The energy merchant sector could see several more years of low wholesale prices, which in turn will complicate their ability to refinance upcoming debt maturities at their regulated utilities, according to a new report by Standard & Poor’s Ratings Services (S&P).

The power plant buildup, which began in 1997, now is facing overcapacity, slow demand growth and low price elasticity, and will severely complicate the ability of energy merchants to refinance. Most of the plants were financed through banks at medium-term debt, which will come due between 2003 and 2006. S&P estimates the total for the entire energy merchant sector is more than $90 billion.

In an analysis of refinancing needs over the next four years, S&P looked at 23 power companies, including 15 with a mix of revenues from regulated and unregulated activities, and eight others totally unregulated in a competitive market. In its report, analysts warned that “the sheer magnitude of the amounts that require refinancing over a relatively short time span in a market where investors have declining confidence in the sector will make refinancing challenging.”

Although some companies have better access to capital than others, analysts found that “generally…bad news relating to accounting irregularities, trading losses, regulatory uncertainty and a general lack of investor confidence in the overall business model have plagued the sector, making this one of the worst times in recent history to refinance debt.”

Data compiled from public filings with the Securities and Exchange Commission took into account consolidated recourse and nonrecourse obligations, but excluded nonconsolidated obligations (always considered for ratings purposes). “Depending on the company, refinancing needs at nonrecourse subsidiaries or projects account for anywhere from zero to 100% of the refinancing needs. In total, nonrecourse refinancing needs for the 23 companies surveyed represent about 20% of the total $90 billion.”

For analytical purposes, S&P viewed the debt at core utility subsidiaries as recourse, and would expect the parent company to continue to support them. S&P noted that corporate obligations with more diversified cash flow and unencumbered assets “may refinance with relative ease.”

However, the “reverse is also true: project level or subsidiary level non-recourse obligations that rely on a more concentrated stream of cash flow will likely suffer a greater degree of refinancing difficulty.” For some cases, S&P noted that some non-recourse project loans would not be refinanced, with projects given to lenders. Also, sponsors could drop investments not likely to contribute in the long term to shareholder value.

“In fact, many companies’ recent actions have supported this. For example, PG&E National Energy Group Inc. has announced it will not make an equity contribution to its GenHoldings subsidiary; TXU Corp. no longer supports its TXU Europe subsidiary; and Xcel Energy Inc.’s support for NRG has waned. This is not to say that investments with good long-term economic prospects will not be able to find financing.”

Most at risk are those companies that are highly leveraged, have large bullet maturities, have highly volatile cash flow or those that invested heavily in construction programs. S&P added that “mini perm financings” were used in the past few years because companies financed a lot of the construction book with this short-term financing method.

“These companies will probably have the most difficult time refinancing those loans, as banks may require some type of equity infusion,” said analysts, and “equity may be difficult to raise given the lack of investor confidence in the sector. Otherwise, banks will likely structure 100% cash sweeps and extract security positions, leaving the companies with little return on their investments and, in some cases, less cash flow to service corporate level debt.”

In this category, companies with the most difficulty include Calpine Corp., NRG Energy Inc., and PG&E NEG, said S&P. Analysts also put TECO Energy Inc. into the category because of its exposure as an unconsolidated subsidiary. “While this obligation does not appear on TECO’s balance sheet, Standard & Poor’s is concerned about the ability of the company to refinance it given the size of the facility and the deterioration in the asset quality.”

Meanwhile, companies whose cash flow is more “volatile and significantly driven from the competitive wholesale market or the emerging markets” will have a difficult time with refinancing maturities,” and will be more challenged to refinance at favorable terms than companies with more diversified cash flow.” Calpine, AES Corp., NRG, PG&E NEG, Reliant Resources Inc., Mirant Corp. and Edison Mission Energy (EME) are in this category, said analysts.

