ENERGYSOUTH INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarter Ended June 30, 2002
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Commission File No. 0-29604
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ENERGYSOUTH, INC.
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(Exact name of registrant as specified in its charter)

Alabama 58-2358943
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

2828 Dauphin Street, Mobile, Alabama 36606
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(Address of principal executive office) (Zip Code)

Registrant's telephone number, including area code 251-450-4774
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

Common stock ($.01 par value) outstanding at July 31, 2002 - 5,015,162 shares.

ENERGYSOUTH, INC.

INDEX

2

PART 1. FINANCIAL INFORMATION

CONSOLIDATED BALANCE SHEETS

See Accompanying Notes to Consolidated Financial Statements

3

CONSOLIDATED BALANCE SHEETS

See Accompanying Notes to Consolidated Financial Statements

4

CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)

See Accompanying Notes to Consolidated Financial Statements

5

CONSOLIDATED STATEMENTS OF RETAINED EARNINGS
(Unaudited)

CONSOLIDATED STATEMENTS
OF CASH FLOWS
(Unaudited)

See Accompanying Notes to Consolidated Financial Statements

6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1. The consolidated financial statements of EnergySouth, Inc. and its
subsidiaries (collectively the Company) include the accounts of Mobile Gas
Service Corporation (Mobile Gas); EnergySouth Services, Inc. (Services); MGS
Storage Services (Storage); MGS Marketing Services, Inc. (Marketing); a 90.9%
owned partnership, Bay Gas Storage Company, Ltd. (Bay Gas); and a 51% owned
partnership, Southern Gas Transmission Company (SGT). All significant
intercompany balances and transactions have been eliminated. Certain amounts in
the prior year financial statements have been reclassified to conform with the
fiscal year 2002 financial statement presentation.

Note 2. The accompanying unaudited condensed financial statements have been
prepared in accordance with the instructions to Form 10-Q and do not include all
of the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements. All
adjustments, consisting of normal and recurring accruals, which are, in the
opinion of management, necessary to present fairly the results for the interim
periods have been made. The statements should be read in conjunction with the
summary of accounting policies and notes to financial statements included in the
Annual Report on Form 10-K of the Company for the fiscal year ended September
30, 2001.

Note 3. Due to the high percentage of customers using gas for heating, the
Company's operations are seasonal in nature. Therefore, the results of
operations for the three and nine-month periods ended June 30, 2002 and 2001 are
not indicative of the results to be expected for the full year.

Note 4. On June 10, 2002, the Alabama Public Service Commission (APSC) approved
Mobile Gas' request for the Rate Stabilization and Equalization (RSE) rate
setting process to be effective October 1, 2002 through September 30, 2005, and
thereafter, unless modified or discontinued by APSC order. Under RSE, the APSC
conducts quarterly reviews to determine, based on Mobile Gas' projections and
fiscal year-to-date performance, whether Mobile Gas' return on equity is
expected to be within the allowed range of 13.35% to 13.85%. Reductions in rates
can be made quarterly to bring the projected return within allowed range;
increases, however, are allowed only once each fiscal year, effective December
1, and cannot exceed four percent of prior-year revenues. RSE limits the amount
of Mobile Gas' equity upon which a return is permitted to 60 percent of its
total capitalization and provides for certain cost control measures designed to
monitor Mobile Gas' operations and maintenance (O&M) expense. Under the
inflation-based cost control measurement established by the APSC, if a change in
Mobile Gas' O&M expense per customer falls within 1.5 percentage points above or
below the change in the Consumer Price Index for All Urban Customers (index
range), no adjustment is required. If the change in O&M expense per customer
exceeds the index range, three-quarters of the difference is returned to
customers. To the extent the change is less than the index range, the utility
benefits by one-half of the difference through future rate adjustments.

