Moody’s Investors Service downgraded the long-term debt ratings of Peoples Energy Corp. of Chicago and its utility subsidiaries, citing the continuing decline in profitability of its core gas distribution business (LDCs) and its increased focus on riskier gas exploration and production.

Moody’s dropped the parent company to Baa2 senior unsecured from A3, and subsidiaries Peoples Gas Light and Coke (PGLC) and North Shore Gas to A1 senior secured from Aa3. The outlook on all three is negative. The action affects approximately $900 million of debt securities.

Moody’s said the downgrades, the result of a review begun in January, reflect the view that Peoples’ credit profile is unlikely to regain its historic strength. The negative outlook is based on “the potential for their near-term results being significantly weaker than the company’s current expectations. The LDCs still dominate Peoples’ earnings, but their contribution to consolidated earnings is falling with the rise in diversified earnings, particularly E&P,” Moody’s said..

The rating agency sees the weakness in the LDCs’ and Peoples’ earnings likely extending into this year and next while the LDCs undergo a rate case amidst continuing cost pressures and flat margin growth. There will be further setbacks from the settlement of a gas cost case which, while eliminating a longstanding overhang on the company, will result in a refund of about $100 million pre-tax, a portion of which will be funded with debt (see Daily GPI, March 6).

Peoples plans to file a rate increase request with the Illinois Commerce Commission soon. However, the lengthy regulatory process means the company will not collect on a full year of new rates until 2008, and there is a risk its LDCs will not win adequate rate relief.

Moody’s also worries a rate order will not introduce rate design elements that would address the negative effects the company has been experiencing from warmer-than-normal weather, bad debt expense, and falling per-customer usage.

It also believes it is unlikely a rate increase would be enough to offset the risks of its growing E&P business, which requires stronger credit metrics to maintain the current ratings level. “Peoples’ strategic direction puts business risk on an upward trend, as demonstrated by recent transactions,” including the $139 million acquisition of oil and gas reserves. The purchase price will be financed by the sales of Peoples’ power assets and the last of its passive E&P equity investments.

“In selling the power assets, Peoples has avoided debt financing this acquisition, but has traded a stable, low-risk cash generating asset for a riskier capital-consuming one,” Moody’s said, pointing out that Peoples has yet to establish a track record in E&P. “In terms of Moody’s rating methodology for E&P, Peoples’ E&P has a low speculative-grade risk profile. Its reserves and production base compares among the smallest and most geographically concentrated of Moody’s universe of independent E&P companies.”

Further, below-market hedges are preventing the company from collecting on the high natural gas market prices, Moody’s said, also questioning the E&P operation’s efficiency in an environment of inflated drilling costs.

Moody’s will be watching Peoples’ E&P performance, as well as the coming rate case, with the possibility of further downgrades. Peoples ‘Prime-2 and Peoples Gas Light’s Prime-1 commercial paper ratings were not under review in the current action

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