As the myriad of regulatory issues continues to be resolved, a Standard & Poor’s (S&P) natural gas analyst predicted last week that there will be increasingly positive interest from creditors and investors toward energy merchants. Meanwhile, Fitch Ratings Thursday upgraded Dynegy Inc.’s outlook to “stable,” and S&P Friday removed The Williams Cos. Inc. from its CreditWatch list.

In a 48-page report, “Industry Survey on Natural Gas,” released on Wednesday, Craig Shere, an equity analyst for S&P, detailed several implications from the “seemingly negative” show cause orders issued by the Federal Energy Regulatory Commission staff in March.

“Despite its allegations of wrongdoing and its negative tone, the FERC report heralds an improving outlook for beleaguered energy merchants,” said Shere. “Given the involvement of most energy merchants in both the electric and natural gas markets, a resolution of this power regulatory uncertainty is important for the natural gas industry. The connection is made even stronger when one considers that the overwhelming majority of new power plants in the United States are both natural gas-fired and owned by unregulated energy merchants.”

S&P believes California’s demand for refunds of close to $9 billion for market manipulation “would be hard to justify,” however, now that the refund exposures have been defined, “we believe that creditors and investors will be more likely to look favorably on the energy merchant group.”

Since early April 2003, Shere noted that the findings of market manipulation “have had limited implications for energy merchants,” and FERC has yet to decide whether to approve its staff’s recommendations to seek disgorgement of profits from companies’ alleged violations.

In his review of energy merchant refinancings, asset sales and management changes, Shere notes that some of the greatest risk exposures for the industry developed from the lack of energy trading structures and institutions. “As a fast growing, nascent industry energy trading was like a Wild West frontier town,” he wrote. “In this developing world, good guys thought they could survive on the quality of an honest man’s word, and bad buys thought they could take advantage of lawlessness. Both were wrong.” But the analyst found that industry participants and regulators are moving to develop structures to resolve unforeseen credit risks and to “foil efforts” to manipulate the system.

Among other things, S&P noted that many companies have responded to concerns about possible index price manipulation by moving data reporting from the trading desks to the risk management offices. Still, other issues remain, including mercury emission rules that will affect power plants and FERC’s proposed Standard Market Design.

S&P also expects merger activity among natural gas companies, including intra-industry and gas/electric mergers, eventually will return. “Consolidation will be driven by a growing need for natural gas to supply power plants, the increased scale required to manage volatile natural gas prices and rising credit requirements for all operations (regarding diversification, size, liquidity and proportion of equity funding to debt.”

For more information on the S&P report, visit the web site at www.standardandpoors.com.

Several favorable actions and events led Fitch Ratings to give Dynegy Inc. and its affiliates a “stable” outlook on Thursday, removing the energy merchant from Rating Watch Negative for the first time in nearly 20 months.

Fitch affirmed and removed Dynegy, Dynegy Holdings Inc., Illinois Power (IP) and Illinova Corp. from the negative rating outlook, where they had been placed in November 2001, when Dynegy was attempting to merge with Enron Corp.

The credit ratings agency also assigned a “B+” rating to Dynegy Holdings’ secured $1.1 billion revolving credit facility and $200 million term loan A, both maturing on Feb. 15, 2005. It assigned a “B” rating to its $360 million term loan B, which matures on Dec. 15, 2005.

“The removal of the Negative Rating Watch status reflects the lessening of near-term default risk as a result of several favorable actions and events,” said Fitch analysts, who noted that in April, Dynegy Holdings entered into its new $1.66 billion secured bank credit facility.

The facility requires no scheduled amortization of principal and should be adequate to fund ongoing collateral and operating needs through 2004. In addition, the risk of a default and resulting debt acceleration triggered by certain financial covenants contained in the prior credit facilities and Polaris lease has been eliminated.

Fitch also cited other “favorable” recent actions, including the filing of audited financial statements for years 1999 through 2002 with “material disclosures consistent with expectations,” the sale of Dynegy’s U.S. communications business, the reporting of “stronger than anticipated” operating results for the first quarter of 2003 and the closing of an agreement with Southern Co. to terminate three wholesale tolling arrangements eliminating $1.7 billion of future capacity payments.