7

In conjunction with the approval of RSE, the APSC approved an Enhanced Stability
Reserve (ESR), beginning October 1, 2002, to which Mobile Gas may charge the
full amount of: 1) extraordinary O&M expenses resulting from force majeure
events such as storms, severe weather, and outages, when one such event results
in more than $100,000 of additional O&M expense or a combination of two or more
such events results in more than $150,000 of additional O&M expense during a
fiscal year; or 2) losses of revenue from any individual industrial or
commercial customer in excess of $100,000 during the fiscal year, if such losses
cause Mobile Gas' return on equity to fall below 13.35%. An initial ESR balance
of $1.0 million will be recorded October 1, 2002 and recovered from ratepayers
evenly over a three-year period beginning October 1, 2002. Subject to APSC
approval, additional funding, up to a maximum reserve balance of $1.5 million,
may be provided by any future non-recurring revenue should such revenue cause
Mobile Gas' return on equity for the fiscal year to exceed 13.85%. Following a
year in which a charge against the ESR is made, the APSC provides for accruals
to the ESR of no more than $15,000 monthly until the maximum funding level is
achieved.

Note 5. The Company is principally engaged in the distribution and storage of
natural gas. Through Mobile Gas and SGT, the Company is engaged primarily in the
distribution and transportation of natural gas to residential, commercial and
industrial customers in southwest Alabama. The APSC regulates the Company's gas
distribution operations. For the major portion of the Company's business, the
APSC approves rates which are intended to permit the recovery of the cost of
service including a return on investment. Gas deliveries to certain industrial
customers are subject to regulation by the APSC through contract approval.

Through Storage and Bay Gas, the Company provides for the underground storage of
natural gas and transportation services. The APSC regulates intrastate storage
operations through contract approval. Interstate gas storage contracts do not
require APSC approval since the Federal Energy Regulatory Commission (FERC),
which has jurisdiction over such contracts, allows them to have market-based
rates. The FERC has granted authority to Bay Gas to provide transportation-only
services to interstate and intrastate shippers and approved rates for such
services.

The Company also provides natural gas marketing, merchandising, and other
energy-related services through Marketing, Mobile Gas, and Services.

8

Segment earnings information presented in the table below includes intersegment
revenues which are eliminated in consolidation. Such intersegment revenues are
primarily amounts paid by the Natural Gas Distribution segment to the Natural
Gas Storage segment.

9

Note 6. Basic earnings per share are computed based on the weighted average
number of common shares outstanding during each period. Diluted earnings per
share are computed based on the weighted average number of common shares
outstanding and diluted potential common shares, using the treasury stock
method, outstanding during each period.

Average common shares used to compute basic earnings per share differed from
average common shares used to compute diluted earnings per share by equivalent
shares of 105,000 and 63,000 for the three months ended June 30, 2002 and 2001,
respectively, 92,000 and 58,000 for the nine months ended June 30, 2002 and
2001, respectively, and 85,000 and 54,000 for the twelve months ended June 30,
2002 and 2001, respectively. These differences in equivalent shares are from
outstanding stock options.

Note 7. In December 2000, Bay Gas completed the sale of $55,000,000 of senior
secured notes. Approximately $18,670,000 of the proceeds was used to pay the
balance of existing debt incurred to construct Bay Gas' first natural gas
storage cavern. In connection with the early payment of the existing debt, Bay
Gas incurred an extraordinary loss on early extinguishment of debt which totaled
$2,454,000, consisting of a $2,026,000 make-whole premium and a write-off of
$428,000 of unamortized issuance costs relating to the financing of the first
cavern. After deducting the minority interest of $223,000 and a tax benefit of
$808,000, the extraordinary loss recorded by the Company was $1,423,000.

Note 8. In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 141, "Business Combinations"
(SFAS 141) and No. 142, "Goodwill and Other Intangible Assets" (SFAS 142). SFAS
141 eliminates the pooling-of-interest method of accounting for all business
combinations initiated after June 30, 2001 and did not have a material impact on
the Company's financial statements. SFAS 142 requires that goodwill and other
certain intangible assets no longer be amortized, but instead tested for
impairment on an annual basis. SFAS 142 is not expected to have a material
impact on the Company's financial statements and will be adopted by the Company
on October 1, 2002.

