Energy merchant and power generation company earnings could jump more than 30% in 2001, while earnings for integrated electric utilities could rise 12%, according to Steven Fleishman, head of Merrill Lynch’s global power and gas research group.

“We expect a renewed focus on companies that are low-cost producers, have locked in margins through long-term contracts, and have the merchant capability to take advantage of the inherent volatility in the energy sector,” Fleishman told reporters during a regularly scheduled “Merrill Lynch Bull Sessions” program last week.

Looking at the corporate power picture, Fleishman noted that “after a sparkling year in 2000, this year has been a roller coaster” for independent power producers (IPPs) and the utility sector. At the same time, he noted that “fortunately, there have been more ups than downs.” IPP share prices through late May are up 10%, while electric utilities are down 1.7%, or flat excluding California utilities. In either case, those shares and IPPs outperformed the Standard and Poor’s 500 Index, which was down 5% over the same time period.

“The energy crunch is driving higher prices and returns for the industry and attractive opportunities for new investment,” Fleishman said. “Price volatility is fueling striking merchant profits and renewed interest in long-term contracts.” And, on a related basis, the California crisis has created a political and legal overhang on the industry as officials try to fix the energy crisis, he added. Overall, despite the concerns, “we contend that the competitive market is working.” The industry is drilling for gas and adding power plants at record levels, he went on to say, noting that price spikes in these commodities have already shown an impact on softening demand. “To that end, we are already beginning to see market prices start to fall, helping to solve the crisis.”

Meanwhile, the current high-energy costs in California are producing less severe bond-rating issues than those faced by other states over the past 25 years, the firm’s analysts suggested. John Hallacy, manager of Merrill Lynch’s municipal credit research group, said that while there have been state bond-rating downgrades over the last quarter century, no state rating has fallen to below investment grade. He noted that studies demonstrate that, on average, municipal securities merit higher credit consideration than corporate securities because of much lower default rates, coupled with sovereign powers of states.

“Moreover, the California economy is essentially sound and thus the issues brought about by the high-cost of energy there are different from other state-related issues over the past 25 years,” Hallacy went on to say. Hallacy noted that while California has joined a group of states that have experienced financial drains due to specific events over the past 25 years, he believes the current situation is different since fundamental economic dislocations were the cause in most of the other cases.

Hallacy also highlighted some of the differences between California’s energy crisis and the energy-related difficulties experienced by Texas in the early 1980s. Among other things, he noted that the California energy sector, as a component of gross state product, is in the low-single digit range as compared to the 20% range for Texas in the early 1980s prior to that state’s energy bust. “California’s exposure to the utility crisis has more to do with cash flow and timeliness than the fundamental problem Texas had with the energy sector in the mid-1980s,” said Hallacy.”However, if the utility crisis in California is allowed to continue unabated, the crisis will become a fundamental problem as it begins to affect business decisions being made in the state at the margin,” he said, noting that steps have been taken to prevent this scenario.

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