SOUTHERN CALIFORNIA GAS CO - Annual Report: 2005 (Form 10-K)

SoCalGas is subject to federal, state and local governmental agencies. The primary regulatory agency is the CPUC, which regulates utility rates and operations. The FERC regulates interstate transportation of natural gas and various related matters. Municipalities and other local authorities regulate the location of utility assets, including natural gas pipelines.

Natural Gas Revenue and Cost of Natural Gas. Natural gas revenues increased by $620 million (16%) to $4.6 billion in 2005, and the cost of natural gas increased by $547 million (24%) to $2.8 billion in 2005. The increases in 2005 were due to higher natural gas prices, which are passed on to customers, offset by a small decrease in volume. In addition, natural gas revenues increased due to higher authorized margin of $28 million, the CPUC's 2005 Cost of Service decision eliminating 2004 revenue sharing (for which $18 million was included in revenue in 2005), $14 million in DSM awards in 2005 and $14 million of higher revenues for recoverable expenses, which are fully offset in other operating expenses. SoCalGas' weighted average cost per million British thermal units (mmbtu) of natural gas was $7.71 in 2005, $5.92 in 2004 and $5.05 in 2003.

Although the current regulatory framework provides that the cost of natural gas purchased for customers and the variations in that cost are passed through to the customers on a substantially concurrent basis, SoCalGas' Gas Cost Incentive Mechanism (GCIM) allows SoCalGas to share in the savings or costs from buying natural gas for customers below or above market-based monthly benchmarks. The mechanism permits full recovery of all costs within a tolerance band around the benchmark price. The costs or savings outside the tolerance band are shared between customers and shareholders. Further discussion is provided in Notes 1 and 8 of the notes to Consolidated Financial Statements.

Natural gas revenues increased by $456 million (13%) to $4.0 billion in 2004 compared to 2003, and the cost of natural gas increased by $453 million (25%) to $2.3 billion in 2004 compared to 2003. The increase in 2004 was primarily attributable to natural gas price increases, an increase in margin of $33 million and $18 million from a favorable Cost of Service decision in 2004, offset by $48 million of GCIM awards and $1 million of Performance-Based Regulation (PBR) awards recognized during 2003. Performance awards are discussed in Note 8 of the notes to Consolidated Financial Statements.

The table below summarizes natural gas volumes and revenues by customer class for the years ended December 31, 2005, 2004 and 2003.

Natural Gas Sales, Transportation and Exchange
(Volumes in billion cubic feet, dollars in millions)

Litigation Expenses. Litigation expenses were $99 million, $41 million and $34 million for 2005, 2004 and 2003, respectively. The increase in 2005 was primarily due to an increase in litigation reserves related to matters arising from the 2000 - 2001 California energy crisis. Note 9 of the notes to Consolidated Financial Statements provides additional information concerning this matter.

Other Operating Expenses. Other operating expenses at SoCalGas were $954 million, $908 million and $916 million in 2005, 2004 and 2003, respectively. The increase in 2005 was primarily due to $25 million favorable resolution of regulatory matters in 2004 and $14 million higher recoverable expenses in 2005.

Other Income, Net. Other income, net, as discussed further in Note 1 of the notes to Consolidated Financial Statements, consists primarily of interest income from short-term investments, income taxes on non-operating income, interest income/expense from regulatory balancing accounts and allowance for equity funds used during construction. Excluding the impact of income taxes on non-operating income, other income at SoCalGas was $10 million, $17 million, and $40 million in 2005, 2004 and 2003, respectively. The decrease in 2005 was due to the favorable impact on 2004 interest income from a CPUC Cost of Service decision, offset by an increase in interest income in 2005. The decrease in 2004 from 2003 was due to higher interest income in 2003 resulting from the favorable $30 million before-tax resolution of prior years' income tax issues with the Internal Revenue Service (IRS).

Income Taxes. Income tax expense at SoCalGas was $97 million, $154 million and $150 million in 2005, 2004 and 2003, respectively. The corresponding effective income tax rates were 31 percent, 40 percent and 42 percent. The decrease in 2005 expense was due to lower pre-tax income and the lower effective tax rate. The decrease in the effective rate was due primarily to a $24 million favorable resolution of prior years' income tax issues in 2005 at SoCalGas.

