving laws and regulations may require expenditures over a long timeframe. It is our position that, at this time, the appropriate remediation is being undertaken at all the relevant sites. Refer to Note 12 -Environmental Matters of the Notes to Consolidated Financial Statements for further discussion of these matters.

Industry Consolidation

In recent years, the energy industry has seen a number of consolidations, combinations, disaggregations and strategic alliances. Consolidation will present combining entities with the challenges of remaining focused on the customer and integrating different organizations. Others in the energy industry are discontinuing operations in certain portions of the energy industry or divesting portions of their business and facilities.

From time to time, we perform studies and, in some cases, hold discussions regarding utility and energy-related investments and strategic transactions with other companies. The ultimate effect on us of any such investments and transactions that may occur cannot be determined at this time.

Economic Conditions and Interest Rates

We operate in one of the nation's largest regional economies, including several of the nation's wealthiest counties. Over time, the economic strength of our service territory has allowed Washington Gas to expand its regulated delivery service customer base at a relatively stable rate. In addition, the region provides an active market for our subsidiaries to market natural gas, electricity and other energy-related products and services.

The national economy has shown continued modest growth in gross domestic product, personal consumption and fixed investment during fiscal 2012. Consumer de-leveraging just after the recession has given way to improvements in the auto and housing markets. The unemployment rate has also improved modestly. Our regulated utility continues to benefit from customer growth in our service area, and recent gains in housing prices in the Washington DC area indicate strengthening demand and improved prospects for housing and continued customer growth in the future. We remain optimistic about these trends, but are mindful of federal spending and the possibility of across-the-board cuts if legislators are unable to prioritize expenditures.

In this low-growth environment and with rising energy prices, WGL Holdings and Washington Gas may be affected by continued levels of customer conservation and year-over-year increases in uncollectible accounts expense. Refer to "Non-Weather Related Changes in Natural Gas Consumption Patterns", above, for a discussion of regulatory mechanisms in place to mitigate the effects of customer conservation at Washington Gas.

Treasury interest rates fell during fiscal year 2012, and the Federal Reserve announced its third round of quantitative easing, keeping short-term rates near zero percent in a further attempt to stimulate the economy. Year-over-year, national inflation was 2.0% as measured by the consumer price index (CPI-U), but inflation is a concern longer term. Refer to "Inflation" below for a discussion of the regulatory impacts of inflation and the section entitled "General Factors Affecting Liquidity" for a discussion of our access to capital markets. . . .

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