In June 2001, the FASB issued Statement of Financial Accounting Standards No.
143, "Accounting for Asset Retirement Obligations" (SFAS 143). SFAS 143
addresses the recognition and measurement of a liability for an asset retirement
obligation and the associated asset retirement costs. It requires that an
existing legal obligation associated with the retirement of a tangible
long-lived asset be recognized as a liability when incurred and outlines the
method of measuring that liability. The Company will adopt SFAS 143 on October
1, 2002. Based upon a preliminary review, the adoption of this standard is not
expected to have an impact on the Company's financial statements. The
requirements of this statement will be considered however if any legal
obligations relating to the retirement of long-lived assets arise in the future.

In August 2001, FASB issued Statement of Financial Accounting Standards No. 144,
"Accounting for the Impairment of Disposal of Long-Lived Assets" (SFAS 144)
which addresses accounting and reporting standards for long-lived assets. SFAS
144 applies to recognized long-lived assets of an entity to be held and used or
to be disposed of and develops a single

10

accounting model for the disposal of long-lived assets, whether previously held
or newly acquired. SFAS 144 is not expected to have an impact on the Company's
financial statements when adopted by the Company on October 1, 2002.

Note 9. In November 2001, Bay Gas entered into an agreement which grants an
option to transport additional volumes in excess of the volumes currently under
long-term contract. During the first quarter of fiscal 2002, Bay Gas received
$3,274,000 in consideration of the option agreement, of which the unamortized
balance, $1,896,000, is classified as unearned revenue on EnergySouth's
consolidated balance sheet and is being amortized over the remaining life of the
option agreement.

11

ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION

THE COMPANY

EnergySouth, Inc. (EnergySouth) is a holding company for a family of energy
businesses. EnergySouth and its consolidated subsidiaries are collectively
referred to herein as the "Company." The Company, through Mobile Gas Service
Corporation (Mobile Gas) and Southern Gas Transmission Company (SGT), is engaged
in the distribution of natural gas to residential, commercial and industrial
customers in southwest Alabama. Through Bay Gas Storage Company, Ltd. (Bay Gas),
the Company provides underground natural gas storage services and transportation
services. Other EnergySouth subsidiaries are engaged in gas marketing,
merchandising and other energy-related services.

The Alabama Public Service Commission (APSC) regulates the Company's gas
distribution and storage operations. Mobile Gas' rate tariffs for gas
distribution allow a pass-through to customers of the cost of gas, certain
taxes, and incremental costs associated with the replacement of cast iron mains.
These costs, therefore, have little direct impact on the Company's margins.
Other costs, including a return on investment, are recovered through rates
approved by the APSC. The APSC certificated Bay Gas as an Alabama gas storage
public utility in 1992. Bay Gas provides substantial, long-term services for
Mobile Gas and other customers that include storage and transportation of
natural gas from interstate and intrastate sources. The APSC does not regulate
rates for Bay Gas interstate gas storage and storage-related services. The
Federal Energy Regulatory Commission (FERC), which has jurisdiction over
interstate services, allows Bay Gas to charge market-based rates for such
services. Market-based rates minimize regulatory involvement in the setting of
rates for storage services and allow Bay Gas to respond to market conditions.
Bay Gas also provides interstate transportation-only services. The FERC last
issued orders on October 11, 2001 and June 3, 2002 approving rates for such
services.

The Company's distribution business is highly seasonal and temperature-sensitive
since residential and commercial customers use more gas during colder weather
for space heating. As a result, gas revenues, cost of gas and related taxes in
any given period reflect, in addition to other factors, the impact of weather,
through either increased or decreased sales volumes. The Company utilizes a
temperature rate adjustment rider to mitigate the impact that unusually cold or
warm weather has on operating margins by reducing the base rate portion of
customers' bills in colder than normal weather and increasing the base rate
portion of customers' bills in warmer than normal weather. Normal weather for
the Company's service territory is defined as the 30-year average temperature as
determined by the National Weather Service.