“Companies that have encumbered all of their assets with secured debt and have little security to give the banks as an inducement to roll over maturities will have an even greater problem negotiating a refinancing.” This includes companies that have traditionally financed operations with secured project financings, in addition to having significant parent company debt, including AES, NRG, PG&E NEG and Mirant. “This double leverage will likely have a negative effect on refinancing. Companies of each type may still secure refinancing, but on difficult terms and prices.”

Comparing the magnitude of refinancings for the next four years as a percent of total capitalization and as a percent of total debt outstanding (calculated as of June 30, 2002) for the 10 largest exposures, S&P “views Reliant Resources as particularly at risk given that its refinancing need is significant at 44% of overall capitalization. Furthermore, it represents 85% of Reliant’s debt. Reliant’s future is highly dependent on its banking relationships, and the willingness of the banks to refinance on acceptable terms.”

Said S&P, “Calpine, Mirant, PG&E NEG, CMS Energy Corp. and NRG follow closely behind with large portions of their capital structures subject to refinancing. Except for CMS, these companies also suffer from relatively volatile cash flow from merchant projects — projects that were originally valued and financed when the outlook for power prices was more positive than it is now.”

For maturities due in 2003, S&P found that companies most at risk were Reliant Resources, American Electric Power Co. Inc. Dynegy Inc., and PG&E NEG. “Again, the calculation is based on consolidated totals, and for certain companies the debt to be refinanced is at non-recourse subsidiaries. Noteworthy is Reliant, which has 85% of its total debt due in 2003. This is more than twice the amount, as a percent of total debt, of any other company’s refinancing needs.”

However, S&P warned that refinancing short-term debt is “only one of the several challenges facing the energy merchant sector.” The sector’s current credit ratings “have been on a rapid decline throughout most of 2002…[and] the ratings trend for the sector is overwhelmingly negative. Since July 1, 2002, there have been 57 downgrades in the sector, and for the past six months, there were 78 downgrades. This compares to 81 downgrades in all of 2001.”

For capital-intensive firms like power companies, S&P noted that “short-term liquidity becomes paramount.” Because many of the energy merchants were growing their businesses in the past few years, they had significantly increased their debt load to fund the growth, and were under the assumption that the debt would be refinanced in the “broad capital markets” in the future.

“Unfortunately, the future is here and the outlook is bleak,” said analysts. “The debt capital that once flowed freely has all but dried up. Banking relationships have become paramount for these companies, since they face large debt maturities that were incurred to grow the companies.”

S&P believes that “the merchant energy sector is promising to be the next wave of significant problems for banks, following on the heels of the telecommunications-sector issue.” Analysts estimated that banks have made $70 billion of loans to the surveyed energy merchant companies, and of that, “$43 billion comes due in the next four years and forms part of the $90 billion of short-term maturities.”

Loan quality began a “sharp slide” in the third quarter of this year, when NRG went into default, said S&P. “Other companies remain under pressure. Non-investment-grade credit quality of outstanding loans ranges between 68% and 34% of the total exposures of the energy portfolios.”

Analysts found that J.P. Morgan Chase’s exposure is 47% non-investment grade, while Bank of Nova Scotia’s is 58%, and Bank of Montreal’s is 55% non-investment grade. “These ratings distributions could change quickly, however. Many energy companies currently maintaining investment-grade ratings have negative outlooks (Aquila) or are on CreditWatch with negative implications (EME, El Paso Corp.).”

Using a recent regulatory examination of shared national credits (SNC exam), analysts said there are “signals” of credit deterioration and “the oil, gas, pipeline, and utilities industry sector had the second largest jump in adversely rated credits in the 2002 SNC exam, just behind the telecommunications and cable sector. In 2002, adversely rated credits in the sector rose 188% over 2001, reaching 14.4% of total commitments.”

To read the full report, “Refinancing of Over $90 Billion Medium-Term Debt May Strain Power Sector and Associated Banks,” visit www.standardandpoors.com.

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