Net Income. SoCalGas recorded net income of $212 million, $233 million and $210 million in 2005, 2004 and 2003, respectively. The decrease in 2005 was due primarily to the resolution of the 2004 Cost of Service proceedings (as discussed further in Note 8 of the notes to Consolidated Financial Statement) which favorably affected 2004 net income by $34 million, an increase of $32 million after-tax in California energy crisis litigation expenses (as discussed further in Note 9 of the notes to Consolidated Financial Statements) and the $9 million after-tax gain from the sale of the Hawaiian Gardens property in 2004, offset by favorable resolution of income tax issues in 2005 of $24 million, higher margins in 2005 of $17 million after-tax and the recognition of DSM awards of $8 million after-tax in 2005. In addition to the 2004 matters noted above, the increase in 2004 from 2003 was due to higher margins in 2004 and losses in 2003 associated with a long-term sublease of portions of its headquarters building, offset by the favorable resolution of income tax issues and by higher GCIM awards in 2003.

At December 31, 2005, there was $90 million in unrestricted cash and $412 million in available unused, committed lines of credit at SoCalGas. Management believes that these amounts and cash flows from operations and security issuances will be adequate to finance capital expenditures and meet liquidity requirements and other commitments. Forecasted capital expenditures for the next five years are discussed in "Future Capital Expenditures for Utility Plant." Management continues to regularly monitor SoCalGas' ability to finance the needs of its operating, investing and financing activities in a manner consistent with its intention to maintain strong, investment-quality credit ratings.

Net cash provided by PE's consolidated operating activities totaled $288 million, $546 million and $377 million for 2005, 2004 and 2003, respectively. Net cash provided by SoCalGas' operating activities totaled $264 million, $501 million and $385 million for 2005, 2004 and 2003, respectively.

The 2005 change in net cash provided by operating activities was primarily due to a $261 million change in overcollected regulatory balancing accounts, a $197 million change in income taxes payable mainly due to an increase in income tax payments and a $58 million decrease in accounts payable in 2005, partially offset by a $104 million reduction of accounts receivable and a $157 million increase in other liabilities in 2005. The 2005 change in net cash provided by SoCalGas' operating activities was primarily due to a $261 million change in overcollected regulatory balancing accounts and a $210 million change in income taxes payable mainly due to an increase in income tax payments in 2005, partially offset by a $102 million reduction of accounts receivable and a $140 million increase in other liabilities in 2005.

The increase in 2004 compared to 2003 was primarily attributable to changes in regulatory balancing accounts and an increase in accounts payable in 2004, offset by a higher increase in accounts receivable in 2004.

The company made pension plan and other postretirement benefit plan contributions of $1 million and $36 million, respectively, during 2005. During 2004, the company contributed $42 million to other postretirement benefit plans but made no contribution to the pension plan.

Net cash used in PE's consolidated investing activities totaled $381 million, $295 million and $218 million for 2005, 2004 and 2003, respectively. Net cash used in SoCalGas' investing activities totaled $361 million, $253 million and $279 million for 2005, 2004 and 2003, respectively. The increase in cash used in investing activities in 2005 was due to a $50 million increase in capital expenditures and a $30 million (of which $51 million applied to SoCalGas) increase in loans to affiliates.

PE's increase in cash used in investing activities in 2004 compared to 2003 was primarily due to lower affiliate loan repayments received in 2004. For SoCalGas, the decrease in cash used in investing activities was due to higher repayments received from Sempra Energy in 2004.

Significant capital expenditures in 2006 are expected to include $400 million for improvements to the distribution and transmission systems. These expenditures are expected to be financed by cash flows from operations, asset sales and security issuances.

Over the next five years, the company expects to make capital expenditures of $2 billion, including $400 million in each of the next five years.

