Speculative energy trading is history for American Electric Power (AEP), which said Thursday that the company will instead focus on asset-based energy trading and marketing geographically — wherever it has facilities — becoming more conservative, more cost efficient, more cash-wise and less growth oriented.

The massive changes in what was once North America’s largest wholesale power trader and one of the top three natural gas marketers, will come at a price, however. AEP has revised downward its year-over-year earnings for 2002, and also expects flat-to-lower earnings for 2003. AEP expects to now earn in a range between $2.85 and $3.15 per share this year, down from an earlier forecast of $3.20-$3.35 a share. In the third quarter alone, estimated earnings will be about $1.05.

The losses at the Columbus, OH-based utility company have come quickly. AEP Wholesale was the number one North American power marketer in the second quarter, according to NGI‘s rankings, with sales of 185,387 MM kWh. It reported 198,906 MM kWh sales in the first quarter of 2002 (see NGI, Sept. 6). AEP also was the third largest natural gas marketer in NGI ‘s second-quarter survey of North American gas marketers, reporting sales volumes totaling 15.35 Bcf/d for the quarter, as well as 16.40 Bcf/d in the first quarter of 2002. Ironically, Aquila Wholesale was ranked number two in NGI‘s second-quarter survey, and it also has exited speculative energy marketing and trading.

With speculative trades gone, estimated earnings overall for the third and fourth quarters of 2002 will be 18 cents lower than earlier AEP estimates. Also losing money in the second half of this year will be AEP’s retail and wholesale costs, especially in Texas, where it is mothballing at least seven power plants. Those inactive facilities will take earnings down another 10 cents. And 2003 gets no better: earnings are expected to be flat or even lower.

CEO E. Linn Draper emphasized that the decision “doesn’t reflect a lack of confidence in the competence or integrity of our trading operations.” He said there would be reductions within the energy trading and marketing division “but I anticipate that many will remain with the company.”

However, five employees were fired last week after they were caught giving false data to energy trade publications for use in calculating indexes. In a press release the company said it discovered the inaccuracies during an internal review of its trading activities. Prior to learning about the reporting of inaccurate data, AEP had instituted measures to require that all price information provided for use in market indexes be verified and reported by the office of AEP’s chief risk officer. AEP said it could not determine if the inaccurate data had any impact on the published indexes.

“We did not approve and we do not condone this sort of activity,” said Eric van der Walde, executive vice president of AEP Energy Services. “We are serious about ethical business practices and took action immediately after discovering this activity.”

He declined to speculate on how many personnel are now in the trading unit, or how many sales are being made. van der Walde said the wholesale unit has changed its strategy and will focus on asset-based sales alone.

“We will scale back our market activity so that it will be centered around our assets. We will be in power markets in the Midwest and Texas, natural gas in the Gulf Coast region and Texas, and the power and coal markets in the United Kingdom.”

He said he did not anticipate unwinding contracts, but rather letting them continue until they are completed. “We are just putting this concept in place and expect to implement it in the next two weeks.”

Asked specifically whether AEP would follow Aquila and exit energy trading, van der Walde hedged his answer and affirmed that AEP would “optimize the assets that we have, and trade geographically where we own physical things.” He said contracts outstanding may be wound down “naturally,” but added the company would “look at each situation individually to see what makes sense. If there is nothing for us, we’ll let it wind down naturally as well.”

AEP Energy Services was created in 1997 as the wholesale marketing and trading subsidiary, and has routinely remained with the top five of North American wholesale marketers for both power and natural gas. The division also operates, and will continue to operate, about 22,000 MW of U.S. and UK generation, 6,400 miles of gas pipe and 128 Bcf of storage.

As part of its pullback in Europe, where it employs 140 people overall, AEP is leaving the German or Nordic power markets “in an orderly fashion,” and will only trade in the United Kingdom, where it owns the Ferrybridge C and Fiddler’s Ferry power stations in northern England. The plants are two of England’s largest coal-fired facilities. The move to end speculative trading most likely will affect volumes in the UK market, where AEP was a key participant in the trading platform IntercontinentalExchange. Its staff included many ex-Enron Corp. traders, which AEP hired after the company was bankrupt.

Asked about expansion in other areas going forward, Draper was firm. “It is clear in today’s environment, that it’s not the time to be spending on capital acquisitions. You shouldn’t expect to see any significant acquisitions in the near term.” In fact, along with cutbacks in wholesale trading, AEP is now working with its management team to make capital cuts across the board. Without them, AEP will not hit its revised targets for this year, said Susan Tomasky, AEP’s executive vice president of policy, finance and strategic planning.

