Dynegy reported a devastating third-quarter loss of $1.8 billion ($4.92/share) on Wednesday, warned of more writedowns in the fourth quarter, failed to offer any earnings guidance going forward, and finally stunned investors and analysts with no conference call to explain. To make matters even worse, the once-formidable alliance between Dynegy and ChevronTexaco appeared notably strained Wednesday, and negotiations were under way to terminate lucrative natural gas sales contracts now scheduled through August 2006.

ChevronTexaco’s third-quarter earnings, set for release early Thursday, may hold the news that Dynegy Inc. investors have been dreading and analysts long predicting. Whether ChevronTexaco announces a write off on the rest of its Dynegy investment is questionable, but there are clear signs that the news will not be positive.

If the natural gas sales contracts between the two companies are terminated, it would mark a sure end to Dynegy’s marketing and trading business. Under the contracts, subsidiary Dynegy Marketing and Trade now purchases most of ChevronTexaco’s Lower 48 U.S. natural gas production (about 2.4 Bcf/d) and supplies the gas requirements for the major’s refineries and corporate facilities. Apparently, the negotiations only involve the marketing agreements, they do not affect the natural gas processing and liquids agreements with Dynegy Midstream Services, both ChevronTexaco and Dynegy reported.

In a written statement concerning the negotiations, Dynegy said it would meet all of its contractual obligations to ChevronTexaco “unless and until other arrangements have been agreed upon and made. [A] key part of the discussions,” said Dynegy in a statement, “is to ensure that any agreement reached would have no adverse effect on customers.” ChevronTexaco is a 26.5% shareholder in Dynegy, and has had a working relationship with the company since 1996 to market its North American natural gas. ChevronTexaco plans to release its 2002 third-quarter earnings at 11 a.m. EST on Thursday.

Whether the termination of the contracts will have an adverse effect on Dynegy going forward is still to be determined, but energy analysts have long waited for official word on what ChevronTexaco planned to do — pull out or invest more. In happier times — less than 12 months ago — Dynegy and ChevronTexaco expanded the natural gas sales agreements, which gave Dynegy the right to purchase nearly all of legacy Texaco’s undedicated U.S. gas and natural gas liquids production through Aug. 31, 2006 (see Daily GPI, Dec. 20, 2001 ). The expanded agreement increased the volume of gas purchased by Dynegy to 3 Bcf/d, and increased supply and service for 2 Bcf/d for legacy Texaco facilities and third-party term markets. The contract started Feb. 1.

The agreement not under negotiation, which also was expanded last December, gave Dynegy the contract to process ChevronTexaco’s natural gas. In the upgraded contract, Dynegy agreed to process uncommitted gas production from former Texaco properties as well as ChevronTexaco leases in the Gulf of Mexico. According to ChevronTexaco’s third-quarter report for 2001 (the first as a merged company), U.S. net production of crude oil and natural gas liquids totaled 331 million bbl/d. Its U.S. net natural gas production, onshore and in the Gulf of Mexico, that was available for sale totaled 1,160 MMcf/d in the third quarter a year ago. Neither Dynegy nor ChevronTexaco have provided the details of the marketing or processing contracts.

Without the lucrative marketing deal, Dynegy’s retention of the processing rights and its other processing contracts still would make it a player in the midstream services sector, according to some analysts. Standard & Poor’s John Kennedy, who follows Dynegy, noted that the company’s gathering and processing business has “high cash-flow potential,” even though there is a commodity price risk associated with absolute liquid prices. He said that Dynegy’s risk management skills also would “help smooth out this unit’s profits and soften possible losses.” Dynegy’s midstream unit benefits from “significant downstream activities,” said Kennedy, and those activities are “primarily fee-based.”

In a restructuring plan announced in July, Dynegy was working to raise capital by selling $250 million of its natural gas midstream assets to Dynegy Energy Partners LP, a master limited partnership (MLP) that the Securities and Exchange Commission had earlier expected to approve in the third quarter (see Daily GPI, July 22 ). Dynegy had proposed the MLP then to handle fractionation, storage, terminalling, transportation, distribution and marketing of natural gas liquids in North America.

It’s questionable whether the MLP will ever come about, and some believe that Dynegy may not be able to prevent bankruptcy — especially if it loses the support of ChevronTexaco. Raymond James’ analyst Jon Kyle Cartwright surmised Wednesday that financial analysts may be pressuring ChevronTexaco to get out. Said Cartwright, “it’s real ugly if ChevronTexaco walks away from them..That was their real hope.”

Gordon Howald, an analyst with Credit Lyonnaise Securities, said Dynegy’s crisis may well lead to a write down by ChevronTexaco.”They’re just going to write the rest of this thing off, call it a bad investment and move on,” he said. “Why do you need Dynegy? You don’t need the liabilities. All they needed were those traders, and now they’re available.”

Christopher Ellinghaus, who follows Dynegy for Williams Capital Group, called the ChevronTexaco announcement a “blow to the Dynegy legacy.” Pondering whether the news was “another nail in the coffin or end of the ordeal,” Ellinghaus noted that the disclosure “helps to clarify some confusion we had regarding Dynegy’s earlier announcement to disband its trading operations. Maintaining the CVX contracts implied that Dynegy would need to retain a significant natural gas trading capability. Now it is clear that Dynegy does indeed intend to fully exit the trading and marketing business.”