Construction programs are periodically reviewed and revised by the company in response to changes in regulation, economic conditions, competition, customer growth, inflation, customer rates, the cost of capital and environmental requirements, as discussed in Note 9 of the notes to Consolidated Financial Statements.

The company intends to finance its capital expenditures in a manner that will maintain its strong investment-grade ratings and capital structure.

The amounts and timing of capital expenditures are subject to approvals by the CPUC, the FERC and other regulatory bodies.

Net cash provided by (used in) financing activities totaled $149 million, $(249) million and $(149) million for 2005, 2004 and 2003, respectively. Net cash provided by (used in) SoCalGas' financing activities totaled $153 million, $(246) million and $(96) million for 2005, 2004 and 2003, respectively.

The 2005 increase was primarily due to a $150 million increase in issuances of long-term debt , a $50 million decrease in common dividends paid in 2005 and a $175 million repayment on long-term debt in 2004.

The cash used in financing activities for 2004 increased due to lower issuances of long-term debt, offset by lower payments on long-term debt.

In November 2005, the company publicly offered and sold $250 million of 5.75% first mortgage bonds, maturing in 2035.

In December 2004, SoCalGas issued $100 million of floating rate first mortgage bonds maturing in December 2009. The interest rate is based on the 3-month LIBOR rate plus 0.17%.

Payments on long-term debt in 2004 included $175 million of SoCalGas' first mortgage bonds.

In 2003, SoCalGas issued $500 million of first mortgage bonds.

Payments on long-term debt in 2003 included $325 million of SoCalGas' first mortgage bonds. In addition, $70 million of SoCalGas' $75 million medium-term notes were put back to the company.

Note 2 of the notes to Consolidated Financial Statements provides information concerning lines of credit and further discussion of debt activity.

Common dividends paid to Sempra Energy were $150 million in 2005, compared to $200 million in 2004 and $250 million in 2003. Dividends paid by SoCalGas to PE amounted to $150 million in 2005 and $200 million in each of 2004 and 2003.

The payment and amount of future dividends are within the discretion of the companies' boards of directors. The CPUC's regulation of SoCalGas' capital structure limits the amounts that are available for loans and dividends to Sempra Energy from SoCalGas. At December 31, 2005, the company could have provided a total (combined loans and dividends) of $118 million to Sempra Energy.

Total capitalization, including the current portion of long-term debt, at December 31, 2005 was $3 billion, of which $2.6 billion applied to SoCalGas. The debt-to-capitalization ratios were 39 percent and 46 percent at December 31, 2005 for PE and SoCalGas, respectively.

The following is a summary of the companies' principal contractual commitments at December 31, 2005. Additional information concerning commitments is provided above and in Notes 2, 4 and 9 of the notes to Consolidated Financial Statements.

(1) Based on forward rates in effect at December 31, 2005.
(2) Amounts are after reduction for the Medicare Part D subsidy and only include expected payments to the plans for the next 10 years.

The table excludes contracts between affiliates, intercompany debt, individual contracts that have annual cash requirements of less than $1 million and employment contracts.

Performance of the company will depend primarily on the ratemaking and regulatory process, natural gas industry restructuring, and the changing energy marketplace. Performance will also depend on the successful completion of construction programs, which are discussed in various places in this report. These factors are discussed in Note 8 of the notes to Consolidated Financial Statements.

Litigation

Note 9 of the notes to Consolidated Financial Statements describes litigation (primarily cases arising from the California energy crisis), the ultimate resolution of which could have a material adverse effect on future performance.

Industry Developments

Note 8 of the notes to Consolidated Financial Statements describes natural gas restructuring and rates, and other pending proceedings and investigations.

Market risk is the risk of erosion of the company's cash flows, net income, asset values and equity due to adverse changes in prices for various commodities, and in interest rates.

The company has adopted policies governing its market risk management and trading activities of all affiliates. Assisted by the company's Risk Management Department (RMD), the company's Risk Management Committee (RMC) consisting of senior officers, establishes policy for and oversees company-wide energy risk management activities and monitors the results of trading and other activities to ensure compliance with the company's stated energy risk management policies and applicable regulatory requirements. The RMD receives daily information detailing positions regarding market positions that create credit, liquidity and market risk and monitors energy price risk management and measures and reports the market and credit risk associated with these positions to the RMC.