The new ratings, said Fitch, reflect its latest assessment of Dynegy’s overall credit profile. “The Stable Outlook status reflects the company’s satisfactory liquidity position and lessened near-term default risk,” and the ratings outlook recognizes Dynegy’s ongoing concerns, which include the execution risk associated with the restructuring/extension of $1.5 billion of preferred stock held by ChevronTexaco (CVX) that matures in November 2003; the “significant cash drain” from five remaining wholesale tolling agreements and the difficulty of terminating the agreements; the practical limits of materially reducing debt levels through cash from operations; and the negative overhang from ongoing government investigations and litigation.

On a consolidated basis, Fitch said Dynegy has about $8 billion of debt obligations not counting the $1.5 billion of ChevronTexaco preferred stock and payment obligations under its remaining tolling agreements, with a net present value of about $1.4 billion. “Furthermore, while recent efforts to eliminate third-party marketing and trading activities has helped ease collateral requirements and improve liquidity, the company must continue to provide substantial amounts of collateral to support its generation and midstream operations.”

The new bank facilities will allow Dynegy “limited flexibility to repurchase outstanding debt. However, all targeted large asset sales have been completed and equity financing is not likely. Even under improved operating conditions, cash flows from core operations remain weak relative to its high debt burden and any financial recovery should be gradual.”

As of May 12, consolidated liquidity at Dynegy was nearly $1.8 billion, said analysts. “Assuming a restructuring of the ChevronTexaco preferred stock and given a manageable maturity schedule, liquidity should be adequate for Dynegy and its affiliates through 2004 even if IP’s proposed sale of its electric transmission system does not occur.”

Also on Friday, S&P affirmed its “B+: long-term corporate credit rating on The Williams Cos. Inc., and removed the company and its subsidiaries from CreditWatch with negative implications, where they were placed July 23, 2002. However, S&P kept its negative outlook on the company.

“The upgrade on Williams’ senior unsecured debt is based on the fact that the senior debt at the Williams companies is no longer materially subordinate to debt at the operating companies, after the recent asset sales,” said analysts.

Analysts said a “significant credit concern” is Williams’ “ability to stem the cash drain from the energy marketing and trading (EM&T) business unit. For example, EM&T was responsible for a $790 million cash drain in 2002 and for a $292 million cash drain in the first quarter of 2002. However, because EM&T performs all commodity risk management for Williams, less than 60% of the cash usage is actually for the EM&T trading operations. More than 40% is for Canadian and domestic midstream fuel and gas shrink requirements and for margin on hedged E&P gas contracts in the $4 area. However, Williams must demonstrate that this business unit will not be a significant user of cash in 2003.”

Removing the company from CreditWatch “reflects the high likelihood that Williams will have sufficient cash available to repay the $1.17 billion maturity due in July 2003 and that liquidity issues are no longer the primary credit concern. Williams was successful in its sale of Texas Gas Transmission Corp. to Loews Corp for $1.05 billion on May 16, 2003, and plans to pay off the existing $1.17 billion loan at Williams RMT with a $500 million secured term loan financing, plus additional available cash. Also, given the likelihood of closing on the Williams Energy Partners sale and the other announced deals closing in second-quarter 2003, Williams should have sufficient cash to repay the $1.4 billion Williams Communications Group note that matures in March 2004.”

S&P kept the negative outlook because of Williams’ “weak financial ratios for 2002 and continued expected weakness in 2003. For example, funds from operations (FFO) interest coverage ratios for 2002 were 1.4x, and FFO to debt was 5.6%, which is indicative of a rating at the lower end of the `B’ category. The expectation for 2003 does not show significant improvement. However, the projected ratios for 2004 are more in line with the current rating. If Williams is able to stem the cash drain from EM&T and meet or exceed financial ratio expectations in 2003, the outlook could be revised. However, if financial ratios fall considerably below expectations, the rating could be lowered.”

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