The analyst said, “the demise of Dynegy as a premier energy marketer and trader remains nearly as remarkable as the demise of Enron itself. Clearly, the realization of the end of its trading business means Dynegy will never return to its former luster, but it is completely unclear what, if anything, it will be in the future.”

As to what the present picture looks like, the announced contract negotiations preceded Dynegy’s quarterly losses, which included after-tax charges of $1.75 billion for the following:

“This was a difficult quarter for Dynegy, as it was for other companies in our sector, but one that was expected as Dynegy executed its capital and liquidity plan, experienced unprecedented industry and market conditions and began its organizational restructuring initiatives,” said Bruce Williamson, the company’s new president and CEO. “Dynegy’s results can be attributed to a number of primarily non-cash charges and the loss on the sale of Northern Natural Gas. These charges did not and will not affect the company’s liquidity position, which remains at a level that is sufficient to operate our businesses and meet our customer commitments,” he said.

Williamson affirmed that the merchant sector had continued to experience a “downturn characterized by lower liquidity levels, reduced power prices and credit concerns.” He said Dynegy’s strategy is to manage these challenges by restructuring the company around its generation assets, natural gas liquids and regulated energy delivery businesses, and “to exit aspects of the marketing and trading business unrelated to our physical assets. By executing the elements of this restructuring plan, the company will significantly reduce collateral requirements and expenses and, in the process, rebuild itself.”

The Wholesale Energy Network segment, which just a year ago powered the company toward ever-stronger earnings, has been reduced to now consist of generation, storage and customer risk management activities. The risk services will be centered on the physical delivery of and risk management activities around wholesale natural gas, power and coal. Reported net loss for Wholesale was $1.26 billion in the quarter, which included after-tax charges of $1.18 billion. Wholesale recognized a $908 million charge associated with the write-down of goodwill resulting from the reduction in near-term power prices, an increase in the rate of return required for investors to enter the merchant energy sector and the company’s decision to exit the marketing and trading business.

Within Wholesale, the Asset Businesses, or owned generation segment, reported operating income of $44 million in the quarter, compared with operating income of $187 million for the third quarter of 2001 (after the impact of general and administrative expenses and depreciation and amortization). Lower power prices reflected the decrease in earnings.

Wholesale’s Customer and Risk Management activities, including controlled assets, marketing and trading, reported an operating loss of $346 million, compared with earnings of $125 million for the third quarter of 2001. The loss included the deduction for general and administrative expenses and depreciation and amortization. Results also were impacted by an increase in risk management reserves of $223 million because of reduced liquidity in the power markets, as well as the collapse in wholesale origination activities and energy trading related to the company’s credit ratings and industry conditions.

Other impacts to Wholesale included a decrease in equity earnings from unconsolidated investments due to lower prices and an overall decline in demand, primarily in Dynegy’s West Coast Power joint venture. There also was an increase in interest expense due to higher debt outstanding.

Dynegy noted that revisions to the Generally Accepted Accounting Principles now require all energy trading revenues to be reported on a net basis beginning third quarter 2002. As a result, revenues for the third quarter and year-to-date are 82% and 83% less, respectively, than what would have been reported on a gross basis before the accounting changes.

Dynegy Midstream Services, which includes North American natural gas liquids processing, liquids fractionation, distribution and marketing, reported quarterly net income of $4 million, including after-tax charges of $4 million, compared to $12 million a year ago. Results were impacted by lower realized natural gas liquids prices and market liquidity, which was “moderately offset by an increase in straddle plant processing volumes,” said Dynegy.

For its Transmission and Distribution segment, which includes Illinois Power, Dynegy reported net income from continuing operations totaled $36 million in the third quarter 2002, compared to $26 million in the third quarter 2001. Illinois Power’s performance benefited from seasonal weather, resulting in greater residential and commercial electricity usage.

The company’s communications segment, Dynegy Global Communications, reported net loss of $30 million in the quarter, compared to a net loss of $15 million a year ago. Dynegy said that the unit has limited its capital spending and reduced its operating costs by renegotiating long-term contracts. It also is looking for a partnership for the segment, or would sell the business outright.

As of Sept. 30, Dynegy said it had approximately $1 billion of cash-on-hand, including $189 million in net proceeds from the UK Hornsea sale. The company also had $286 million of availability under its bank facilities and approximately $300 million of highly liquid inventory. The proceeds from the Hornsea sale were subsequently used to pay down part of the bridge financing in October. Total posted collateral, including cash and letters of credit, was approximately $1.3 billion.

Dynegy said it would not offer earnings guidance “due to industry conditions and pending asset sales.” It now is assessing “potential fourth quarter charges, which may include, but are not limited to, charges associated with the recently announced reduction in workforce and organizational restructuring, the cumulative effect related to the recently announced change in accounting principles impacting the energy trading business, and charges associated with exiting certain aspects of the marketing and trading business.”

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