Along with other tools, the company uses Value at Risk (VaR) to measure its exposure to market risk. VaR is an estimate of the potential loss on a position or portfolio of positions over a specified holding period, based on normal market conditions and within a given statistical confidence interval. The company has adopted the variance/covariance methodology in its calculation of VaR, and uses both the 95-percent and 99-percent confidence intervals. VaR is calculated independently by the RMD for the company. Historical and implied volatilities and correlations between instruments and positions are used in the calculation. The company uses energy and natural gas derivatives to manage natural gas and energy price risk associated with servicing load requirements. The use of energy and natural gas derivatives is in compliance with risk management and trading activity plans that have been filed and approved by the CPUC. Any costs or gains/losses associated with the use of energy and natural gas derivatives, which use is in compliance with CPUC approved plans, are considered to be commodity costs that are passed on to customers in a substantially concurrent basis.

Revenue recognition is discussed in Note 1 and the additional market risk information regarding derivative instruments is discussed in Note 6 of the notes to Consolidated Financial Statements.

The following discussion of the company's primary market risk exposures as of December 31, 2005 includes a discussion of how these exposures are managed.

Market risk related to physical commodities is created by volatility in the prices and basis of natural gas. The company's market risk is impacted by changes in volatility and liquidity in the markets in which these commodities or related financial instruments are traded. The company is exposed, in varying degrees, to price risk, primarily in the natural gas markets. The company's policy is to manage this risk within a framework that considers the unique markets, and operating and regulatory environments.

The company's market risk exposure is limited due to CPUC-authorized rate recovery of the costs of natural gas purchases and sales. However, the company may, at times, be exposed to market risk as a result of SoCalGas' GCIM, which is discussed in Note 8 of the notes to Consolidated Financial Statements. If commodity prices were to rise too rapidly, it is likely that volumes would decline. This would increase the per-unit fixed costs, which could lead to further volume declines. The company manages its risk within the parameters of its market risk management framework. As of December 31, 2005, the company's VaR was not material and the procurement activities are in compliance with the procurement plans filed with and approved by the CPUC.

The company is exposed to fluctuations in interest rates primarily as a result of its short-term and long-term debt. The company historically has funded operations through long-term debt issues at fixed rates of interest recovered in utility rates. Some more-recent debt offerings have been issued with floating rates. Subject to regulatory constraints, interest-rate swaps may be used to adjust interest-rate exposures.

At December 31, 2005, the company had $863 million of fixed-rate debt and $248 million of variable-rate debt. Interest on fixed-rate debt is fully recovered in rates on a historical cost basis and interest on variable-rate debt is provided for in rates on a forecasted basis. At December 31, 2005, the company's fixed-rate debt had a one-year VaR of $105 million and its variable-rate debt had a one-year VaR of $7 million.

At December 31, 2005, the notional amount of interest-rate swap transactions totaled $150 million. Note 2 of the notes to Consolidated Financial Statements provides further information regarding interest-rate swap transactions.

In addition, the company is subject to the effect of interest-rate fluctuations on the assets of its pension plans and other postretirement plans. However, the effects of these fluctuations are expected to be passed on to customers.

Credit risk is the risk of loss that would be incurred as a result of nonperformance by counterparties of their contractual obligations. As with market risk, the company has adopted policies governing the management of credit risk. Credit risk management is performed by the company's credit department and overseen by the company's RMC. Using rigorous models, the RMD and the company calculate current and potential credit risk to counterparties on a daily basis and monitor actual balances in comparison to approved limits. The company avoids concentration of counterparties whenever possible, and management believes its credit policies associated with counterparties significantly reduce overall credit risk. These policies include an evaluation of prospective counterparties' financial condition (including credit ratings), collateral requirements under certain circumstances, the use of standardized agreements that allow for the netting of positive and negative exposures associated with a single counterparty, and other security such as lock-box liens and downgrade triggers. The company believes that adequate reserves have been provided for counterparty nonperformance.

