Natural Gas Market Conditions and Unisource Natural Gas Bills Bob Gray, Arizona Corporation Commission Staff February 24, 2004

Arizonas Natural Gas Supplies No instate production or storage Arizonas natural gas comes from the San Juan supply basin in northwest New Mexico and the Permian supply basin in west Texas Unisource and other Arizona entities contract with natural gas producers in these supply basins to buy volumes of natural gas Arizona entities, including Unisource, hold pipeline capacity rights on interstate pipeline systems to deliver natural gas to the local distribution systems in Arizona The price and availability of natural gas to Unisource is impacted by regional and national natural gas market conditions

United States Natural Gas Market Source: United States Energy Information Administration

The National Market for Natural Gas Wellhead prices for natural gas were deregulated by the federal government in the 1980s For many years there was a gas bubble. This means there was more natural gas supply than demand, so natural gas prices were typically quite low In recent years the balance between supply and demand has changed significantly, resulting in higher and more volatile natural gas prices

Recent Headlines USA Today, February 14, 2004 – Heating bills, pump prices shock consumers, Virginia and Cincinnati customers are quoted regarding their much higher natural gas bills Reuters News, February 20, 2004 – Energy Spike Hikes Inflation in January Alan Greenspan, June 2003 – Today's tight natural gas markets have been a long time in coming, and futures prices suggest that we are not apt to return to earlier periods of relative abundance and low prices anytime soon.

Current Market Conditions U.S. production in the traditional lower 48 supply basins has weakened in recent years Canadian imports, which have typically made up approximately 15% of U.S. supplies, declined in 2002 for the first time in 14 years and appear likely to continue to decline Natural gas exports to Mexico continue to grow Increased reliance on natural gas-fired electricity generation has driven increased natural gas demand Natural gas intensive industries such as fertilizer and chemicals have been particularly hard hit by large natural gas price increases, resulting in job losses and some relocations to overseas areas Natural gas storage inventories have fluctuated significantly and low storage levels have contributed to several recent price spikes

Current Market Conditions (continued) The growth areas for natural gas supply are the central Rockies, liquid natural gas imports, and Arctic natural gas, but each of these options faces environmental and other concerns Drilling for natural gas has increased as natural gas prices have increased recently, but despite higher rig counts, producers have struggled to maintain production at current levels Weather is always an important factor. Recent cold weather conditions in the large consuming regions of the Midwest and Northeast have contributed to price volatility and higher prices In summary, natural gas market prices appear likely to remain high and display significant volatility for the foreseeable future

Arizonas Situation Arizona consumers served by all Arizona gas companies have experienced significantly higher natural gas prices in recent years Most of Arizonas natural gas is currently delivered through El Paso Natural Gas Companys interstate pipeline system, with small amounts delivered over the Transwestern and Questar systems A number of companies are considering constructing new pipeline and/or storage infrastructure in Arizona Arizona natural gas demand continues to grow, driven primarily by increased production of electricity by natural gas fired generators

Components in Natural Gas Rates Cost of natural gas - includes the cost of purchasing the natural gas commodity in the supply basins in New Mexico and western Texas as well as the cost of transporting the natural gas to Unisources distribution system in Arizona. Adjusts monthly based upon the Commission approved purchased gas adjustor mechanism. Other costs - includes the cost of facilities, metering, billing, customer service, etc. Also includes the companys allowed profit margin. These costs dont change outside a rate proceeding and subsequent order from the Commission.

Customer Charge – A fixed charge which is applied each month. Doesnt change outside of a rate proceeding. Basic Cost of Service - Rate per therm of usage. Fixed rate of $ per therm. Doesnt change outside of a rate proceeding. The charges collected through the Customer Charge and Basic Cost of Service rate are for recovery of costs other than the gas commodity costs, with the exception of a built in base cost of gas of $0.40 per therm. This base cost of gas doesnt change outside a rate proceeding. The base cost of gas is an estimated average cost for Unisource to acquire the natural gas commodity and the ability to transport it over the interstate pipeline system Rate Components

PGA Cost – This monthly PGA rate is set for each month by taking the difference between Unisources average cost per therm of purchasing natural gas supplies for the previous 12 months and the base cost of gas. PGA Surcharge – This is a temporary per therm surcharge on customers bills. Such a surcharge is only implemented when Unisource has spent a lot more money to buy natural gas than what it has received from ratepayers to pay for the natural gas commodity. Circuit-Breaker Mechanism – Under this mechanism residential usage above 140% of average residential usage each month from December through March is not subject to the PGA surcharge Rate Components

Other Issues Unisources PGA mechanism is a straight pass through, meaning the company makes no profit on the cost of the natural gas commodity. Unisource files monthly reports with the Commission, documenting its natural gas commodity costs and recovery of such costs from its customers. The Commission has formally recognized price stability as one of the goals of the gas purchasing process and has directed Unisource and other gas utilities to buy a portion of their gas supplies on fixed price, longer term contracts. In April 2003 the Commission initiated a Notice of Inquiry on Natural Gas Infrastructure to work with utilities and others to look at issues regarding additional natural gas pipeline and storage infrastructure in Arizona. Such additional infrastructure can assist Arizona in addressing the cost, flexibility, and reliability of natural gas service in Arizona.