It is a perfect storm of conflicting economic supply/demand winds in the North American natural gas markets that is fouling the immediate futures of many independent electric generators, and the credit ratings of some of the merchant power firms are suffering, according to an industry report released last Thursday by Standard & Poor’s Ratings Services (S&P), “U.S. Power Merchants Continue to Suffer from Low Natural Gas Prices.”

Recent third quarter results from Edison International and Sempra Energy’s respective independent generators confirmed this as Edison Mission Group (EMG) reported a loss for the third quarter and Sempra Generation reported profits that were nearly half of what they had been in the same quarter a year earlier ($43 million vs. $94 million for the quarter last year).

In the past six months, S&P said it has downgraded three companies, upgraded one, and revised an outlook on another company to negative. S&P said its “most significant” ratings change was the two-notch downgrade of EMG’s Edison Mission Energy to ‘B’ from ‘BB-‘. The outlook remained negative.

That downgrade was based on declining spark spreads in a portfolio that was largely unhedged and facing what the rating agency called “significant upcoming environmental spending requirements and other committed capital on the company’s wind generation investments.”

S&P further downgraded Energy Future Holdings Corp. to “CC” from “B-” largely because of the “decline in expected gross margins from weaker merchant markets” and a decision to defer interest payments on pay-in-kind notes on top of a balance sheet that was already highly leveraged. Similarly, S&P revised Dynegy’s outlook to negative due to a weak merchant market’s harmful impact on a relatively low-hedged generation portfolio.

Conversely, S&P upgraded NRG to “BB-” from “B+” and revised its business risk profile to “fair” from “weak” due to the company’s highly hedged book through 2012 and an improved financial profile. Finally, the rating firm removed Constellation’s corporate credit rating from “CreditWatch negative” and lowered it to “BBB-” from “BBB” on the Maryland regulators’ approval of the company’s proposed nuclear joint venture with Electricite de France International. S&P said the downgrade was accompanied by a change in the company’s business profile to “satisfactory” from “strong.”

“The past year has underscored the exposure of U.S. unregulated merchant power generators to commodity price risks,” the report said. “The recession has not only decimated natural gas prices, but also increased the possibility that reserve margins tightening, which power merchants desire, will be pushed further out, changing market fundamentals. Meanwhile, additional gas supply has come in at exactly the time when demand was falling.”

Realization of strong cash flows and an improvement in financial profiles could occur much later than many power merchants hoped for.

“A lot has been said, as should be, about a plunge in demand,” according to the S&P report. “However, the supply side is also emerging as a major contributor to the bearish merchant sentiment in the near to medium term.” S&P cited the Oct. 27 preliminary report by Congressional Research Service (CRS), Congress’s public policy research arm, which estimated a 25% increase in three years in the nation’s recoverable gas reserves.

CRS said the increase represents almost 90 years of economically recoverable reserves. “While it is unclear how economical this production could be, new horizontal drilling and hydraulic multi-stage fracturing can result in lower-than-expected natural gas prices, even in the long term,” the S&P report said.

Nevertheless, the report concluded that natural gas prices will likely remain susceptible to volatility due to supply shocks.

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