The company monitors credit risk through a credit approval process and the assignment and monitoring of credit limits. These credit limits are established based on risk and return considerations under terms customarily available in the industry.

As noted above under "Interest Rate Risk," the company periodically enters into interest-rate swap agreements to moderate exposure to interest-rate changes and to lower the overall cost of borrowing. The company would be exposed to interest-rate fluctuations on the underlying debt should counterparties to the agreement not perform.

Certain accounting policies are viewed by management as critical because their application is the most relevant, judgmental and/or material to the company's financial position and results of operations, and/or because they require the use of material judgments and estimates.

The company's significant accounting policies are described in Note 1 of the notes to Consolidated Financial Statements. The most critical policies, all of which are mandatory under generally accepted accounting principles and the regulations of the Securities and Exchange Commission, are the following:

In connection with the application of these and other accounting policies, the company makes estimates and judgments about various matters. The most significant of these involve:

Differences between estimates and actual amounts have had significant impacts in the past and are likely to have significant impacts in the future.

As discussed elsewhere herein, the company uses exchange quotations or other third-party pricing to estimate fair values. When no such data is available, it uses internally developed models and other techniques. The assumed collectibility of receivables considers the aging of the receivables, the credit-worthiness of customers and the enforceability of contracts, where applicable. The assumed collectibility of regulatory assets considers legal and regulatory decisions involving the specific items or similar items. The assumed collectibility of other assets considers the nature of the item, the enforceability of contracts where applicable, the credit-worthiness of the other parties and other factors. The anticipated resolution of income tax issues considers past resolutions of the same or similar issue, the status of any income tax examination in progress and positions taken by taxing authorities with other taxpayers with similar issues. Actuarial assumptions are based on the advice of the company's independent actuaries. The likelihood of deferred tax recovery is based on analyses of the deferred tax assets and the company's expectation of future financial and/or taxable income, based on its strategic planning.

Choices among alternative accounting policies that are material to the company's financial statements and information concerning significant estimates have been discussed with the audit committee of the board of directors.

Key non-cash performance indicators for the company include numbers of customers and quantities of natural gas sold. The information is provided in "Overview" and "Results of Operations."

SFAS 143, "Accounting for Asset Retirement Obligations" and FIN 47, "Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143": SFAS 143 requires entities to record the fair value of liabilities for legal obligations related to asset retirements in the period in which they are incurred. It also requires the company to reclassify amounts recovered in rates for future removal costs not covered by a legal obligation from accumulated depreciation to a regulatory liability. Issued in March 2005, FIN 47 clarifies that the term conditional asset-retirement obligation as used in SFAS 143 refers to a legal obligation to perform an asset-retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 requires companies to recognize a liability for the fair value of a conditional asset-retirement obligation if the fair value of the obligation can be reasonably estimated. FIN 47 is effective for the company's 2005 annual report.

The information required by Item 7A is set forth under "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Market Risk."

Company management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of company management, including the principal executive officer and principal financial officer, the company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the company's evaluation under the framework in Internal Control -- Integrated Framework, management concluded that the company's internal control over financial reporting was effective as of December 31, 2005. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2005 has been audited by Deloitte & Touche LLP, as stated in its report, which is included herein.

To the Board of Directors and Shareholders of Pacific Enterprises:

We have audited the accompanying consolidated balance sheets of Pacific Enterprises and subsidiaries (the "Company") as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

As described in Note 1 to the financial statements, the Company adopted Financial Accounting Standards Board Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143, effective December 31, 2005.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 21, 2006 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.

/S/ DELOITTE & TOUCHE LLP

San Diego, California
February 21, 2006

To the Board of Directors and Shareholders of Pacific Enterprises:

We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that Pacific Enterprises and subsidiaries (the "Company") maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.  Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinions.

A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated February 21, 2006 expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the Company's adoption of a new accounting standard.

/s/ DELOITTE & TOUCHE LLP

San Diego, California
February 21, 2006

PACIFIC ENTERPRISES AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED INCOME
(Dollars in millions)