SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

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

For Quarter Ended March 31, 2004

Commission File No. 0-29604

ENERGYSOUTH, INC.

Registrant’s telephone number, including area code 251-450-4774

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 by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 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 May 10, 2004 – 5,199,886 shares.

ENERGYSOUTH, INC.
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2004

INDEX

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PART 1. FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

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UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See Accompanying Notes to Unaudited Condensed Consolidated Financial Statements

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Principles of Consolidation

The consolidated financial statements of EnergySouth, Inc. (EnergySouth) and its subsidiaries (collectively, the Company) include the accounts of Mobile Gas Service Corporation (Mobile Gas); EnergySouth Services, Inc. (Services); MGS Storage Services, Inc. (Storage); a 90.9% owned limited partnership, Bay Gas Storage Company, Ltd. (Bay Gas), and a 51% owned partnership, Southern Gas Transmission Company (SGT). Minority interest represents the respective other owners’ proportionate shares of the income and equity of Bay Gas and SGT. All significant intercompany balances and transactions have been eliminated.

Note 2. Basis of Presentation

The accompanying unaudited consolidated condensed financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and disclosures 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, 2003.

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 six-month periods ended March 31, 2004 and 2003 are not indicative of the results to be expected for the full year.

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The table below summarizes operating results for the twelve months ended March 31, 2004 and 2003:

Note 3. Stock-Based Compensation

The Company accounts for its employee stock option plans under the intrinsic value recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. As stock options have been issued with exercise prices equal to the market value of the underlying shares on the grant date, no compensation cost has been recognized.

Had compensation cost for the plans been determined based on the fair value of the options on the grant date, consistent with Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and earnings per share would have been as follows:

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Note 4. Retirement Plans and Other Benefits

The Company has a noncontributory, defined benefit plan covering substantially all of its employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and average compensation during the last five years of employment, or years of service and average compensation during the term of employment. The Company annually contributes to the plan the amount deductible for federal income tax purposes.

The Company also provides certain health care and life insurance benefits for retired employees. Substantially all employees may become eligible for such benefits if they retire under the provisions of the Company’s retirement plan. The Company is accruing the costs of such benefits over the expected service period of the employees.

In December 2003, the Financial Accounting Standards Board (FASB) issued a revised Statement of Financial Accounting Standards No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (SFAS 132R) which, in part, requires interim disclosures of the net periodic benefit cost recognized for each period for which a statement of income is presented.

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For fiscal year 2004, the Company does not anticipate making any contributions to its pension plan due to the fact the plan is currently fully funded and any contributions to the Company’s postretirement benefit plan are expected to be immaterial.

Note 5. Rates and Regulatory Matters

On June 10, 2002, the 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 the allowed range; increases, however, are allowed only once each fiscal year, effective December 1, and cannot exceed four percent of prior-year revenues. Mobile Gas rate adjustments, which became effective December 1, 2003 and 2002, were designed to increase annual revenues by approximately $2.8 million and $2.2 million,

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respectively. 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. The increase in O&M expenses per customer was within the index range for the rate year ended September 30, 2003; therefore, no adjustments were required.

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 was recorded October 1, 2002 and is being recovered from customers through rates. 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%. During the year ended September 30, 2003, Mobile Gas charged $146,000 against the ESR due to revenue losses from a large industrial customer. 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; however, no such accruals have been made during the three and six-month periods ended March 31, 2004. The ESR balance of $854,000 at March 31, 2004 is included in the Consolidated Financial Statements as part of Regulatory Liabilities.

Mobile Gas’ rates contain a temperature adjustment rider which is designed to offset the impact of unusually cold or warm weather on the Company’s operating margins. The adjustment is calculated monthly for the months of November through April and applied to customers’ bills in the same billing cycle in which the weather variation occurs. The temperature adjustment rider applies to substantially all residential and small commercial customers.

The Company is subject to the provisions of FASB Statement No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS 71). Regulatory assets represent probable future revenues associated with certain costs that are expected to be recovered from customers through the ratemaking process. Regulatory liabilities represent probable future reductions in revenues associated with amounts that are expected to be credited to customers through the ratemaking process. The following table presents the significant regulatory assets and liabilities as of the stated dates (in thousands):

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In the event that a portion of the Company’s operations should no longer be subject to the provisions of SFAS No. 71, the Company would be required to write off related regulatory assets and liabilities that are not specifically addressed through regulated rates. In addition, the Company would be required to determine if any impairment to other assets exists, including plant, and write down the assets, if impaired, to their fair market value.

