Merchant energy shares were hammered last week by multiple factors, the most significant being a FERC inquiry into the California electricity transactions of 150 energy merchants and power generators prompted by several Enron memos disclosed by FERC on Monday (see related story). Dynegy was struck particularly hard following an announcement on Tuesday that the Securities and Exchange Commission launched a formal investigation into its Alpha Project — a complex gas supply transaction. That was followed by news that some large “wash-out” power deals with CMS Energy might also be included in the probe.

On Friday, Reliant Resources was dragged into the spotlight when it had to back out of a $500 million bond offering to examine similar wash-out transactions. CMS also admited on Friday that it was under an informal investigation by the SEC because of the deals.

“CMS Energy is cooperating fully with the SEC in this matter,” the company said. CMS said it had been asked to provide information in connection with an informal inquiry “into simultaneous purchases and sales of electricity with the same counterparties at the same price. These transactions, which involved no profit or loss, are of the type which were the subject of recent press reports.”

According to Dynegy, a two-fold Nov. 15 power transaction began at 10:08 a.m. CST, when Dynegy bought a month’s worth of electricity at $25.50/MWh from CMS-MST. At exactly the same time, Dynegy sold CMS-MST the same amount at the same price. Twenty minutes later, at 10:28 CST, Dynegy conducted another trade to buy and sell a year’s worth of capacity from CMS-MST at $34/MWh.

Dynegy spokesman John Sousa told NGI that the CMS request last November was for such a “significantly large volume, that we viewed it as a really good opportunity to ‘stress test,’ if you will…our online platform. It didn’t benefit us financially or volumetrically.”

However, these types of transactions apparently weren’t designed just to test Dynegydirect. Other companies engaged in them as well. News reports about Dynegy, CMS and Reliant alleged the purpose of the transactions was to bolster the companies record of trading volumes.

Reliant said Friday it “believes it had similar transactions and is working to quantify the amount and assess the impact of those transactions.” A spokeswoman said it was prudent to review these transactions because of certain disclosure requirements for a bond offering.

The “wash” power deals were the last of the negative news in a solid week of trouble for energy merchants. Dynegy Inc. Chairman Chuck Watson took nearly an hour on Wednesday to refute “unsubstantiated rumors and innuendo” as well as answer questions about a formal investigation by the Securities and Exchange Commission (SEC). At times upbeat, at times clearly frustrated by the market’s response, Watson said, “I don’t want to let it go any further. Our stock price is a huge concern to us right now and to you as well.” The stock sell off is a “reaction to a crisis in confidence” about “issues that have absolutely no validity at all. Investors are not trading on fundamentals right now. They are trading on nerves.”

The conference call with Watson and COO Steve Bergstrom on Wednesday followed a traumatic day for the Houston-based energy marketer, which saw its stock plunge dramatically minutes after the market opened Tuesday. The rush to sell followed an announcement by Dynegy that the staff of the SEC had recommended a formal investigation of the company’s Project Alpha. The SEC had been informally investigating the project for several weeks.

When the New York Stock Exchange rang the bell, investors rang Dynegy’s, knocking shares down almost 20% in early trading before stabilizing by mid-afternoon. In a day in which rumors were tossed about that the company would follow in bankrupt Enron Corp.’s path, investors still managed to gain confidence. At the close, Dynegy still lost 9% to end at $11.15.

Despite the stock decline, energy traders remained behind the company and said there had been no changes during the day. One source said his company was “always checking creditworthiness, but we haven’t made any change toward Dynegy.”

However, on Wednesday Standard & Poor’s placed Dynegy and its subsidiaries on CreditWatch with negative implications (BBB/Watch Negative/A-3). Ratings analyst John Kennedy wrote, “The announcement of a formal SEC investigation into the firm’s Alpha transaction, allegations of price manipulation in California, and dislocation in the capital and energy markets,” led to the ratings change. “The CreditWatch listing is more reflective of these near-term events than the prior negative outlook, whose time horizon is longer-term. Standard & Poor’s notes that absent these near-term events, Dynegy’s fundamental business model has not changed.”

Watson, who has long been open and available with analysts and the press, urged investors to have confidence in the company. “These are tough times…when people shine. This company’s going to be fine. When you look at the opportunities we have, we are more focused on the priority of increasing shareholder value.” He said the value may not be “this week, not next month, but over the long haul. And I intend to be here for the long haul.”

Besides all of the Enron-related background noise affecting most of the other energy stocks — especially energy traders — Dynegy, he said, has been wrongly “painted by the same brush…Our stock is not the same as Enron. There’s an absolute value that can be translated to our asset base. We have to look at the medium and the long term right now. The future price is what we will focus on. Dynegy is a strong, growing, viable concern. I want everyone to understand this.”

Bergstrom acknowledged there was “a lot of nervousness in the market, not only on Wall Street but in the energy markets as well.” Last week, Bergstrom said it would take $750 million to fully collateralize the entire company, including liquids purchases. “It has gone up to about $300 million in peak capacity this week, still well within the $750 million. The market is more nervous than last week, and rightly so. We have tried to mitigate that, and everything is functioning well, as well as it could be. Liquidity is still fine, and we are still operating as close to normal as could be.”

Bergstrom also addressed reports that inferred there were more credit triggers that could force the company to have more liquidity problems than it has disclosed. However, Bergstrom said Dynegy had “fully disclosed” its financial commitments (included in the 2001 annual report). “There is $301 million in total triggers. That’s it. That’s the extent of it. It has been fully disclosed. It’s no more than that.” Some reports had indicated that Dynegy had not disclosed the $301 million, and that it would erase its liquidity margin in the event of a downgrade to junk status.

