DEFS is one of the leading gatherers of natural gas and is one of the largest producers of natural gas liquids (NGLs) in North America. DEFS was formed on March 31, 2000, through the combination of the midstream gas businesses of Phillips Petroleum Company (now ConocoPhillips (COP)) and Duke Energy Corp. (DUK). Currently, COP (IDR 'A-'; Rating Outlook Positive) and DUK subsidiary Duke Capital, LLC (IDR 'BBB-'; Rating Watch Positive) each own a 50% interest in DEFS. DUK plans to spin off its natural gas operations, including its interest in DEFS, on January 1, 2007, in a transaction that is expected to be credit neutral for Duke Capital and DEFS.
DEFS' rating and stable rating outlook reflect the following characteristics: a conservative capital structure and generally strong current and projected credit measures; significant scale and scope of operations and geographic diversity of assets; supportive corporate sponsors in DUK and COP; and a highly discretionary capital spending program. Also recognized in the rating is DEFS' ongoing financial exposure to fluctuations in commodity prices.
In its rating analysis Fitch also considered DEFS' relationship with DCP Midstream Partners, L.P. (DCP), a master limited partnership (MLP) formed with the dropdown of midstream assets from DEFS valued at $376 million. Currently, DEFS owns the 2% general partnership interest and 40% of the limited partnership interests in DCP. On October 10, 2006, DEFS announced it would drop down $77 million of wholesale propane assets to DCP in a transaction expected to close in the fourth quarter of 2006. In addition, DEFS has committed to contribute an additional $250 million of yet to be identified assets to DCP by the second quarter of 2007. While the credit implications of these transactions are not expected to be material, over the longer term, as DCP expands it operations through future dropdowns and third-party acquisitions, the relationship between entities will become a more significant factor in DEFS' rating.
Cash flow margins are highly dependent on realized prices for NGLs, which is correlated to the price of crude oil. Exposure to natural gas prices is limited due to the company's balanced mix of fee-based, percentage of proceeds (POP), and keep-whole contracts. DEFS has been able to reduce its economic sensitivity to commodity pricing and promote greater financial stability by renegotiating and converting a portion of its keep-whole contracts, which are exposed to frac spreads, to POP or minimum fee arrangements. Keep-whole contracts now generate between 5% and 10% of DEFS' gross margin.
Favorable market pricing for NGLs, which now exceed $1.00 per gallon, has contributed to positive margins and strong credit measures. Moreover, Fitch's short-term credit outlook for the midstream services sector is positive given the strength of the underlying industry fundamentals. Funds from operations (FFO) interest coverage exceeded 7.4 times (x) for the twelve months ended Dec. 31, 2005 and debt to FFO was under 1.5x. Credit ratios have continued to strengthen in 2006 due to increased margins and debt reduction which have more than compensated for the loss of TEPPCO Partners, L.P. distributions when it was sold in February 2005. To further minimize NGL price risk, management has in the past utilized a hedging strategy when necessary to ensure minimum cash requirements (interest, dividends, and maintenance capital) will be sufficiently covered even in a very unfavorable commodity price environment. DEFS has not used hedges during 2006. However, DEFS has provided credit support for a five-year hedge related to forecasted production of assets it initially contributed to DCP.
Projected cash flow credit measures based on a reasonable base case remain strong for current ratings. The company generates substantial free cash flow, benefiting from manageable maintenance and volume replacement capital expenditures. Growth spending at DEFS is highly discretionary and should be entirely supportable though internal cash generation. Growth through acquisitions could occur at both DEFS and DCP and would likely require external financing.
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