12

RESULTS OF OPERATIONS

INCOME BEFORE EXTRAORDINARY LOSS

All earnings per share amounts referred to herein are computed on a diluted
basis and all financial statement changes discussed herein for the three, nine,
and twelve months ended June 30, 2002 are based upon comparative income before
extraordinary loss of prior periods as shown in the table below:

Earnings before extraordinary loss increased $415,000 or $0.08 per share,
$2,490,000 or $0.47 per share, and $2,288,000 or $0.43 per share, respectively,
for the three, nine, and twelve month periods ending June 30, 2002 due to
increased earnings from Mobile Gas' distribution business and Bay Gas' storage
and transportation business. Earnings from Mobile Gas' distribution business
were positively impacted as a result of the general rate increase discussed
below. Bay Gas' earnings increased due to an increase in transportation revenues
and the option agreement discussed below in Natural Gas Storage. These increases
in earnings were partially offset by an increase in reserves for slow moving
merchandise inventory which resulted in losses from merchandising activities for
the current year three and nine month periods and reduced earnings for the
twelve months ending June 30, 2002. See Note 5 for financial information by
business segment.

RATE PROCEEDINGS

In May 2001, Mobile Gas filed a petition with the APSC to increase its base
rates to customers for the first time since 1995. A general rate increase covers
such costs as increased operating expenses, taxes, depreciation, and financing
costs of the gas distribution system. The APSC approved new base rates,
effective October 2, 2001, which are designed to increase annual gas revenues by
approximately $7.8 million and allow Mobile Gas the opportunity to earn a rate
of return on equity of 13.6%.

In May 2001, Mobile Gas also requested approval of a Rate Stabilization and
Equalization (RSE) tariff, a ratemaking methodology already used by the APSC to
regulate certain other utilities, which would allow for periodic rate
adjustments in the future. The APSC conducted a hearing in May 2002 and
subsequently approved Mobile Gas' RSE request. See Note 4 above for a more
detailed explanation of RSE.

13

OPERATING REVENUES

The table below summarizes the change in operating revenues for the three, nine,
and twelve- month periods ended June 30, 2002 and 2001:

NATURAL GAS DISTRIBUTION

Revenue from the sale and transportation of gas to customers by the distribution
business decreased $1,003,000 (7%), $23,878,000 (28%), and $23,151,000 (23%) for
the three, nine, and twelve-month periods ended June 30, 2002 as compared to the
same prior year periods. The decrease experienced in all three periods is due
primarily to a decrease in revenue from temperature-sensitive customers of
$859,000 (8%), $20,992,000 (29%), and $20,249,000 (25%), respectively, for the
three, nine, and twelve month periods. The decline in revenues can be
attributed, in part, to the lower prices of natural gas experienced during this
year's heating season as compared to last year. During the winter of fiscal year
2001, natural gas

14

prices increased to levels which far exceeded their 10-year average. The price
of natural gas has declined significantly during the first three quarters of
fiscal year 2002 as compared with the prior year periods. Fluctuations in the
actual cost of gas are passed on to customers through the purchased gas
adjustment provision of the rate tariffs and do not directly result in any
increase or decrease in margins or profits. Volumes delivered to
temperature-sensitive customers increased approximately 5% during the three
months ended June 30, 2002 as compared to the prior year due to an increase in
usage per customer. Volumes delivered during the nine and twelve months ended
June 30, 2002 decreased approximately 17% and 14%, respectively, due to warmer
weather conditions and a slight decrease in customers served during these
periods. Weather in Mobile Gas' service area during the 2001-2002 winter heating
season was 3% warmer than normal and 20% warmer than the prior year heating
season.

