The Power Party May Be Winding Down

If price caps spread, profits could drop industrywide

Another week, another clash between California and its power suppliers. On June 25, state officials and representatives of the nation's power companies began federally ordered settlement talks involving nearly $9 billion in alleged overcharges for wholesale power. Those negotiations come on the heels of a June 18 ruling by the Federal Energy Regulatory Commission that imposed limited price controls throughout California and the rest of the Western U.S. power market.

As California succeeds in reining in rampant prices, investors fear that government intervention will erode the booming earnings of power generators that own plants, such as Duke Energy North America, as well as power marketers such as Enron Corp. that buy output from plants and sell it to other customers. "There's a lot of investor skepticism in this area right now," says Roger Mortimer, a portfolio manager with AIM Global Resources in San Francisco, which holds stakes in several power companies.

Small wonder. For most of the industry, profits soared last year. Now, fearing the party is over for everyone, investors have pushed shares of power generators and marketers down about 30% since June 1. But some observers say investors have overreacted, penalizing all indiscriminately even though some industry players are likely to fare better in the new environment than others.

Most of the concern stems from fears that price caps in the West could spread to other states, stifling the deregulation that has fueled profits all over the country. For example, New York's attorney general has already asked FERC for similar price caps there. "Controls tend to breed further controls," says analyst Raymond Niles of Salomon Smith Barney. "It is now increasingly likely that regulators will attempt to regulate, rather than letting market forces correct the problem."

In the West, it appears FERC had little choice but to act after the California market spun out of control. The June 18 FERC order, effective through September, 2002, limits the price that power companies can charge on spot markets throughout the West. But many analysts agree that the new price ceilings won't limit the ability of most power companies to make a profit in the region. The main reason: A shift toward long-term buying is already under way in California. These days, only about 20% of the state's power is bought on the spot market, vs. 100% a year ago. Long-term contracts, which usually last 5 to 10 years, tend to be more profitable because producers can lock in fixed prices.

Analysts say power producers such as Calpine (CPN ), Dynegy (DYN ), and Duke Energy (DUK ), which have tied up virtually all of their production capacity through long-term contracts, should do well. But companies such as Houston-based Reliant Resources Inc., which don't have long-term contracts in place for most of their capacity or still have contracts pending, could be hurt. "For people who don't have their economics locked in, clearly earnings will come down quite a bit," says Stephen Bergstrom, Dynegy's president and chief operating officer.

FEWER MIDDLEMEN. But the biggest losers under the new FERC regs may be power traders such as Enron (ENE ) and Aquila Inc. Some analysts now expect to see lower trading activity in the Western power grid because long-term contracts make the market less volatile. That means less need for middlemen to trade.

Nevertheless, both Enron and Aquila argue that they don't have significant exposure in the West and that they, too, have wrapped up long-term contracts. Meanwhile, both are moving into other markets that should boost trading volume. Aquila is building power plants in the Midwest and Southwest, for example, while Enron is expanding into new markets such as metals, paper, and pulp. "We're not moving off our earnings outlook at all," says Aquila CEO and Director Keith Stamm. But until that outlook becomes reality, investors will likely remain skeptical.

By Stephanie Anderson Forest in Dallas, with bureau reports

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