Note 6. Earnings Per Share

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 63,000 and 58,000 for the three months ended March 31, 2004 and 2003, respectively, and 63,000 and 60,000 for the six months ended March 31, 2004 and 2003. These differences in equivalent shares are from outstanding stock options.

Note 7. Segment Information

The Company is principally engaged in two reportable business segments: Natural Gas Distribution and Natural Gas Storage. The Natural Gas Distribution segment is actively engaged in the distribution and transportation of natural gas to residential, commercial and industrial customers through Mobile Gas and SGT. The Natural Gas Storage segment provides for the underground storage of natural gas and transportation services through the

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operations of Bay Gas and Storage. Through Mobile Gas and Services, the Company also provides merchandising and other energy-related services which are aggregated with EnergySouth, the holding company, and included in the Other segment.

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.

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Note 8. Unearned Revenue

In November 2001, Bay Gas entered into an agreement which granted a customer a nineteen-month option to transport additional volumes in excess of the volumes under long-term contract. During the first quarter of fiscal 2002, Bay Gas received $3,274,000 in consideration of the option agreement, which was fully amortized as of the end of May 2003.

Note 9. Contingencies

Like many gas distribution companies, prior to the widespread availability of natural gas, the Company manufactured gas for sale to its customers. In contrast to some other companies which operated multiple manufactured gas plants, the Company and its predecessor operated only one such plant, which discontinued operations in 1933. The process for manufacturing gas produced by-products and residuals, such as coal tar, and certain remnants of these residuals are sometimes found at former gas manufacturing sites.

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The Company conducted a preliminary assessment in 1994 of its former gas plant site and has tested certain waters in the vicinity of the site. The Company developed and has implemented a plan for the site based on the advice of environmental consultants, which involves securing and monitoring the site, and continued testing. In 2000, the Company commenced discussions with the City of Mobile regarding the possible development of the property as a city park. As part of this process, the Alabama Department of Environmental Management (“ADEM”) is conducting a “Brownfields” evaluation of the property. It is anticipated that this assessment will be completed by mid-2004. Preliminary data received from ADEM has been reviewed by the Company’s environmental consultants. Based on information received to date, the Company does not believe that the site currently poses any threat to human health or the environment. At this time, the Company continues to believe that material remediation costs are unlikely and has therefore established no reserve for such costs in its financial statements. The Company intends that, should further investigation or changes in environmental laws or regulations require material expenditures for evaluation or remediation, with regard to the site, it would apply to the APSC for appropriate rate recovery of such costs. However, there can be no assurances that the APSC would approve the recovery of such costs or the amount and timing of any such recovery.

The Company is involved in litigation arising in the normal course of business. Management believes that the ultimate resolution of such litigation will not have a material adverse effect on the consolidated financial statements of the Company.

Note 10. Accounting Principles

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. Management has determined that the Company has no material legal obligations for the retirement of its assets. However, the Company provides a provision, as part of its depreciation expense, for the ultimate cost of asset retirements and removal. Removal costs are not a legal obligation as defined by SFAS No. 143 but rather the result of cost-based regulation and therefore are accounted for under provision of SFAS No. 71, Accounting for the Effects of Certain Types of Regulation. Upon adoption of SFAS No. 143 on October 1, 2002, the Company reclassified removal costs, previously recognized within accumulated depreciation, that do not have an associated legal retirement obligation as a regulatory liability, in accordance with regulatory treatment.

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Note 11. Subsequent Event

The Company maintains The Second Amended and Restated EnergySouth, Inc. Non-Employee Directors Deferred Fee Plan (the Plan) which is a nonqualified deferred compensation plan available to each director of the Company who is not an employee of the Company. Under the Plan, the Company provides each such director with the opportunity to defer receipt of fees to be paid to such director as a member of the Board of Directors of the Company. A director who enrolls in the Plan may elect to have the deferred compensation credited in the form of phantom stock and any payments from the Plan to satisfy the deferred compensation obligations of such director will be made in shares of common stock. On April 1, 2004, the Company registered with the Securities and Exchange Commission a total of 60,000 shares of common stock of the Company to be reserved for issuance in satisfaction of the deferred compensation obligations.

The Company has established a non-qualified grantor trust (the Trust) to assist in meeting obligations under the Plan. On April 2, 2004, the Company issued 36,727 shares of common stock to fund the Trust. The assets held in the Trust are intended to be used to pay benefits payable under the Plan, but are subject to, among other things, the claims of general creditors of the Company.

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Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 merchandising, financing, and other energy-related services.

