Merrill Lynch: 'Concerns du Jour' Pressuring Energy Sector

The departure of Sen. James Jeffords from the Republican Party, declining natural gas prices and the absence of hot weather are beginning to ripple throughout the energy industry, with many of the leading energy stocks dipping lower last week and creating an "increasingly selective" investing environment, said Merrill Lynch analyst Donato J. Eassey Thursday.

The natural gas sector overall was down an average of 5.2% at the end of last week and is off 14.1% year-to-date, "primarily the result of the continuing rhetoric flowing out of California as well as the seasonal slackening demand for natural gas, resulting in lower commodity prices," Eassey said.

However, Merrill Lynch maintains its stance that "nothing has changed with respect to fundamentals." The investment firm expects earnings per share (EPS) growth this year, relative to last year, to average 24% for natural gas energy merchants. In 2002, the growth will be around 20%.

"These expectations are supported by our belief that the volatility in natural gas prices, and not the absolute price level, will continue to drive growth in these companies' merchant operations north of 30% annually," Eassey said.

Merrill Lynch's Henry Hub price projection is $5.00/Mcf in 2001, "moving to $4.25 in '02." Eassey noted that this year's estimate is below Nymex's strip of $5.07/MMBtu.

In his Natural Gas Weekly Perspectives, Eassey noted that many of the leading energy merchant, independent power producer and utility stocks are coming under pressure because of the "political changes in Washington and the potential adverse implications for the Bush Energy Plan (including the possibility for price caps on power in the West)."

Also, the declining natural gas and power prices nationwide are driving down stocks because of "the absence of any sustained hot weather and concern regarding oversupply." However, the analyst said that he believes the "ultimate outcome will have to be one that maintains reliability as well as be one that the markets (both industry and equity) can handle. At the end of the day, companies and investors need to see long-term incentives for investing in the infrastructure necessary to rebalance supply and demand."

If caps are imposed in the West, "we believe that they would need to be set at a relatively high level in order to keep the lights on." He noted that "most of California generators have locked a majority of their supply in long-term contracts with the state that would not be subject to caps."

The Merrill Lynch analyst said he was less worried about the political problems and more worried about the markets, specifically the declining natural gas prices and the coming summer months. "While the early robust build in gas storage was not completely unexpected, given the significant deficit to last year and the expectation for price spikes during the summer's peak, this has clearly led to an increase in weather-risk, with a normal summer now critical to maintaining price strength."

Eassey said a cool summer would reduce earnings per share potential for the uncontracted portion of portfolios, and "could also hurt investor sentiment." However, a hot summer where power prices remained at current levels would raise more near-term concern about "generation overbuild."

Even with the current "concerns du jour," Eassey noted that "it is the volatility in energy prices rather than the actual price" driving profitability in the energy sector. "Indeed, we believe many of these companies are taking full advantage of these downward price moves just as effectively as they did on the way up."

Eassey noted that investors could take advantage of "price weakness" in the energy merchant sector, "building larger positions particularly in the lower price/earnings names," including Williams Cos. and El Paso Corp.

Meanwhile, Steven Fleishman, head of Merrill Lynch's global power and gas research group, last week said that energy merchant and power generation company earnings could jump more than 30% in 2001, while earnings for integrated electric utilities could rise 12%. "We expect a renewed focus on companies that are low-cost producers, have locked in margins through long-term contracts, and have the merchant capability to take advantage of the inherent volatility in the energy sector," Fleishman told reporters during a regularly scheduled "Merrill Lynch Bull Sessions" program last week.

Looking at the corporate power picture, Fleishman noted that "after a sparkling year in 2000, this year has been a roller coaster" for independent power producers (IPPs) and the utility sector. At the same time, he noted that "fortunately, there have been more ups than downs." IPP share prices through late May are up 10%, while electric utilities are down 1.7%, or flat, excluding California utilities. In either case, those shares and IPPs outperformed the Standard and Poor's 500 Index, which was down 5% over the same time period.

"The energy crunch is driving higher prices and returns for the industry and attractive opportunities for new investment," Fleishman said. "Price volatility is fueling striking merchant profits and renewed interest in long-term contracts," the Merrill Lynch executive continued. "And, on a related basis, the California crisis has created a political and legal overhang on the industry as officials try to fix the energy crisis," he added. Overall, despite the concerns, "we contend that the competitive market is working," Fleishman said. "The industry is drilling for gas and adding power plants at record levels," he went on to say, noting that price spikes in these commodities have already shown an impact on softening demand. "To that end, we are already beginning to see market prices start to fall, helping to solve the crisis," the Merrill Lynch executive stated.

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