Revenue from gas sales to large commercial and industrial customers decreased
$239,000 (12%), $3,014,000 (37%), and $2,796,000 (28%), respectively, for the
three, nine, and twelve month periods ended June 30, 2002 due primarily to the
decline in natural gas prices as discussed above. Volumes delivered to these
customers during the three months ended June 30, 2002 increased approximately
14% due primarily to one customer that switched from transportation services to
sales. Volumes delivered decreased 13% for each of the nine and twelve month
periods ended June 30, 2002 due to a general decline in usage attributed to
economic conditions and one industrial customer that used significantly more gas
in the prior year periods due to unique operational needs that did not occur in
the current year periods.

Gas transportation revenues, excluding Bay Gas, increased $55,000 (3%) for the
three month period ended June 30, 2002 and declined $114,000 (2%) and $330,000
(4%), respectively, for the nine and twelve month periods ended June 30, 2002 as
compared to the same periods in fiscal 2001. The closure of the International
Paper plant in late December 2000 and a decrease in volumes transported to other
plants in the pulp and paper industry are the primary reasons for the decrease
in revenues during the nine and twelve month periods. Volumes transported to
customers decreased 13%, 8% and 5%, respectively, for the three, nine and twelve
month periods. In addition to the International Paper closure, transportation
volumes for the nine and twelve month periods ended June 30, 2002 were impacted
by the Corus Group plc (Corus, formerly known as British Steel) plant closure in
late October 2000. Because of minimum payment provisions of the contract with
Corus, the Corus plant closure did not have a significant impact on
transportation revenues. Partially offsetting the decline in transportation
volumes as a result of these plant closures and reduced demand associated with
the pulp and paper industry was increased demand from other customers such as
Alabama Power's new gas-powered co-generation facility that became fully
operational in the first quarter of fiscal year 2001 and the start-up of another
co-generation facility in June 2001 to which Mobile Gas has a long-term
transportation contract.

Distribution margins increased $1,439,000 (18%), $5,133,000 (15%), and
$4,916,000 (11%) for the three, nine, and twelve month periods, respectively, as
compared to the same prior year periods primarily as a result of the general
rate increase which became effective October 2, 2001.

15

The following table summarizes gas distribution margins (excluding Bay Gas) for
the three, nine, and twelve-month periods ended June 30, 2002 and 2001 and the
related volumes delivered (excluding Bay Gas) to customers.

NATURAL GAS STORAGE

The construction of natural gas-fired electric generation facilities in the
southeast, and specifically in the Mobile area, has provided new opportunities
for EnergySouth companies to provide gas storage and transportation services.
Bay Gas is currently constructing a second storage cavern. A substantial portion
of the capacity of this cavern has been contracted for, through a fifteen year
agreement, with Southern Company Services, Inc., an affiliate of Southern
Company, as agent for certain Southern Company subsidiaries. Management
currently believes that the date for commencement of operations of the second
storage cavern, originally anticipated to be in December 2002, will be no later
than April 1, 2003. The Company does not expect the delayed commencement of
operations to have a material effect on its financial condition or results of
operations.

In order to provide additional pipeline capacity to serve existing customers'
transportation needs and provide the infrastructure for anticipated growth in
the area, Bay Gas has completed construction of two major pipelines.
Construction was completed in fiscal 2001 of an 11-mile, 20-inch pipeline that
parallels the northern portion of the existing Bay Gas pipeline. Construction
was completed in November 2001 of a new 18-mile, 24-inch pipeline that connects
Bay Gas' existing line with Gulf South Pipeline Company's (Gulf South)
high-pressure pipeline and provides a second connection with Mobile Gas'
distribution system.

16

Bay Gas' storage and transportation revenues (excluding revenues received from
Mobile Gas) increased $810,000 (83%), $2,421,000 (88%), and $2,369,000 (61%),
respectively, for the three, nine, and twelve month periods ended June 30, 2002
compared to the corresponding prior year periods. Contributing to the increase
was transportation of natural gas to Phase I of Alabama Power's Plant Barry
co-generation facility which became operational in June 2000 and the completion
of Phase II of Alabama Power's gas-powered generating facility at Plant Barry in
June 2001. Additionally, in November 2001, Bay Gas began transporting gas under
another long-term contract upon completion of the new 24-inch, 18 mile pipeline
that connects Bay Gas to Gulf South's high pressure pipeline. Bay Gas also
entered into an agreement in November 2001 which grants an option to transport
additional volumes in excess of the volumes currently under long-term contract.
Bay Gas received $3,274,000 in consideration of the option agreement that is
being amortized over a nineteen-month option period.