Results Of Operations

Consolidated Earnings

All earnings per share amounts referred to herein are computed on a diluted basis. Earnings per share for the three and six months ended March 31, 2004 increased $0.13 and $0.26, increases of 12% and 15%, respectively, as compared to the same prior year periods due to increased earnings from Mobile Gas’ natural gas distribution system and Bay Gas’ natural gas storage business. Financial information by business segment is shown in Note 7 to the unaudited Consolidated Financial Statements above.

Earnings from the Company’s natural gas distribution business increased $0.13 and $0.22, per share, respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods. Mobile Gas’ earnings were positively impacted by rate adjustments which became effective December 1, 2003 and 2002 based upon the guidelines established under the Rate Stabilization and Equalization (RSE) tariff. For further information on RSE, see “Natural Gas Distribution” below. Earnings were also positively impacted by an increase in temperature-sensitive customers’ gas consumption, when adjusted for weather, during the first and second quarters of fiscal year 2004 as compared to the same prior year periods. Increased margins during the current year three and six-month periods were partially offset by increased operating expenses.

The Company’s natural gas storage business, operated by Bay Gas, contributed increased earnings per share of $0.03 and $0.07, respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods. The positive earnings contributions are due primarily to increased storage revenues from its second storage cavern placed in service on April 1, 2003. Increased revenues were partially offset by additional operations and maintenance costs, depreciation expense and property taxes due to the completion of the second storage cavern.

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Earnings from other business operations decreased $0.03 for each of the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to a decrease in the second quarter of fiscal year 2004 in interest income from financing activities and additional reserves for bad debt and slow-moving inventory.

Natural Gas Distribution

The natural gas distribution segment of the Company is actively engaged in the distribution and transportation of natural gas to residential, commercial and industrial customers in southwest Alabama through Mobile Gas and SGT.

The Alabama Public Service Commission (APSC) regulates the Company’s gas distribution operations. Mobile Gas’ rate tariffs for gas distribution allow rate adjustments to pass through to customers 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, which are defined as natural gas distribution revenues less the cost of gas and related taxes.

In fiscal year 2002, the APSC approved Mobile Gas’ request for a Rate Stabilization and Equalization (RSE) tariff, a ratemaking methodology already used by the APSC to regulate certain other utilities. Rate adjustments, designed to increase annual gas revenues by approximately $2.8 million and $2.2 million, were implemented under the RSE tariff effective December 1, 2003 and 2002, respectively. See Note 5 to the Unaudited Condensed Consolidated Financial Statements for a more detailed explanation.

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 during the months of November through April 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.

Natural gas distribution revenues increased $6,007,000 (19%) and $11,756,000 (22%), respectively, during the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due primarily to the rate adjustments to recover increased gas costs paid to suppliers. Revenues also increased during the current year periods as a result of the RSE rate adjustments which went into effect on December 1, 2003 and 2002. These increases in revenues were slightly offset by a 4% decline in volumes delivered to temperature-sensitive customers during the three and six-month periods due to temperatures that were 8% and 10%, respectively, warmer than the same periods last year and a slight decline in the number of temperature-sensitive customers served during the current year periods.

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Revenues from the sale of natural gas to large commercial and industrial customers increased $366,000 (16%) and $469,000 (11%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to the increase in the price of natural gas and the RSE adjustments. The increases were partially offset by 10% and 19% declines, respectively, in volumes delivered to these customers due to higher natural gas prices and general economic conditions.

The cost of natural gas increased $4,481,000 (32%) and $8,986,000 (39%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to higher commodity gas prices. Natural gas distribution margins increased for the three and six-month periods ended March 31, 2004 primarily as a result of the RSE rate adjustments. Also, consumption by temperature-sensitive customers, when adjusted for weather, increased during the first two quarters of fiscal year 2004 compared to the same prior year periods. These increases in margin were partially offset by a slight decline in the number of temperature-sensitive customers served during the current year periods and the declines in volumes delivered to large commercial and industrial customers which are not subject to the temperature rate adjustment rider.

Revenues from transportation customers declined $97,000 (5%) and $175,000 (5%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods with a corresponding decline in volumes of 12% and 8%, respectively, due primarily to increased gas prices and general economic conditions. In addition to plant closings in recent years, a chemical company, which was a customer of Mobile Gas, ceased operations of its Mobile plant in June 2003 and some industrial plants have decreased production or switched to alternative fuels.

