By Craig Shere, CFA
Standard & Poor's already has a positive outlook for the S&P Multi-Utilities & Unregulated Power index -- which includes natural-gas utilities that have exploration and production (E&P) operations, as well as energy merchants. Now it's being supported by the ongoing recovery of beleaguered energy merchants. We're reiterating our outlook on the group, which we upgraded from neutral to positive in late April.
S&P is optimistic about prospects for the group's members that conduct natural-gas distribution and E&P operations. In addition, the unregulated energy-merchant group has begun to show both fundamental and technical signs of bottoming. Year-to-date through Apr. 24, the S&P Multi-Utilities & Unregulated Power Index increased 8%, after a 60.2% decline in 2002. The S&P 1500 rose 3.2%, following a drop of 22.5% in 2002.
THE RIGHT PRICE.
Some recent developments appear to have positive implications for subindex members. At April's end, energy merchant Calpine (CPN ) announced the sale of a financial interest in a qualified facility power plant (a class of small power projects from which utilities are obligated to buy power) for $82 million. The fact that Calpine got the price it had expected bodes well for its efforts to enhance its liquidity as it conducts further asset sales.
Also, El Paso (EP ) announced the sale of a Philadelphia-area refinery, and Mirant (MIR ) finished its audits on its 2000-02 financial statements, alleviating some investor uncertainty. Duke Energy (DUK ) and Dynegy (DYN ) posted better-than-expected earnings.
Companies in the group with E&P operations should benefit from rising gas prices. With declining gas production, a steep drop-off in production rates on existing wells, and potential for a recovery in demand, we see strong possibilities for prices to advance. The pending imposition of stricter environmental-emission rules should further increase demand for electricity from natuarl-gas-fired power plants.
GAMING THE SYSTEM.
A number of small successes among energy merchants is another good sign. Thus far in 2003, Allegheny Energy (AYE ), Reliant Resources (RRI ), and Dynegy have successfully refinanced maturing debt with longer-term obligations. Williams Cos. (WMB ) struck a settlement in November, 2002, with California pertaining to refund issues relating to the 2000-01 energy crisis and the price of ongoing power delivery in the state.
El Paso resolved allegations of price manipulation of natural gas during the 2000-01 crisis with Western states in March, 2003. Both El Paso and Dynegy also resolved Commodities Futures Trading Commission investigations into misreporting of natural-gas pricing data.
Recent actions taken by the Federal Energy Regulatory Commission appear to have limited fundamental implications for the energy merchants. In late March, FERC issued "show cause" orders to three energy traders, including Reliant Resources, for written explanation as to why the commission shouldn't revoke market trading privileges. Also, FERC increased California refund adjustments industrywide relating to the 2001 crisis, and its staff issued a 344-page report detailing how energy merchants gamed the system.
While we now expect the broader group to outperform the S&P 1500 for the remainder of 2003, selective bankruptcies within the energy-merchant segment could wipe out shareholder value. Given the credit, regulatory, and operating risks, only aggressive investors should consider this volatile group. Indeed, Mirant's 2003 financial statements were flagged by its auditors with a "going concern" caution -- suggesting the possibility of bankruptcy if debt maturities aren't refinanced.
Our top picks in the sector are Williams, an energy merchant that should be considered only by aggressive investors, and Questar (STR ), a gas utility with E&P operations. Both of these companies carry an S&P investment opinion of 5 STARS (buy). Calpine and Reliant Resources (both energy merchants), and National Fuel Gas (NFG ) and Equitable Resources (EQT ) (gas utilities with E&P) are each ranked 4 STARS (accumulate). We carry a 3-STAR (hold) recommendation for other energy merchants, including AES, El Paso, Mirant, Duke, and Dynegy.
Analyst Shere follows stocks of multiline utilities for Standard & Poor's