MERCHANDISING REVENUES

Merchandising sales revenues increased $198,000 (30%), $385,000 (17%), and
$453,000 (16%) for the three, nine, and twelve months ended June 30, 2002 as
compared to the same periods last year due, in part, to an increase in the sale
of natural gas generators and increased sales from the specialty stores.

OTHER REVENUES

Other operating revenues consist primarily of interest income from the financing
of merchandise sales that occur at the Company and through trade programs. Other
revenues also include revenues from engineering consulting, pipeline corrosion
protection services and gas marketing services. Other revenues increased $49,000
(17%) and $40,000 (4%), respectively, for the three and nine month periods ended
June 30, 2002 and decreased $66,000 (5%) for the twelve month period end June
30, 2002. The increase during the three and nine month period was due to a
general increase in the various categories outlined above. The twelve-month
decrease was due to a decline in revenues associated with pipeline corrosion
protection services and a decline in financing of merchandise sales.

OPERATING EXPENSES

Operations and maintenance (O&M) expenses increased $1,113,000 (21%), $1,764,000
(11%), and $982,000 (5%), respectively, for the three, nine, and twelve month
periods ended June 30, 2002, as a result of the following: an increase in
reserves for slow moving merchandise inventory of $366,000, an increase in the
liability for deferred director fees of $227,000 as a result of the increase in
market value of EnergySouth stock at June 30, 2002, and unscheduled repairs of
$95,000 on one of Bay Gas' compressors. Also contributing to the increase in O&M
expenses was an increase in payroll and payroll related costs, the expansion of
Bay Gas' operations and the expansion of other businesses including the opening
of a second specialty store, the relocation of one specialty store, and the
start-up of sales of natural gas generators.

17

Increases in depreciation expense for the three, nine, and twelve month periods
were due to increased investment in property, plant and equipment from Mobile
Gas' and Bay Gas' capital expansion projects.

Taxes, other than income taxes (other taxes), primarily consist of property
taxes and business license taxes that are based on gross revenues and fluctuate
accordingly. Other taxes increased $114,000 (9%) for the three month period
ended June 30, 2002 due primarily to an increase in ad valorem taxes and
declined $829,000 (13%), and $589,000 (8%) for the nine and twelve months ended
June 30, 2002 due primarily to decreases in business license taxes associated
with a decline in gas revenues.

OTHER INCOME AND EXPENSES

Interest expense decreased $179,000 (8%) for the three-month period ended June
30, 2002 due to a decline in the average short term borrowing rate and a decline
in outstanding debt during the period. Interest expense increased $413,000 (7%)
and $1,272,000 (18%), respectively, for the nine and twelve month periods ended
June 30, 2002 due primarily to the issuance of $55 million of Bay Gas Senior
Secured Notes (see "Liquidity and Capital Resources" below) in December 2000.

Allowance for borrowed funds used during construction represents the
capitalization of interest costs to construction work-in-progress. Capitalized
interest costs decreased $157,000 (23%) for the three months ended June 30,
2002, primarily due to the completion of Bay Gas' pipeline projects and a
decline in Mobile Gas' capital expenditures, and increased for the nine and
twelve months ended June 30, 2002 by $422,000 (39%) and $1,066,000 (99%),
respectively, due primarily to the construction of Bay Gas' second storage
cavern and pipeline projects.

Interest income decreased $331,000 (96%), $797,000 (74%), and $769,000 (63%) for
the three, nine, and twelve month periods ended June 30, 2002 due primarily to a
decline in the amount of the unused portion of debt issuance proceeds of Bay Gas
available for investment.

