In a small bit of irony last December when Enron Corp. had filed for bankruptcy, American Electric Power’s Eric van der Walde, the executive vice president of trading and marketing, said the wholesale energy marketplace was “bigger and stronger than any one company” and other leading wholesale energy providers would weather the storm and fill “any market needs that may arise.” That was then, this is now. Few market observers are so confident today.

There was a near complete absence of confidence in the energy market and its players last Tuesday, a day that many energy merchants may well refer to as Black Tuesday. It was a tragic day on Wall Street, in which almost no company with a marketing and trading arm escaped unscathed. The day began with Dynegy Inc. reducing its 2002 outlook for cash flow; Duke Energy warning that it would not meet its earnings estimates for the year; and with El Paso Corp.’s off-balance sheet business transactions being questioned by the Wall Street Journal and The New York Times (see related stories).

Analysts followed with downgrades of several energy merchants, but perhaps the most devastating was a report by Banc of America analysts Tuesday in which 11 energy merchants were downgraded. “Due to ongoing risks that are impossible to quantify, the wholesale energy group continues to suffer the death of 1,000 cuts,” analysts William Maze and Shelby G. Tucker said. “Although we downgraded the sector at year-end, we did not go far enough, as we misjudged…risks which continue to rise…all brought on by the snowballing effects of Enron’s collapse” (see related story).

Investors, apparently, could take it no longer. More than 33 million shares of Dynegy exchanged hands Tuesday (the usual volume is 7 million), and the company dropped as low as 91 cents, before rallying near the end to close at $1.23, off 64%. The week Enron filed for bankruptcy, Dynegy was selling for about $31.

However, Dynegy did not suffer alone. Every one of the 27 energy merchants that NGI covers lost value on Tuesday, including Reliant Energy Inc., down 42%; Reliant Resources Inc., 39%; Williams, 40%; Mirant Corp., 31%; El Paso Corp., 23%; and Calpine Corp., 23%. Williams closed at $1.19. AEP, which months ago expected no fallout from Enron, was down almost 10% to close at $23.51; in December 2001, it was selling for $41.50. Even companies that so far have been unscathed by scandal or investigations were hit Tuesday, with TXU Corp. off more than 10%, while Dominion and Entergy Corp. were down about 9%.

As the never-ending negative news continued on Tuesday, the bond market also weakened, pulled down by the energy sector. Dynegy’s bonds fell the most, 10 points to a bid of 35 cents on the dollar, and were quoted at the same price regardless of maturity, a sign that the market expects a bankruptcy filing, according to traders. If Dynegy were to file for bankruptcy, the bondholders would rank equally in asset claims, regardless of maturity. Williams’ bonds were down about five points, and its 10-year paper was bid at 40 cents on the dollar, which was down five cents from the day before.

The situation prompted Federal Energy Regulatory Commission Chairman Pat Wood to warn Congress that credit and liquidity problems at several top pipelines and power companies could put a major crimp in future plans to bolster the nation’s energy infrastructure, both for gas and electricity.

Testifying before the Senate Energy and Natural Resources Committee, Wood said he asked his staff at FERC on Wednesday to list for him “the top companies on the natural gas side…for pipelines.” The first was El Paso Natural Gas, which was followed in descending order by Williams, Duke Energy, NiSource, Kinder Morgan and Enron, he noted.

“Not all the companies on that list are what you would call in trouble, but more than half of them are,” he said. “And so if we’re to depend on that list to be the golden arrow… to make sure we have sufficient natural gas, the recent creditworthiness issues that have been raised about a number of these companies really do bring us to a critical point on the future of infrastructure investments in this country.”

While the need to stay ahead of that curve on construction has generally been met over the past decade, Wood said that he fears that may not be the case anymore. A lack of new gas pipeline construction would significantly affect the electricity market as well.

Although energy sector stock prices fared relatively better Wednesday than on “Black Tuesday,” a red alert remained in the trading community. “I think those of us who make it through the end of the year without collapsing will be the ones who form the basis of the future industry after the crisis has passed,” noted a Midwestern gas trader.

“This market is going to suffer from low liquidity for some time to come, maybe into 2003,” said another trader.

“When the infrastructure doesn’t get built in the next few years, they may realize that energy merchants and pipeline companies were needed,” lamented another cash market player. The market is not nearly as efficient as it used to be, he noted. It’s been said before that bid-ask spreads have been widening since the credit crunch began, “but the widening has gotten notably greater this week,” while bankruptcy speculation began building around some companies.