Operations and maintenance (O&M) expenses increased $35,000 (1%) and $176,000 (2%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods. On January 16, 2004, Mobile Gas eliminated sixteen positions, primarily in its marketing and operations divisions. Termination benefits were offered to those employees that included a lump sum payment based upon their years of service with Mobile Gas, outplacement services, one-on-one counseling and job search assistance. In accordance with Statement of Financial Accounting Standards No. 88, “Employer’s Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” Mobile Gas expensed $270,000 during the second quarter of fiscal year 2004 related to the special termination benefits.

O&M expenses for bad debt reserves increased $217,000 and $308,000, respectively, during the three and six- month periods ended March 31, 2004 as compared to the same prior year periods due to a rise in gas revenues associated with the increase in natural gas prices discussed above. In response to the corresponding increase in revenues, Mobile Gas has established additional reserves for anticipated uncollectible account balances for gas delivered during the current year winter heating season. Also contributing to the increase in O&M expenses for the three and six month periods were increases in each period in insurance and benefits expense.

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Partially offsetting the increase in O&M expenses for the three and six month periods were reductions in promotional and advertising campaigns and non-routine maintenance expenses which occurred in the prior year three month period.

Depreciation expense increased $72,000 (4%) and $144,000 (4%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to Mobile Gas’ capital expansion projects and increased investment in property, plant and equipment.

Other taxes primarily consist of property taxes and business license taxes that are based on gross revenues and fluctuate accordingly. Other taxes increased $324,000 (14%) and $654,000 (17%), respectively, for the three and six-month periods ended March 31, 2004 due primarily to the increased revenues discussed above.

Interest expense decreased $96,000 (11%) and $181,000 (10%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to a slight decline in short-term borrowing rates.

Minority interest reflects the minority partner’s share of pre-tax earnings of the SGT partnership, of which EnergySouth’s subsidiary holds a controlling interest. Minority interest decreased $30,000 (41%) and $60,000 (41%), respectively, during the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to a decline in pretax earnings of the partnership.

Natural Gas Storage

The natural gas storage segment provides for the underground storage of natural gas and transportation services, through the operations of Bay Gas. The APSC certificated Bay Gas as an Alabama gas storage public utility in 1992. Through its first storage cavern with 2.3 Bcf of working gas capacity and connected pipeline, Bay Gas thereafter began providing 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 firm and interruptible services. On March 4, 2004 in accordance with FERC filing requirements, Bay Gas filed a petition with the FERC requesting approval of rates for transportation-only service. The FERC last issued orders on October 11, 2001 and June 3, 2002 approving rates for such services.

The construction of natural gas-fired electric generation facilities in the Southeast has created opportunities to provide gas storage and transportation services. Construction of Phase I of

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Bay Gas’ second storage cavern was completed and the cavern was placed into service April 1, 2003. Bay Gas has entered into a fifteen-year contract with Southern Company Services, Inc. (Southern), an affiliate of Southern Company, for a substantial portion of the second cavern capacity. Currently, the second storage cavern has a working capacity of 3.7 Bcf and will provide sufficient capacity to serve the new long-term contract with Southern as well as other customers. Continuing cavern development is planned to provide for an additional 1.0 Bcf of working gas capacity. Together, the two caverns at Bay Gas hold 6.0 Bcf, with injection and withdrawal capacity of 200 MMcf and 610 MMcf per day, respectively, but are currently planned to hold 7.0 Bcf, with injection and withdrawal capacity of 300 MMcf and 700 MMcf per day, respectively. The additional cavern development is projected to continue in fiscal 2004 without interruption of storage operations.

Bay Gas’ revenues increased $1,211,000 (38%) and $2,500,000 (40%), respectively, during the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due primarily to additional storage revenues associated with the commencement of operations of the second cavern and a new storage agreement which was signed during the first quarter of fiscal year 2004. Storage revenues were partially offset by the expiration in May 2003 of an option agreement for transportation services over and above contracted volumes. Bay Gas entered into an agreement in November 2001 which granted to a customer an option to order transportation of additional volumes in excess of the volumes currently under long-term contract. Bay Gas received $3,274,000 in consideration of the option agreement which was amortized over the nineteen-month option period. See Note 8 to the Unaudited Condensed Consolidated Financial Statements for additional information pertaining to the option agreement.

Operations and maintenance (O&M) expenses increased $191,000 (31%) and $456,000 (43%), respectively, during the three and six-month periods ended March 31, 2004 as compared to the same prior year periods primarily due to a general increase in operating costs as a result of the expansion activities of Bay Gas.

Depreciation expense increased $93,000 (18%) and $185,000 (18%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due primarily to the second storage cavern which was placed in service in April 2003.