Regarding the Federal Energy Regulatory Commission’s new investigation of energy marketers gaming the California market, Watson said the “news stories do not contain any new information…Dynegy has been and continues to be in full compliance with the rules and regulations in California. We have cooperated fully with the FERC [and] California officials. We were not in collusion with Enron on marketing. Dynegy is being painted with the same brush as Enron.”

Watson added, “The California issue to me is really unfortunate. All the companies have responded fully to California, fully to the FERC, we believe the…stories were an expansion of that. At the end of the day, I’m not convinced they’ll find anything different than the State of California did.” He added that what was happening with FERC and California was “not nearly as significant as the last 48 hours” had been for Dynegy.

The SEC’s formal investigation, begun with an informal inquiry several weeks ago, centers around Project Alpha, a physical gas supply transaction completed in April 2001 by Dynegy subsidiary DMT Supply LP. The transaction consists of a five-year contract with ABG Gas Supply LLC, an unrelated third party, that gave Dynegy access to a significant long-term supply of physical gas, cash funding and a permanent tax benefit.

Under terms of the contract, DMT bought gas at a discount to market prices over the first nine months of the contract. For the remaining 51 months of the contract, DMT will purchase gas at a premium to market prices. ABG acquires the gas through standard New York Mercantile Exchange contracts to fulfill its sales commitments to DMT, which then takes title to the gas at Henry Hub and markets it to customers.

The transaction gave Dynegy a tax benefit of about $85 million, and $35 million in costs on a pre-tax basis last year. Dynegy originally classified the net cash inflow from the gas supply contract as operating cash flow in its quarterly and year-end financials. Activity under the contract resulted in net cash inflow of about $300 million in 2001. The company had to revise its 2001 financial statements, however, following the SEC’s informal probe.

Dynegy said it is in talks with several bidders to sell some of its UK natural gas storage assets, which were purchased just six months ago from the BG Group. Apparently, up to seven companies are in talks with the energy trader to take over a minority stake in its Rough offshore gas storage assets, which were struck by a trawler last Wednesday and will have to be repaired, as well as the Hornsea site, a proposed storage facility in the United Kingdom. The company also plans to sell some other assets to bolster its balance sheet. However, it has come under even more pressure in recent weeks after announcing it would have revise its balance sheet for 2001 because of Project Alpha. Watson reiterated that the company’s priority was keeping its investment credit rating.

Dynegy does not have “a lot of non-performing assets,” said Watson, and that makes it more difficult to decide what it might want to sell to enhance the balance sheet. “The market is difficult right now in some regards, but there are some good buys out there, if you will.”

Investment analysts reacting to the news appeared optimistic about Dynegy overall. Morningstar analyst Rob Plaza said, “While we see nothing on the near-term horizon to jump-start Dynegy stock, we think downside from here should be limited.” Credit Suisse First Boston’s Curt Launer said, “We view Dynegy’s ultimate valuation potential, ownership by ChevronTexaco, and options to deal with issues as warranting the maintenance of our Strong Buy rating.”

Wachovia Securities analyst Thomas Hamlin, who maintains a buy on Dynegy, said, “To the extent that a below investment-grade rating would result in a higher cost of capital for new investment, I think there would be some limitations on future growth in their business until they can get that resolved. However, he noted that Dynegy is “very different” from Enron. “Over 80% of its business is asset-related; it’s about delivering gas to end customers who use it. When Enron lost its investment-grade rating, it lost its principal asset, which was working capital. Dynegy [owns] pipelines, gas storage, power plants [and a] liquids business. Losing their investment grade would have an impact, but it’s not the whole business.”

RBC Capital Markets, meanwhile, said the SEC investigation, “along with the recent expansion by the FERC into the California trading of energy marketers…adds significant risk, and the company could see a Moody’s downgrade.” It lowered its rating on Dynegy to Sector Perform with Above Average Risk, down from Outperform with Average Risk. UBS Warburg analysts James Yannello and Ronald Barone added that “it is prudent to carry more conservative assumptions at this juncture” concerning Dynegy. They kept their rating at hold, noting that further developments have the potential to push Dynegy shares “dramatically in either direction.”

The stocks of Dynegy, Mirant and Reliant all were down more than 10% again on Friday: Dynegy’s dropped $1.17 to close at $9.88; its shares were above $15 on Monday. Mirant lost $0.92 Friday to close at $8.11, and Reliant Resources lost $2.49 to close at $12.00, while parent Reliant Energy lost $3.15 to close at $21.45. The impact appeared to spill over into other marketer stocks. Williams, Aquila, Calpine and AES stocks were off between 5% and 7%.

Meanwhile, Mirant affirmed Friday that it had not engaged in any transactions for the purpose of artificially enhancing its trading volumes or revenues. “Because of the rumor and discussion about our industry, I feel compelled to make it clear that Mirant has not performed any simultaneous buy and sell trades with counterparties for the purpose of inflating its trading volumes or revenues,” Marce Fuller, Mirant CEO, said regarding the CMS transactions. “This type of activity is not tolerated, nor will it ever be tolerated, at Mirant. Our trades are conducted to serve our customers, to balance our portfolio, to manage risk and achieve business purposes.”

Mirant also confirmed that it received the Federal Energy Regulatory Commission’s (FERC) request for data relating to the company’s energy marketing operation, and that it will comply fully with that request. The Commission has requested sworn statements from 150 marketers doing business in the California market as to whether they had engaged in apparent “gaming” of the market as outlined in internal Enron memos revealed early in the week.

“We support FERC’s efforts to clear the air once and for all on practices associated with the marketing of power in the Western states,” said Fuller. “Mirant has provided an enormous amount of information to FERC and other parties over the past two years regarding our activities in that region but is more than willing to do so again. We believe that our actions were in compliance with the rules and regulations established by the Western states and FERC.”

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