A year ago, the cover story of Oil and Gas Investor focused on the hot industry phenomenon of energy convergence. Electric utilities were snapping up natural gas pipeline and distribution companies to form new energy conglomerates. The principal reason? Natural gas pipeline and distribution companies enjoy higher earnings growth rates than electric utilities-largely from unregulated activities such as gas marketing, brokering and risk management-and they trade at higher earnings multiples, noted Curt N. Launer, natural gas analyst for Donaldson Lufkin & Jenrette in New York. John E. Olson, natural gas analyst for Sanders Morris Harris in Houston, observed at the time, "Energy conglomerates have surpassed every other energy sector-including the major oils-in terms of total returns (stock price appreciation plus dividends). In light of this, we expect during the next five years to see another 10 to 15 energy conglomerates evolve, with $30- to $40-billion asset bases." Do analysts still feel this way? "As far as natural gas pipeline companies are concerned, there are very few of them left to be acquired," says Ronald J. Barone, natural gas analyst for PaineWebber Inc. in New York. "Coastal Corp. is being acquired by El Paso Energy; Columbia Energy Group by NiSource Inc.; and MCN Corp. by Detroit Edison. And while Equitable Resources could be acquired, most of the consolidation in this sector has already taken place. Where we're likely to see more merger activity is in the LDC (local gas distribution company) sector." Says Barone, "With the deregulation of the utility industry, electrics are seeking complementary operations, expansions into new markets and a broader menu of services that lead to one-stop-shopping for energy customers. Also, size, scale and scope are going to be important to compete and survive." Edward J. Tirello Jr., utilities analyst for Deutsche Banc Alex. Brown in New York, says, "If I'm an electric utility and you're a local gas distribution company, I don't want you bringing in some partner and selling electricity to your gas customers-who also happen to be my electric customers. Therefore, I'm going to buy you out. It's simple economics." In a recent report, the analyst stresses that convergence remains the major theme in the electric power and diversified natural gas pipeline industries. "Gas pipelines and marketers are building, buying or contracting for electric-generation capacity; meanwhile, merchant power generators and electric utilities are buying, contracting and trading natural gas," explains Tirello. "As the U.S. [power] industry shifts toward gas-fired electric generation on the margin for incremental supplies, the skills used in both industries and the profit-arbitrage opportunities between fuels and markets are making the energy industries converge." Says Launer, "There still is the desire on the part of electrics to buy into the natural gas industry-because that industry grows faster, has higher valuations and better managements in terms of dealing with deregulation. However, the share prices of electrics aren't where those companies would like them to be for convergence deals-without those deals being very dilutive to shareholders." Indeed, Southern Co., which in the past has indicated its desire to acquire natural gas assets, has recently watched its share price topple from $33 to the low $20s. Olson notes another factor that could slow down the momentum of convergence deals. As of year-end, pooling-of-interests accounting, which has been a beneficial common denominator in just about all the big convergence mergers in the past few years, will no longer be able to be used by consolidators. "Instead, they'll have to use purchase accounting," he says. "This increases the cost of a transaction because assets must be marked up to account for the difference between the purchase price paid for assets-which typically includes a goodwill premium-and the lower net worth of the acquired assets." This aside, Olson expects the convergence trend to continue, as energy companies seek to enhance their control over the flow of commodities-gas, electricity and bandwidth. "In addition, we're now witnessing a paradigm shift by energy conglomerates into the E&P side of the business. "This is where some excellent profitability may materialize because tight natural gas markets may be here to stay. El Paso-Coastal is splendidly positioned in this regard. Other conglomerates, such as Duke Energy, CMS Energy and The Williams Cos. may have to take a closer look at backward integration into the [upstream] sector."

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