In a new report outlining guidelines and recommendations for the U.S. wholesale merchant industry, Fitch Ratings said energy companies continue to foresee “adverse market conditions,” which has fostered a “new sense of reality” within the sector to reduce debt and improve the financials.

The report focuses on two subsectors: energy merchants, which include independent power producers and diversified energy companies, and affiliate generation companies, which were originally formed to own and operate the nonregulated generating assets of an integrated utility parent.

Hugh Welton, senior director of Fitch Global Power, said the analysis has found that “there is a greater sense of urgency emerging among company management to reduce debt and make permanent improvements to balance sheets, with the goal of improving credit ratings.”

In particular, Fitch found that most liquidity issues and refinancing concerns “put to rest for the time being” the companies in the sector that have focused on improving their balance sheets and restoring or retaining credit ratings. “What seems to be emerging is a greater sense of urgency among company management to pare down debt levels well before the next wave of debt maturities hits the sector in the 2007-2008 time frame.”

Credit ratings will continue to be driven by a combination of industry fundamentals and company-specific factors, analysts said. The primary drivers include regional wholesale power market conditions and commodity market prices for power, natural gas and coal. Weather is a main demand driver in the short term, while forward prices are mostly driven by the supply of power production assets and the level of gas prices.

Fitch noted that the level of cash flow predictability and variability differs on a company-by-company basis, and “will remain a key component” of a ratings analysis.

Natural gas prices to be the “primary driver” of wholesale power prices because gas is expected to be on the margin for an increasing number of hours of the year in most major power consuming regions, including the West, New England, New York, the Electricity Reliability Council of Texas (ERCOT), the Southeast and parts of the Pennsylvania-New Jersey-Maryland Interconnection (PJM).

“The natural gas forward market curve predicts that relatively high gas prices in the $5-6/MMBtu range will persist for the next couple of years, but in fact, actual market prices tend to be more volatile and may be sharply lower or higher than the current forward curve indicates. In an environment in which natural gas prices remain quite uncertain, the optimal generating portfolio to reduce risk should consist of a balanced mix of natural gas-fired and coal/nuclear baseload facilities, as both types of facilities will react very differently to changes in natural gas prices.”

Utilities that have assets in the interstate pipeline sector should see positive results, according to Fitch. “In particular, pipeline assets have demonstrated a high degree of cash flow resiliency during a period of unfavorable external conditions, many of which were related to parent company liquidity woes and explore to volatile merchant power and wholesale trading operations.” Pipelines, said the report, “have consistently exhibited cash flow stability, notwithstanding volatile gas prices, record warm heating season weather in major markets and increased competition.”

A copy of “Fitch’s Approach to Rating Wholesale Energy Companies” is available at www.fitchratings.com.

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