Minority interest reflects the minority partners' share of pre-tax earnings of
the Bay Gas and SGT partnerships, of which EnergySouth's subsidiaries hold
controlling interests. Minority interest increased $13,000 (10%) and $28,000
(6%), respectively, for the three and nine month periods ended June 30, 2002
compared to the same periods in 2001. The three-month increase was due to
increased pre-tax earnings from both Bay Gas and SGT; however, for the
nine-month period, Bay Gas' improved earnings were partially offset by a decline
in SGT earnings. For the twelve month period, minority interest decreased
$48,000 (7%) due partially to a decrease in pre-tax earnings from SGT and due to
the reduction in Olin Corporation's limited partnership interest in Bay Gas from
12.5% to 9.1% in December 2000.

Income tax expense fluctuates with the changes in income before income taxes.
Income tax expense increased $114,000 (61%), $1,486,000 (38%), and $1,575,000
(35%) for the three,

18

nine, and twelve month periods ended June 30, 2002.

LIQUIDITY AND CAPITAL RESOURCES

The Company generally relies on cash generated from operations and, on a
temporary basis, short-term borrowings, to meet working capital requirements and
to finance normal capital expenditures. The Company issues debt and equity for
longer term financing as needed. Operating activities provided cash of
$18,454,000 and $13,102,000, respectively, for the nine months ended June 30,
2002 and 2001. The increase in cash flow from operating activities provided
$5,352,000 more than the prior year due primarily to an increase in net income,
a decline in accounts receivable, and the option payment Bay Gas received during
the first quarter of 2002 classified as unearned revenue, all of which were
partially offset by a decrease in accounts payable and other liabilities.

Cash used by investing activities reflects the capital-intensive nature of the
Company's business. Investing activities used cash of $16,303,000 and
$37,902,000, respectively, for the nine months ended June 30, 2002 and 2001. In
addition to the Company's regular construction program for the distribution
business, Bay Gas completed two pipeline projects and Mobile Gas completed
expansion projects in fiscal 2001 which included providing transportation
services to a new co-generation facility and a 10-mile pipeline that expanded
its system into Baldwin County. Bay Gas' temporary investments of $3.0 million
from the unused proceeds of the December 2000 debt issuance matured in December
2001.

Financing activities used cash of $10,433,000 for the nine-month period ended
June 30, 2002. For the nine months ended June 30, 2002, the pay-down of short
term borrowings, scheduled payments of long term debt, and the payment of
quarterly dividends account for the $10,433,000 cash used. For the nine months
ended June 30, 2001, financing activities provided cash of $35,909,000. In
December 2000, Bay Gas completed the sale of $55,000,000 of senior secured
notes. These notes, which are guaranteed by EnergySouth, are due in 2017 and
accrue interest at an annual rate of 8.45%. The proceeds from the sale of the
notes are being used in part by Bay Gas to construct the second natural gas
storage cavern, pipelines, and related equipment. Additionally, $2,650,000 of
the proceeds was used to repay a note to Mobile Gas for the financing of base
gas in the existing Bay Gas storage cavern and $18,670,000 was used to pay the
balance of the existing debt incurred to construct that storage cavern. In
connection with the early payoff of the existing debt, Bay Gas incurred an
extraordinary loss on the early extinguishment of debt of $2,454,000, consisting
of a $2,026,000 make-whole premium and a write-off of $428,000 of unamortized
issuance costs relating to the financing of the first cavern.

A significant portion of the Company's short-term operational cash needs,
especially during the winter heating season, is the cost of gas supply. A
portion of the firm supply requirements is expected to be met through the
withdrawal of gas from the storage facility owned by Bay Gas. Mobile Gas has
entered into a Gas Storage Agreement under which Bay Gas is to provide storage
services for an initial period of 20 years which began in September 1994 with
the commencement of commercial operations of the storage facility.

19

The Company also has third-party contracts, which expire at various dates
through the year 2011, for the purchase, storage and delivery of gas supplies.
The Company has a gas supply strategy in which it enters into long-term purchase
contracts to lock in prices for a majority of its expected gas sales during the
winter heating seasons.

