Don Felsinger of Sempra Energy

Sempra avoided the big bets on energy deregulation that went bad on competitors and now is profiting from cleaning up their messes. But is the company taking on too much risk?

Since the much-ballyhooed deregulation of the electric power business by several states in the 1990s, energy companies have endured plenty of pain. First Enron Corp. blew up. Then companies like Dynegy and Calpine Corp. overextended themselves by making big bets in energy trading and power generation, only to wind up in financial distress.

One company that successfully negotiated this minefield is San Diegobased Sempra Energy. Under the cautiously opportunistic leadership of CEO Donald Felsinger, 58, Sempra has posted 18 to 20 percent annual profit growth for the past five years. Those who owned Sempra shares during that time gained 145 percent, including dividends. The stock now trades at about $46, up 2.3 percent on the year.

Felsinger joined San Diego Gas & Electric as an engineer in 1972, after graduating from the University of Arizona, and rose through the ranks to become the utility’s CEO in 1996. Two years later SDG&E merged with Southern California Gas Co. to form Sempra, and Felsinger became group president of nonutility activities. In that job he boosted Sempra’s presence in fast-growing, deregulated businesses like natural-gas pipelines and liquefied natural gas storage terminals. LNG, frozen and compressed outside the U.S. and reheated here for use as fuel, is becoming a key energy source as domestic gas supplies decline.

Felsinger has helped Sempra avoid the problems that beset competitors. The company didn’t take on loads of debt to expand power generation -- unlike Calpine, which suffered when demand failed to surface. Sempra capitalized early on the opportunity to raise rates in advance of deregulation, a move California permitted so that utilities with higher-cost infrastructure could compete against rivals with more-modern plants. Other utilities didn’t recoup these “stranded costs” and suffered postderegulation.

Indeed, Sempra has exploited its rivals’ woes by buying up their assets on the cheap. In February it acquired the rights to a proposed gas-fired generation plant south of San Diego that Calpine, currently under federal bankruptcy court protection, had decided not to develop. It has also bought an LNG receiving-terminal project in Louisiana from Dynegy, as well as Enron’s London metals-trading group.

After helping shape Sempra’s strategy for the better part of a decade, Felsinger succeeded Stephen Baum as CEO on January 1. He plans to keep investing in fast-growing businesses like pipelines and LNG storage: Capital spending on such projects is slated for a 50 percent increase this year. But there are challenges. For one, Sempra may become more susceptible to price swings in gas and other commodities. And the company is still nursing its reputation after a $23 billion class-action lawsuit alleging that Sempra deliberately restricted California’s natural gas supply during the state’s 200102 energy crisis. (Early this year Sempra settled the suit for $377 million without admitting wrongdoing.) Felsinger recently spoke with Institutional Investor Contributor Doug Bartholomew.

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Institutional Investor: Is deregulation to blame for the energy industry’s woes, or just bad management?

Felsinger: It was probably some of each. The California deregulation scheme was not thought through as well as it should have been. The rules and regulations should have been more carefully put together. There also was a shortage of infrastructure. Some companies overextended themselves.

How did you avoid these ills?

We worked hard to pay off our stranded costs. Utilities were allowed a five-year window during which they could collect for the cost of their existing generation infrastructure assets. After that they became stranded. This is one reason Pacific Gas & Electric Co. went into bankruptcy and Southern California Edison nearly joined them. We understood the risk and paid off these costs in three years. We also maintained a healthy balance sheet. We didn’t go out and borrow a lot of money.

Why did you settle the suit alleging that you restricted California’s gas supply?

Almost every utilities company that did business during the energy crisis in California got sued. We thought this suit had no merit, but the state judge wanted it to go to a jury. We decided our best risk-management approach was to settle and get on with business. If it had been for a smaller amount, we would have litigated it to preserve our reputation.

Has your reputation suffered as a result of the suit and settlement, and if so, how can you repair it?

I think it is a fair assessment that anybody who was in the energy industry suffered a tarnished reputation, all because of some bad actors. We have been in business about 120 years, and we have weathered some storms. Over time, people will find we are part of the solution. We are building much-needed energy infrastructure for California. We will weather this.

Do you think deregulation is working?

Obviously, the process failed in California and it needs fixing. I have the fundamental belief that competition is good. But we’ve got to take a breather and determine what is best for California. If you look at telephone and cell phone service -- although there always are some bad examples -- in general, consumers are better off with some competition.

Why have you bought so many businesses and plants from competitors?

We have capitalized on their problems. We bought a Dynegy site where they were developing a new LNG receipt terminal to bring new natural gas supplies to North America. And we’ve been having conversations to buy Calpine’s Otay Mesa facility site and build a power plant there. That plant is sorely needed by the people of San Diego. We plan to invest $500 million in new infrastructure there. Each of these companies’ problems provided opportunities for us because we stayed healthy financially.

In 1999, when you were the head of Sempra’s unregulated business, you wanted to acquire KN Energy, but the deal never went through. What happened there?

KN Energy was a leading pipeline operator, and we wanted to buy them, but it became apparent that the company was not worth what they were asking for it. Interestingly enough, now we are partnering in a $4 billion project with Kinder Morgan, the company that purchased KN, to build a 1,350-mile pipeline to move natural gas from the Rocky Mountains to Ohio.

How important strategically are nonutility businesses like that pipeline?

There are tremendous synergies among the unregulated businesses. With our storage, pipeline, generation, commodities and LNG businesses, we are one of the largest marketers of natural gas in North America. We are in a particularly advantageous position because producers of natural gas in other countries don’t know about marketing the gas here the way we do. We store it, bring it to customers and sell it, and what we don’t sell, we burn in our power plant. No other utility-based energy company has been able to diversify as well as we have. Initially we wanted to obtain one third to one half our income from sources other than our two utilities. Last year nonutility businesses accounted for 70 percent of our earnings.

How much will you raise capital spending in the future, and where will you get the money?

We are undertaking the largest capital spending program in the company’s history. We plan to spend $2.3 billion this year on new infrastructure, versus an average of $1.5 billion per year more recently. It’s a big step for us. We have our own coal-fired power plants, which we bought a few years ago, that we think today are worth more to others than they are to us. We bought one Texas coal-fired plant for $120 million four years go that now is worth four times that. Our view is: Let’s sell assets that are overvalued in today’s market and maybe do some borrowing and project financing when needed. This is more efficient than issuing more equity. We also don’t want to borrow too much money and get overleveraged.

Where do you see Sempra expanding its footprint?

We were one of the first companies to identify the need for new natural gas infrastructure in North America. We are currently building two LNG facilities and associated pipelines for more than $1 billion each. We plan to continue to put our resources into natural gas infrastructure, such as storage facilities, LNG receipt facilities and pipelines.

With the investments you are making in pipelines and LNG terminals, isn’t there significant risk in the event demand falls and prices slacken?

The way many companies got in trouble in this industry was by spending lots of money on infrastructure -- and then they couldn’t make enough money to make it pay. We don’t take an if-you-build-it-they-will-come approach. We only build it if we have customers who have signed up with contracts to buy. To give an example, we had fully subscribed our Mexico pipeline for 20 years before we broke ground. In each facility we are building, we have contracts in place for five to 20 years that help protect our shareholders’ money.

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