El Paso Corp. and Duke Energy will be the “clear, immediate winners” as energy traders scramble for their survival on Wall Street, but embattled Williams and Dynegy will be a “jumpball because of the liquidity trap they have gotten themselves into,” said energy industry analyst John Olson of Houston-based Sanders Morris Harris.

While there will be survivors to the current bloodbath, he noted that being an energy marketer and trader in today’s market is the “functional equivalent of having leprosy, herpes, AIDS and brain tumors all at once.”

Olson said he hopes neither Dynegy nor Williams, which have seen their stocks plunge to the near-penny stock level and face severe liquidity problems, will descend into bankruptcy. But he conceded it’s a possibility “with the stocks trading where they are,” and given the fact that Dynegy and Williams have not cut back their trading operations “enough to satisfy Wall Street.”

If they want to maintain big trading operations, “a pre-packaged bankruptcy would be an option,” Olson said.

Investors are fleeing the stocks of energy companies with trading operations, he noted, adding they’re “saying, ‘Who needs this?'” Olson said Sandy Weill, chairman and CEO of CitiGroup, remarked Tuesday that he wished he had never heard of Enron Corp., whose bankruptcy, accounting irregularities and questionable trading practices touched off the crisis among energy traders.

Banc of America analysts last Tuesday admitted they had “misjudged the snowball effect of Enron’s collapse,” and dropped the ratings of 11 energy wholesalers. Other analysts followed with their own downgrades, all noting that the liquidity for many of the formerly well-heeled traders was quickly evaporating. By the end of the week, the merchant sector was making a mixed recovery, but some of the former top merchants saw their marketing businesses take a tumble as investors retreated for safer ground.

“No one can be in any doubt that this is a time of extreme stress” for the energy companies, said Richard Hunter, managing director of Fitch Ratings. Fitch held a teleconference Friday about U.S. wholesale power and gas markets, and some of its analysts reviewed their ratings on several of the companies they have covered — and downgraded — in recent weeks. Hunter said the merchants had a “heady cocktail” of problems in front of them, in light of the regulatory investigations, accounting problems and flight of investors. The companies that have faced the most scrutiny have “undermined the stronger companies.”

Still, Hunter assured analysts that energy trading will not go away, even if some of the players falter. “We do believe there are many companies that will grow out of this, stay out of debt and remain stable as a result,” he said. “We expect to see a consolidation with fewer players with stronger balance sheets. There is always going to be a trading and marketing component for the asset business. In many cases, it is very difficult to separate those two, and it may be difficult to close out trading operations. There will continue to be trading in the future.” However, a more liquid market will not happen anytime soon, Hunter added.

Though not commenting directly on whether the problems within the sector will spread across the market and force many into bankruptcy, Fitch’s Ellen Lapson pointed out that, the “systemic risk that exists is already playing out. There are fewer counterparties to play with, but marketing and trading companies are in the best position to deal with that kind of risk. I’m pretty well confident that marketers and traders are reducing their exposure to those they lack confidence in and are going with those in a good position to manage risk. I would be surprised if we see a huge spread of default in that way.”

In a research report last week titled, “Clearing the Decks,” Banc of America dropped Sempra Energy to “market performer” from “strong buy,” and lowered the ratings of Allegheny Energy, Duke Energy, El Paso Corp., Williams Cos., Mirant Corp., American Electric Power, CMS Energy Corp., Williams and Xcel Energy to “market performer” from “buy.” Reliant Resources Inc. was downgraded to “underperform” from “buy.” (They included Alliant, but noted that it was not actually a wholesaler that fit into the sector.)

“While we regret making this call after so much devastation in the sector, we are downgrading several names with exposure to energy wholesale activities, given our view that risk continues to rise as most recently and vividly illustrated by Williams,” noted analysts William Maze and Shelby Tucker. Williams lost 61% of its value last Monday after it warned it would post a second quarter loss because of the decline in marketing and trading, and its credit was cut to “junk” by Standard & Poor’s twice last week (see related story).

“We are not comfortable with the fact that Williams will be flying without a facility,” said the analysts, noting that Williams has to refinance a $2.2 billion bank facility that matured Monday. “Dynegy, Duke and El Paso have also provided negative headlines over the past week,” they said. “Although these issues are company specific, they were all brought on by…Enron’s collapse. Although we downgraded the sector at year-end, we did not go far enough, as we misjudged these risks, which continue to rise.”

