Quarterly utility earnings are expected to be weak for both gas and electric companies except for those with significant oil and gas exploration and production (E&P) operations or energy marketing and trading that could have benefited from high and volatile commodity prices, according to analysts at Merrill Lynch.

Traditional gas utility companies probably will report light loads and lower earnings for the third quarter, which is typical for the shoulder period. However, integrated utilities with E&P exposure “should have seen upside as natural gas and oil prices have risen significantly in recent months,” noted analyst Sam Brothwell.

He said utility companies such as Equitable Resources and Questar, which have large E&P divisions, should benefit from higher commodity prices, unless they have limited their upside through aggressive hedging. Gas prices during the quarter moderated but remained strong despite light power loads with Henry Hub spot prices averaging about $5.50 compared with $4.65 in the third quarter of 2003. Average West Texas Intermediate crude oil prices were $44.81/bbl compared to $30.43 in 3Q2003, Brothwell noted.

“Unhedged volumes should benefit from very robust commodity prices,”said Brothwell. With more rigs working, we would also expect to see stronger production volumes, which would bode well for earnings and cash flow upside next year.”

Questar’s production is expected to grow 9% this year. With 15 rigs working on the Pinedale Anticline in southwestern Wyoming, “production and reserves should continue their solid growth,” said Brothwell. He also sees the potential for improvements in Questar’s midstream operations, which could outpace the E&P business in terms of growth.

Integrated utilities that have retained energy marketing and trading operations, such as Sempra Energy, also should benefit from the price volatility and increase in priced during the quarter, Brothwell said. Sempra’s “power business should also see upside from a full quarter of increased deliveries under the [California Department of Water Resources] contract as well as the addition of Texas power plants.”

Analyst Steve Fleishman said he expects quarterly earnings in the electric utility sector to tumble about 5.1% on average. “Mild summer weather, higher fuel costs and share dilution are the primary negative drivers,” said Fleishman. “Offsets include rate increases, sales growth excluding weather, and cost savings.”

Summer weather was mild with cooling degree days overall down by 9.6% compared to last summer and down 3.1% compared to normal. Electric power output, however, was flat on average nationwide compared to 3Q2003 because of economic growth this year, according to Merrill Lynch.

Full-year electric utility earnings are expected to be flat but substantial growth is expected in 2005 because of expected normal weather, use of free cash flow, cost savings and rate relief, said Fleishman. “Companies also should benefit from locking in higher power prices on their nuclear and coal generation.”

Fleishman has raised its earnings projections for TXU because of its share repurchase program and incremental cost cutting initiatives. He said TXU earnings in 2004 and 2005 should end up at $2.60 and $4.80 per share, respectively, up from prior estimates of $2.55 and $4.20/share. “TXU’s free cash flow could exceed $1.5 billion in 2005 in our view,” said Fleishman. “We expect that some of this will be used toward a higher dividend with the remainder used toward incremental debt reduction, share repurchases.”

One significant factor that could affecting unregulated power generation going forward is the American Jobs Creation Act, which was passed last week by Congress. If President Bush signs the measure, generators (and other domestic manufacturers) would see a 9% tax cut phased in through 2010. Transmission and distribution of power was excluded from the tax break.

“Although the gradual phase in period will keep the benefits of lower tax rates somewhat limited on a year over year basis we do believe that this is a modest positive for the companies with significant unregulated generation,” said Fleishman. “However, we would note that companies with regulated generation may have to share potential benefits with customers.”

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