Dominion Power 2004 Annual Report Download - page 54

D 2004/Page 52
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
Dominion’s merchant power business is operating in a challenging mar-
ket which could adversely affect its results of operations and future
growth. The success of Dominion’s approximately 9,700-megawatt mer-
chant power business depends upon favorable market conditions as well
as its ability to find buyers willing to enter into power purchase agree-
ments at prices sufficient to cover operating costs. Dominion attempts to
manage these risks by entering into both short-term and long-term fixed
price sales and purchase contracts. However, depressed spot and forward
wholesale power prices, high fuel and commodity costs and excess capac-
ity in the industry could result in lower than expected revenues in
Dominion’s merchant power business.
There are inherent risks in the operation of nuclear facilities. Dominion
operates nuclear facilities that are subject to inherent risks. These include
the threat of terrorist attack and ability to dispose of spent nuclear fuel,
the disposal of which is subject to complex federal and state regulatory
constraints. These risks also include the cost of and Dominion’s ability to
maintain adequate reserves for decommissioning, costs of plant mainte-
nance and exposure to potential liabilities arising out of the operation of
these facilities. Dominion maintains decommissioning trusts and external
insurance coverage to manage the financial exposure to these risks. How-
ever, it is possible that costs arising from claims could exceed the amount
of any insurance coverage.
The use of derivative instruments could result in financial losses and
liquidity constraints. Dominion uses derivative instruments, including
futures, forwards, options and swaps, to manage its commodity and finan-
cial market risks. In addition, Dominion purchases and sells commodity-
based contracts in the natural gas, electricity and oil markets for trading
purposes. In the future, Dominion could recognize financial losses on these
contracts as a result of volatility in the market values of the underlying
commodities or if a counterparty fails to perform under a contract. In the
absence of actively quoted market prices and pricing information from
external sources, the valuation of these contracts involves management’s
judgment or use of estimates. As a result, changes in the underlying
assumptions or use of alternative valuation methods could affect the
reported fair value of these contracts.
In addition, Dominion uses financial derivatives to hedge future sales
of its gas and oil production. These hedge arrangements generally include
margin requirements that require Dominion to deposit funds or post letters
of credit with counterparties to cover the fair value of covered contracts in
excess of agreed upon credit limits. When commodity prices rise to levels
substantially higher than the levels where it has hedged future sales,
Dominion may be required to use a material portion of its available liquidity
to cover these margin requirements. In some circumstances, this could
have a compounding effect on Dominion’s financial liquidity and results.
For additional information concerning derivatives and commodity-based
trading contracts, see
Market Rate Sensitive Instruments and Risk Man-
agement
and Notes 2 and 8 to the Consolidated Financial Statements.
Dominion is exposed to market risks beyond its control in its energy
clearinghouse operations which could adversely affect its results of opera-
tions and future growth. Dominion’s energy clearinghouse and risk manage-
ment operations are subject to multiple market risks including market
liquidity, counterparty credit strength and price volatility. Many industry
participants have experienced severe business downturns resulting in
some companies exiting or curtailing their participation in the energy trad-
ing markets. This has led to a reduction in the number of trading partners
and lower industry trading revenues. Declining creditworthiness of some of
Dominion’s trading counterparties may limit the level of its trading activi-
ties with these parties and increase the risk that these parties may not per-
form under a contract.
Dominion’s exploration and production business is dependent on factors
that cannot be predicted or controlled and that could damage facilities, dis-
rupt production or reduce the book value of its assets. Factors that may
affect Dominion’s financial results include weather that damages or causes
the shutdown of its gas and oil producing facilities, fluctuations in natural
gas and crude oil prices, results of future drilling and well completion
activities and Dominion’s ability to acquire additional land positions in
competitive lease areas, as well as inherent operational risks that could
disrupt production.
Short-term market declines in the prices of natural gas and oil could
adversely affect Dominion’s financial results by causing a permanent write-
down of its natural gas and oil properties as required by the full cost
method of accounting. Under the full cost method, all direct costs of prop-
erty acquisition, exploration and development activities are capitalized. If
net capitalized costs exceed the present value of estimated future net rev-
enues based on hedge-adjusted period-end prices from the production of
proved gas and oil reserves (the ceiling test) in a given country at the end
of any quarterly period, then a permanent write-down of the assets must
be recognized in that period.
An inability to access financial markets could affect the execution of
Dominion’s business plan. Dominion and its Virginia Power and CNG sub-
sidiaries rely on access to both short-term money markets and longer-term
capital markets as a significant source of liquidity for capital requirements
not satisfied by the cash flows from its operations. Management believes
that Dominion and its subsidiaries will maintain sufficient access to these
financial markets based upon current credit ratings. However, certain dis-
ruptions outside of Dominion’s control may increase its cost of borrowing or
restrict its ability to access one or more financial markets. Such disruptions
could include an economic downturn, the bankruptcy of an unrelated
energy company or changes to Dominion’s credit ratings. Restrictions on
Dominion’s ability to access financial markets may affect its ability to exe-
cute its business plan as scheduled.
Changing rating agency requirements could negatively affect Dominion’s
growth and business strategy. As of February 1, 2005, Dominion’s senior
unsecured debt is rated BBB+, negative outlook, by Standard & Poor’s and
Baa1, stable outlook, by Moody’s. Both agencies have implemented more
stringent applications of the financial requirements for various ratings lev-
els. In order to maintain its current credit ratings in light of these or future
new requirements, Dominion may find it necessary to take steps or change
its business plans in ways that may adversely affect its growth and earn-
ings per share. A reduction in Dominion’s credit ratings or the credit ratings
of its Virginia Power and CNG subsidiaries by either Standard & Poor’s or
Moody’s could increase Dominion’s borrowing costs and adversely affect
operating results and could require it to post additional margin in connec-
tion with some of its trading and marketing activities.
Potential changes in accounting practices may adversely affect
Dominion’s financial results. Dominion cannot predict the impact that future
changes in accounting standards or practices may have on public compa-
nies in general, the energy industry or its operations specifically. New