Investors Show Mixed Feelings for FERC's Power Market Ruling

Many energy stocks were hammered hard intially by FERC's western power price mitigation order last week, but the stocks of some generators, marketers and utilities managed to rebound by the end of the week as investment bankers attempted to put a positive spin on the expected impact of the order.

After starting the week above $41, Duke Enery shares bottomed out Friday morning near $38 but rebounded during the day back above $40. Reliant started the week in the mid-$30s, but cascaded down about $4 throughout the week. Enron shares dipped sharply Tuesday losing more than $5 from Monday's high but regained some ground during the week. Williams shares lost about $2 during the week. And Dynegy shares lost ground initially and were volatile throughout the week but ended Friday only down about $1 from the previous Friday.

"We have mixed feelings about this order," Steve Fleishman of Merrill Lynch said in a conference call on Tuesday. While the order should bring some positive stability to the market, it certainly will limit earnings growth from western generation and marketing operations, he said. "On the positive side, there are several points. First, we now have some clear rules of the game. Secondly, it does stick with a market-based program, not specific cost-based rates," he added.

A price cap of about $108/MWh can be calculated using the methodology of 85% of the price in the most recent power emergency, according to Curt Launer of Credit Suisse First Boston. "This compares to our expectation of a $100 limitation. This level is high enough to have no impact on our estimates or valuation targets."

Launer said that his initial concerns about limitation on trading because of the linking of the western states in one market "appear inaccurate because the new rules only affect spot market transactions. Only 20% of California power purchases are spot currently, versus nearly 100% in Dec. 2000." He said the impact on the earnings of Enron, El Paso, Dynegy and Williams "is negligible" and "significantly overdone in terms of valuations."

Initial reactions from politicians on Capitol Hill were positive, with several price cap bills put on hold (see related story). "The key here is this can stem a lot of the political rhetoric and help eliminate some of the overhang on the [companies involved in the western energy market]," said Fleishman. "We hoped we could see something of a relief rally in the stocks...and we seem to be seeing at least a little bit of that."

"We do have concerns, however," he added. It's going to be more challenging for some companies to repeat the growth they've seen the last couple quarters in the West, particularly for those without long-term contracts, according to Fleishman. In addition, the plan probably will limit the price volatility in the spot market, which in turn will lower margins from marketing.

"We could see a flattening out of power prices over the course of the year, which is certainly beneficial to those who are long shoulder month and short peak," he added. "It certainly could move more and more power to the contract market and into the forward markets and away from spot markets."

Those companies that will suffer the least under the new constraints, according to Merrill Lynch, will be those that have locked in long-term contracts for their generation and those that have efficient base-load power for competing against inefficient plants that are setting the caps. "Those that we think will be challenged are those that have less of their capacity under long-term contracts, those that are more dependent on inefficient peakers and those that might be affected by somewhat less volatility in the West than we had in the last few quarters," said Fleishman.

Merrill Lynch's Elizabeth Parrella said nearly all of the merchant generation companies with energy assets in California have sold forward most of their expected output for the balance of the summer if not the entire year. "We would anticipate little if any earnings impact in 2001. With respect to next year, the story is a bit more differentiated." AES, Calpine and NRG should not experience any material impact on earnings, she said. "We think that Mirant and especially Reliant are more exposed, given that a relatively smaller amount of their California portfolios is under long-term contracts."

Despite not signing long-term agreements with the state Department of Water Resources, Duke Energy said it has been aggressively hedging its positions in the West. AES has a long-term tolling agreement with Williams. Calpine is a low-cost baseload generator with large long-term agreements and minimal sales on the spot market. NRG and Dynegy own peaking capacity but have signed long-term contracts with the state through the end of 2004. Mirant's capacity is about two-thirds contracted in 2001, but only about 50% is under contract for 2002, according to Parrella.

On the marketing and trading side, the decrease in wholesale power market volatility should impact earnings negatively, but most of Mirant's margin is from the gas side, Parrella noted. "Reliant Resources is perhaps in the worst position with its peaking plants and its desire to avoid long-term agreements. The West also represents a bigger percentage of total earnings for Reliant than it does, say for example, for NRG or Mirant," she said. "Reliant could come out fairly vocally in opposition to FERC's mitigation plan."

Reliant said in a news release that FERC's new price order, coupled with the increasing lack of certainty with respect to market rules in the West and the unsettling political and regulatory environment in California, will "further destabilize the market."

"We are very concerned that consumers throughout California and the West will be misled by statements made today implying that the battle is won, given recent price drops. Nothing could be further from the truth," said Joe Bob Perkins, president of Reliant Energy Wholesale Group. "Recent price drops are being driven primarily by a temporary weather-driven supply respite, not price controls. Without sound economics that increase available supply and reduce peak demand--and a local/state business environment that encourages new generation investment--consumers can only hope for favorable weather and look forward to forced allocations."

Merrill Lynch analyst Donato Eassey, who had been adamant in his opposition to FERC imposing any kind of rate limits in the western power market, attempted to put a positive spin on the regulatory action in an effort to cool investor concerns. "It does bring some sensibility back to the marketplace and some stability, and I think stability was what was needed in removing a great deal of ambiguity. We think that the fear factors are going to be fading. Keep in mind that most of this has already been priced in [to energy company stocks]. We've lost about $46 billion just with Enron, Dynegy, El Paso and Williams alone. Clearly the market has already taken into account much of what is out there. Their earnings are not going to be that impacted. Both [Williams and Dynegy] possess significant shock absorbing ability. Dynegy markets 3.6 Bcf/d of gas, most of it Chevron's, and will be marketing another 3.5 Bcf/d, assuming they close on the Texaco deal.

"We're still short supply and long demand. The basic equation hasn't changed," said Eassey. "That's going to work into both Dynegy's and Williams' favor very nicely." He noted El Paso could be affected by a FERC ruling in the ongoing gas manipulation case. "Our big concern about El Paso is that they are still the main lightning rod out there, and FERC may now try to get them to the table and get a settlement done."

Eassey said despite the initial decline in Enron's stock price below its 52-week low on Tuesday, to a new low of about $42.35, the company has a stable market position in the West. Enron's stock price subsequently rebounded to end Tuesday up 3.3% after the company publicly confirmed its earnings targets. "There's a lot more to it than what meets the eye here with Enron," Eassey noted. "The tech aspects of the stock are bringing bears out of the woodwork. Keep in mind that less than 10% of their spot market transactions are done on the western side of the nation because those markets aren't open. But Enron tends to be somewhat of a lightning rod." He said that other negative issues, including Enron's activities in Brazil and India, have had an impact. "I think a kaleidoscope of issues have affected the stock. I think that when it's trading below its growth rate like right now, it's an opportunity. But that being said, as the quarter comes to a close here, there could be some further pressure on the stock."

Enron CEO Jeffrey K. Skilling was forced to issue a statement Tuesday reiterating that Enron's business continues to be strong. "Interest in our energy delivery and energy management capabilities has never been higher," he said. "Having reviewed the recent FERC action on price controls in the western U.S., we remain very confident that we will meet the market's consensus recurring earnings estimates of $0.42 and $1.79 per share, respectively, for both the second quarter and full year 2001. We're hopeful this action allows FERC to now concentrate on the vitally important task of opening the nation's electricity grid so that power can move from where it's plentiful to where it's needed."

Eassey said FERC's price mitigation efforts should have a positive impact over the long term. "I think that the stability that this order is probably going to bring to the market, will in fact expedite other markets to move forward over time as their confidence starts to grow that they won't let things get out of hand and they can unbundle markets."

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