“It’s certainly no surprise that we have had pressure on earnings in the near term,” said Tomasky. To reach AEP’s fourth-quarter target of 78 cents in earnings — or the low end of $3 in earnings per share for the entire year 2002, Tomasky broadly described AEP’s cost-cutting plan that will include company reductions across the board, including personnel. Nearly $128 million has already been identified in budget reductions, she said, but the real work now will begin.

“If we assume that our trading contributions are zero for the rest of the year, we could go down [in earnings] another 15 cents,” she said. “On the upside, if we have a return to normal weather, improvement in system sales and value-added components from generation optimization, we could go up 15%. That’s the best picture I can paint for you today.”

Into 2003, Tomasky said the key drivers will be retail sales. It will be a flat year in Texas because of low growth and the loss of customers, as well as uncommitted generation in its ECAR operating area. With only asset-based marketing for power and gas sales, she estimated AEP could earn about $110 million, which would be at least $50 million less than this year’s estimated sales.

“Critical” to earnings for 2003 will be AEP’s operating costs, said Tomasky. “The forecast shows retail loads and system sales will be flat, trading and new investments will be down, and AEP is also facing significant increases in pension and healthcare costs.” She said there is a systematic effort now under way to achieve reductions across the company to guarantee “sustained” savings going forward. Those cuts will be “sufficient to meet our earnings’ targets,” she added. “We expect to identify many reductions by the end of 2002.” She estimated a $30-$40 million reduction in operations, with flat capital costs, and some increase in interest from this year.

Draper said that they are “looking throughout the organization” for places to scale back costs. “Every single manager is charged with finding reductions in his or her part of the organization.”

AEP’s liquidity remains solid, Tomasky said. The company currently has $3.5 billion in lines of credit for backup; $2 billion of commercial paper outstanding; $1.7 billion set aside for corporate separation putting AEP’s regulated assets into a new holding company, which was already planned to be completed by the end of 2003; and $600 million outstanding that matures in April 2003. “We also have $300 million in cash set aside for a rainy day,” Tomasky added. As far as debt payments coming due, AEP has $3.5 million that matures in May 2003 and another $1 billion rolls off a year later. In a worst-case scenario, which would include a downgrade below investment-grade, AEP would most likely borrow in the short term against its credit lines.

As to whether the AEP board of directors might consider cutting the 60 cent dividend, Draper and his team could offer no answers. While he plans to recommend keeping the dividend, he said that the board would be making that decision when it meets as scheduled on Oct. 23.

CreditSights analysts appeared somewhat skeptical following the latest conference call that AEP would keep its dividend, considering its current financial problems. They noted, “AEP steadfastly held to its current dividend, which would mean a payout, at current prices, of around 85%! CEO Draper said they will lower that ratio by boosting earnings, but he also said 2003 earnings will be flat to this year. We weren’t entirely satisfied by the call, and still have some questions and doubts, but we just can’t see AEP as a high yield name. We wouldn’t sell at current levels (AEP `06’s were as low as 72 yesterday morning but rallied to about 80 bid at day’s end), and, for those who can stand likely further volatility, we would give serious thought to buying.”

Noting that they thought AEP had done a “decent job of handling the situation,” especially its move to downsize trading and marketing, analysts also found that AEP’s decision to not build or buy for the foreseeable future “shouldn’t be a real issue for the next year or two, especially in Ohio.”

Said analysts of its UK problems, “AEP is planning on earning $0.10 on the ‘new investments’ and that is part of the upside scenario of $3.15, but may not be achievable. To us, it signals that AEP still doesn’t buy things at correct prices (or just buys the wrong things), but the good news is, they won’t be buying anything else for the foreseeable future. Draper said AEP is basically going to hunker down and not be a buyer of assets, which is good news for bondholders, but bad news for those increasingly desperate sellers out there.”

Reiterating that AEP expected it would be at 46% equity by the end of the year, CreditSights expects Moody’s Investors Service to downgrade the company at least one notch, with “two notches a good possibility and we also think S&P might eventually weigh in with a one- or two-notch move. However, we just don’t see AEP as a below-investment-grade credit, unless they are hiding a whole lot more than we think possible…For those who can stomach the volatility and possible further bad news, we would consider being buyers, mindful that the ride can still be quite wild.”

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