Other taxes consist primarily of property taxes and those taxes increased as a result of the commencement of operations of Bay Gas’ second storage cavern.

Allowance for borrowed funds used during construction represents the capitalization of interest costs to construction work-in-progress. Capitalized interest costs decreased $584,000 and $1,148,000, respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to the completion of Bay Gas’ second storage cavern.

Minority interest reflects the minority partner’s share of pre-tax earnings of the Bay Gas limited partnership, of which EnergySouth’s subsidiary holds a controlling interest. Minority interest increased $32,000 (26%) and $69,000 (29%), respectively, during the three and six-

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month periods ended March 31, 2004 as compared to the same prior year periods due to increased pretax earnings of the limited partnership.

Other

Through Mobile Gas and EnergySouth Services, Inc., which are aggregated with EnergySouth, the holding company, the Company provides merchandising, financing, and other energy-related services to comprise the Other category. See Note 7 to the Unaudited Condensed Consolidated Financial Statements above for segment disclosure.

Income before income taxes from Other business activities decreased $182,000 and $211,000 for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods due to a decrease in interest income from financing activities and the establishment of additional reserves for slow-moving merchandise inventory and bad debt reserves associated with financing activities during the second quarter of fiscal year 2004.

Income Taxes

Income taxes fluctuate with the change in income before income taxes. Income tax expense increased $540,000 (16%) and $959,000 (18%), respectively, for the three and six-month periods ended March 31, 2004 as compared to the same prior year periods.

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. Impacts of operating, investing, and financing activities are shown on the unaudited Consolidated Statements of Cash Flows. Cash provided by operating activities increased $7.8 million during the six-month period ended March 31, 2004 as compared to the same period last year due primarily to collections of increased gas costs from customers. See the Natural Gas Distribution section for additional information regarding the pass-through to customers of the cost of gas.

Cash used in investing activities reflects the capital-intensive nature of the Company’s business. During the six months ended March 31, 2004 and 2003, the Company used cash of $4.1 million and $7.8 million, respectively, for the construction of distribution and storage facilities, purchases of equipment and other general improvements. Also included in the $4.0 million is Mobile Gas’ acquisition of a natural gas distribution system located in Mt. Vernon, Alabama located just north of its service territory and costs associated with the continuing expansion of Bay Gas’ second cavern.

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Financing activities used cash of $7.5 and $5.0 million during the six months ended March 31, 2004 and 2003, respectively. The $2.5 million change in financing activities is due primarily to repayments of long-term debt, including an additional principal payment of $1.7 million allowed under Mobile Gas’ 7.27% Series First Mortgage Bond Agreement.

Funds for the Company’s short-term cash needs are expected to come from cash provided by operations and borrowings under the Company’s revolving credit agreement. At March 31, 2004 the Company had $20.0 million available for borrowing on its revolving credit agreement. The Company pays a fee for its committed lines of credit rather than maintain compensating balances. The commitment fee is 0.125% of the average daily unborrowed amount during the annual period of calculation. The Company believes it has adequate financial flexibility to meet its expected cash needs in the foreseeable future.

The table below summarizes the Company’s contractual obligations and commercial commitments as of March 31, 2004:

Critical Accounting Policies

See “Critical Accounting Policies” under “Management’s Discussion and Analysis of Financial Condition and Results of Operation” included in the Annual Report on Form 10-K of the Company for the fiscal year ended September 30, 2003.

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 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; disruption or interruption of pipelines serving the Bay Gas storage facilities due to accidents

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or other events; risks generally associated with the transportation and storage of 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.

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Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At March 31, 2004 the Company had approximately $93.9 million of long-term debt at fixed interest rates. Interest rates range from 6.9% 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 Annual Report on Form 10-K for the fiscal year ended September 30, 2003 for a discussion of the Company’s risks related to regulation, weather, gas supply and prices, and the capital-intensive nature of the Company’s business.

Item 4 CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, an evaluation (the “Evaluation”) was carried out, under the supervision and with the participation of the Company’s President and Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (“Disclosure Controls”). Based on the Evaluation, the CEO and CFO concluded that the Company’s Disclosure Controls are effective in timely alerting them to material information required to be included in the Company’s periodic SEC reports.

Changes in Internal Control

Internal controls for financial reporting were also evaluated and there have been no significant changes in internal controls or in other factors that could significantly affect those controls subsequent to the date of their last evaluation.

Limitations on the Effectiveness of Controls

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

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PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

		On January 30, 2004, EnergySouth, Inc. filed its current report on Form 8-K reporting earnings for the quarter ended December 31, 2003 and declaration of a dividend.

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.

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