Funds for the Company's short-term cash needs are expected to come from cash
provided by operations, current cash equivalents remaining from the Bay Gas
$55,000,000 debt issue, the issuance of First Mortgage Bonds by Mobile Gas, and
when needed, borrowings under the Company's revolving line of credit agreement.
In July 2002, Mobile Gas received approval from the APSC to issue $12,000,000 of
6.9% First Mortgage Bonds to be amortized over 15 years. It is anticipated that
these bonds will be issued in August 2002. The proceeds will be used to pay off
all current short-term borrowings with remaining funds used to finance ongoing
capital and operational needs.

At June 30, 2002, the Company had a $20 million revolving credit agreement with
a group of banks. Borrowings under the agreement may be made as needed provided
that the Company is in compliance with certain covenants in the revolving credit
agreement and other long-term loan agreements. The Company's long-term debt
instruments contain certain debt to equity ratio requirements and restrictions
on the payment of cash dividends and the purchase of shares of its capital
stock. The Company is currently in compliance with all such covenants and none
of these requirements and restrictions are expected to have a significant impact
on the Company's ability to meet its short-term cash needs.

The table below summarizes the Company's contractual obligations and commercial
commitments as of June 30, 2002:

FORWARD-LOOKING STATEMENTS

Statements contained in this report, which are not historical in nature, are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking statements are made as of
the date of this report and involve known and unknown risks, uncertainties and
other important factors that could cause the actual results, performance or
achievements of EnergySouth or its affiliates, or industry results, to differ
materially from any future results, performance or achievement expressed or
implied by such

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forward-looking statements. Such risks, uncertainties and other important
factors include, among others, risks associated with fluctuations in natural gas
prices, including changes in the historical seasonal variances in natural gas
prices and changes in historical patterns of collections of accounts receivable;
the prices of alternative fuels; the relative pricing of natural gas versus
other energy sources; the availability of other natural gas storage capacity;
failures or delays in completing the planned cavity development project;
disruption or interruption of pipelines serving the Bay Gas storage facilities
due to accidents or other events; risks generally associated with the
transportation and storage of highly volatile natural gas; the possibility that
contracts with storage customers could be terminated under certain
circumstances, or not renewed or extended upon expiration; the prices or terms
of any extended or new contracts; possible loss or material change in the
financial condition of one or more major customers; liability for remedial
actions under environmental regulations; liability resulting from litigation;
national and global economic and political conditions; and changes in tax and
other laws applicable to the business. Additional factors that may impact
forward-looking statements include, but are not limited to, the Company's
ability to successfully achieve internal performance goals, competition, the
effects of state and federal regulation, including rate relief to recover
increased capital and operating costs, general economic conditions, specific
conditions in the Company's service area, and the Company's dependence on
external suppliers, contractors, partners, operators, service providers, and
governmental agencies.

ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At June 30, 2002 the Company had approximately $88.2 million of long-term debt
at fixed interest rates. Interest rates range from 7.27% to 9.00% and the
maturity dates of such debt extend to 2023. See the information provided under
the captions "The Company", "Gas Supply", and "Liquidity and Capital Resources"
in the Company's Form 10-K for the fiscal year ended September 30, 2001 for a
discussion of the Company's risks related to regulation, weather, gas supply,
and the capital-intensive nature of the Company's business.

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PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibit No. Description
----------- -----------

99.1 Certification Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 - Chief
Executive Officer

99.2 Certification Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 - Chief
Financial Officer

(b) Reports on Form 8-K

During the quarter for which this report is filed, the Company
filed no reports on Form 8-K.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

ENERGYSOUTH, INC.
(Registrant)

Date: August 13, 2002 /s/ John S. Davis
--------------- ------------------------------------
John S. Davis
President and
Chief Executive Officer

Date: August 13, 2002 /s/ Charles P. Huffman
--------------- ------------------------------------
Charles P. Huffman
Senior Vice President and
Chief Financial Officer

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INDEX TO EXHIBITS