The utility sector is continuing to benefit from an ongoing improvement in credit fundamentals as well as an overall increase in the “risk appetite” of investors in 2003, according to a report issued last week by CreditSights analysts.

Even though the second quarter investment grade utilities only delivered a 4.94% total return, which lagged the aggregate index’s 4.98%, there was solid evidence of improved performance by many of the companies that had fallen from investment-grade status in the past two years, according to analyst Louise Purtle.

“The ability of names like AES Corp. and Reliant to execute debt exchanges and tap the capital markets captures the extent to which investor risk appetite has increased in what had been one of the most troubled sectors,” Purtle said in a report issued last Wednesday.

In the last half of the year, however, Purtle believes that the repeal of the Public Utility Holding Company Act (PUHCA) holds the biggest implications. “Repeal of the legislation, which has been around since 1935, is making glacial progress through Congress and it is by no means certain that it will pass. But investors would be well advised to consider the implications for utility bondholders.”

Purtle believes that PUHCA has prevented industry “rationalization,” and its repeal “would likely spur a round of consolidation that would inject new blood and new management into the sector, welcome news given the travails that have plagued investment returns since the California energy crisis first broke in January 2000.

As the second quarter closes, other CreditSights analysts have found that on the distribution side, usage was basically flat overall, and despite “massive” overcapacity in some regions, “prices are up everywhere,” which mainly will “benefit companies with excess coal and nuclear generation that they can sell into the market.

Spark spreads narrowed in several regions, making it difficult for “even the most efficient gas-fired generators to make money there,” noted analysts Dot Matthews and Andy DeVries. “However, ERCOT spark spreads were up over 100%, a boon to all those new plants in Texas. Overall, we expect a good quarter from the distributors, a mixed quarter (but better than we expected at least for some at the start of the quarter) from the gas-fired merchants, a very good quarter for any surplus nuclear and coal generation and a blow-out quarter for companies with E&P assets.

“Based on the numbers, we would expect distributors in the South Central, Rocky Mountain and Pacific Northwest to report somewhat better numbers, quarter-over-quarter, with those in other parts of the country seeing basically flat earnings, absent a company-specific situation like a recent rate rise. Some distribution companies may still report lower earnings, especially those in the Midwest,” where the quarter was cooler than normal, but not cool enough to require a lot of heating usage.

Despite flat usage in the quarter, the analysts noted that electric spot prices had been impressive. “One could argue they were so low in Q2 2002 that they had no place else to go but up. However, militating against that theory is the fact that almost everywhere in the country excess capacity is up over last year, as more plants are completed and come on line. With more plants to be finished this year and next, the massive overcapacity situation isn’t likely to change for the next two to three years.”

Another factor that may hold down prices and spark spreads in the second quarter and going forward is the availability of hydro generation, said CreditSights. “After all, free is free. More hydro production also makes it less necessary to run some fossil fuel plants, so the last marginal plant going on the system will be more efficient than would be the case in a drought. Much of the Northeast nearly drowned in the quarter, so while hydro isn’t a big part of the load, it will contribute to generation.”

Going forward, higher natural gas prices will be a problem for generators and consumers alike, said analysts. “In times of high demand, the cost of turning on some gas-fired plants could cause price spikes. The growing concerns about natural gas shortages in the U.S. may force the government to back clean coal or even nuclear construction, to the detriment of all those newly constructed gas-fired plants.”

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