Political, Regulatory Risks Pummel 2Q Gas, Power Earnings

Natural gas and power companies reported their "worst quarterly performance...since early 1998," off 8% overall in the second quarter, versus a 5% gain in the Standard & Poors 500, according to a review by Credit Suisse First Boston Corp. (CSFB). Most problematic for the quarter, said analysts, were "unpredictable" political and regulatory risks, which, combined with lower gas prices, had a negative impact.

Merrill Lynch's Donato J. Eassey also noted last week that a "variety of political --- and not fundamental --- issues" caused problems for energy merchant companies. "The current shrieking we hear is not only the energy investor's cry of pain from the recent valuation decimation stemming from California, it is the sound of the proverbial baby being thrown out with the bath water," he said in his review of energy merchants.

Analyzing earnings of the largest power and gas marketers in the industry, including Enron Corp., El Paso Corp., Williams Co. and Dynegy, CSFB analysts, led by Curt Launer, found that "in each case our analytical conclusions are that the market capitalization losses of these companies in particular and the industry in general far exceed the `worst case' scenarios."

A lot of the problem, said CSFB, is related to the energy crisis in California. "The call for nearly $9 billion of refunds by generators to `Californians' by the governor of California and the hearings at the Federal Energy Regulatory Commission strike us as another example of a politically motivated ploy that has no basis in fundamentals, economics or facts."

CSFB noted that "as with other regulatory and political issues that have impacted the group, we view the current valuations of these stocks as more than adequately reflecting the worst case scenarios in the refund matter." CSFB's fundamental research found that the energy industry's business conditions were good, and that "earnings growth is being delivered." Analysts also expect a "modest upturn in industry sentiment" in second quarter earnings reports and "further recovery as the regulatory and political environmental quiets down and summer heats up."

According to CSFB, the natural gas and power group underperformed the S&P 500 by more than 10% as the second quarter ended, posting an 8% drop compared with a 5% gain for the major market index. The decline accelerated following the April bankruptcy filing by Pacific Gas & Electric Co., analysts noted, and continued as natural gas prices fell.

However, falling earnings were offset by a "marked increase in the demand for outsourcing and risk management-type services. We expect new contract origination to rise significantly, leading to increased merchant earnings across the industry."

Even though natural gas prices have fallen, analysts "anticipate the best quarterly comparisons will result from commodity leverage." CSFB's natural gas price projections include an estimated price of $4.21/Mcf versus $3.43/Mcf in the second quarter of 2000. Its full-year gas-pricing estimate for 2001 now is $4.60/Mcf versus $4.07/Mcf in 2000.

"Strong year-over-year second quarter results, driven by high utilization rates of virtually all industry assets and volatile gas and power markets, add to the pluses evident" in the sector and support the "overweight" rating for the group, said analysts. "We consider the recent declines related to the political and regulatory environment as adding to the opportunity to invest for fundamental growth at low valuations."

Among the majors, CSFB analysts expect Kinder Morgan, with no California risk, to show a 64% increase in earnings per share growth in the second quarter. Dynegy is predicted to have a 38% increase, Williams 30%, Enron 20% and El Paso 8%. The largest percentage increases in the overall group, however, are mostly due to commodity leverage, and will be found in earnings of National Fuel Gas, up 228%; Questar, up 49%, PG&E, 30%; and Dominion Resources, up 19%.

CSFB now projects natural gas demand growth at 2.5-3% annually through 2005, with prices in the $3-4/Mcf range. Power demand is expected to increase at 2%, with average annual prices increasing. "Significant increases in demand for merchant outsourcing and risk management services keeps all industry assets operating at high rates of capacity utilization."

CSFB also sees an increased role for liquefied natural gas (LNG) and Canadian imports to meet the domestic gas demand. Analyst models show Canadian imports (15% of total) growing at 5-8% a year, with LNG imports (less than 1% of total) growing at 15-20% a year. "We project that LNG will supply 6-8% of U.S. demand in 2005."

Analysts also noted that President Bush's proposed National Energy Policy would add to the "credibility of growth rate forecasts for the merchant and asset-based portions of the industry growth rate, which we estimate at 15-18% in earnings per share over the next three to five years." Even though the policy lacks bipartisan support, CSFB analysts said that the "movement toward easier certification of new pipeline construction, new construction and improved access to the electric transmission grid as well as an overall emphasis on energy supply all point to potential pluses for the regulated and unregulated assets, investments and returns in the industry."

Merrill Lynch's Eassey said the "most recent concerns" also related to California Gov. Gray Davis asking for refunds. "In our view, the (energy merchant companies) are far from the rhetorical `energy pirates' and more like convenient scapegoats for California's energy woes; with ultimate redress through the courts still available, we believe the (energy merchant companies) remain on solid ground."

Eassey noted that while stock technicals now were "admittedly challenging, we believe fundamental investors are expected to get a major boost in the form of strong second quarter earnings and companies' firm reiterations of longer-term growth rates." He said that "the fact remains" that the United States will be in short energy supply for the next five years in both natural gas and power, and it is the energy merchants that "have the tools, talent and financial wherewithal necessary to rebalance long-term supply and demand."

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