Dynegy on Tuesday added its name to a list of energy merchants actively pursuing a partner for its trading activities (see related story). Williams had already said it needed a partner, and Calpine and Mirant also have said they could resolve the lingering credit problems with a credit-worthy financial institution. However, the chances any deals could be struck following months of disappointing news may be slim. Maze and Tucker said that “several types of risks continue to plague the group, including that wholesale energy operations will likely remain a radioactive cloud over these names for some time.”

Political risks are expected to increase on the group, as November elections approach, said the analysts, and the sector’s ties to “the president, Enron and California make it a favorite political football. Furthermore, the Enron trial is likely to start late summer, which should add more fuel to the fire, and allow politicians to use corporate greed as a political theme.” The likelihood is “great,” that some of the “Enron dirt will be wiped on other wholesale players.”

Noting that the investigative risks were already high, the Banc of America analysts said they were notched even higher with the “recent subpoenas doled out by the U.S. Attorney’s office” (in Houston). Although they said they “believe there is little chance of wrongdoings…the probability of finding something questionable increases,” the longer the investigations continue.

California’s risks also are a continuing, though smaller, problem for the wholesalers, especially politically. If the state experiences any blackouts or brownouts, the group can expect more scrutiny from California, said the analysts.

Meanwhile, credit risk “remains high with no end in sight. This circular logic has caused illiquidity in the energy trading markets, which has limited profit potential, thus further impairing credit quality.” More asset/goodwill write-downs also may occur, they said, and the mandate for CEOs to sign off on financial statements “could place pressure on reported earnings, particularly since this sector was the epicenter for these concerns.”

Spark spreads, said Banc of America, remain at “lackluster” levels, and the “visibility to earnings” in 2003 and 2004 “is limited as most spark spread hedges roll off. Moreover, it is increasingly unclear as to the viability of the overall merchant model,” said analysts.

What the analysts will look for in terms of a recovery within the wholesale sector include the following:

First to recover once the “wholesale cloud” dissipates likely will be Duke, El Paso, AEP and Sempra, said Maze and Tucker, because of their strong financial positions and “grounding in quality regulated assets.”

Those involved in marketing and trading also are being brutalized by nearly all of the energy analysts, who are finding almost nothing to like and few companies to recommend within the merchant sector. Morningstar analyst Paul Larson even went so far as to warn investors from buying any energy merchant stock in a report on Wednesday.

“The imploding stocks and pending liquidity crisis have slammed the entire industry because finding a creditworthy trading partner is becoming increasingly difficult,” he wrote. “The falling shares will also make it that much more difficult for firms to shore up their balance sheet, making multiple bankruptcies in the sector a growing possibility.”

Salomon Smith Barney analyst Raymond Niles raised his risk rating on El Paso Corp. to “speculative” because of increased scrutiny of the company’s electricity restructuring business and ongoing probes of trading practices by federal agencies. However, UBS Warburg analyst Ron Barone held his “strong buy” recommendation on the stock.

On the upside, Merrill Lynch analyst Elizabeth Parrella said she expects Mirant Corp. to be among the survivors in the group. “The primary financial challenge is the amount of debt maturing in 2003-2004, although this would be alleviated by a new bank facility,” she wrote. Mirant is talking with its lenders about a new credit line. “The ability to refinance maturing debt should improve in later years, as the commodity cycle recovers.”.

Parrella also sees no near-term liquidity crisis at Calpine. As with Mirant, the challenge to Calpine involves upcoming debt maturities in 2003 and 2004 “in the event that the capital markets are still foreclosed to this sector.”

Meanwhile, Niles followed with his report on the sector Tuesday, and downgraded Calpine, AES and Dynegy to “underperform” from “neutral,” citing deteriorating corporate and industry fundamentals in the power and natural gas industry.

In a research note, Niles said the weak commodity prices are continuing to reduce corporate margins. He also noted further evidence of weakening credit quality in the industry after S&P downgraded Dynegy, and pointed to Williams’ “apparent inability to rollover a credit line due July 24.”

As far as individual companies, Credit Suisse First Boston analyst Curt Launer cut Williams’ rating to “hold” from “strong buy.” Launer put a 12-month target for the company at $6. Meanwhile, UBS Warburg’s James Yannello predicted a further near-term drop for Dynegy, and said he hopes to see equity investor ChevronTexaco, which owns about 27% of the company, step in “soon” to improve the company’s liquidity. ChevronTexaco has so far not commented on Dynegy’s current news. Said Yannello, “Dynegy shares could come under further pressure if customers substantially hesitate doing business with it,” and said any “negative findings” from federal investigations would hurt it.

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