Energy Merchants Weather the Storm

Standard & Poor's says the industry has managed its exposure to Enron's bankruptcy reasonably well

Standard & Poor's is maintaining its current ratings, outlooks, and CreditWatch listings on the companies in the energy merchant industry.

Standard & Poor's clearly recognizes the tremendous effect that the Enron Corp. bankruptcy has had on this industry. Indeed, the consequent collapse of investor confidence in an industry that is extraordinarily dependent on confidence has caused valuations to sink and credit spreads to widen tremendously. Press articles have further rocked the markets and infused waves of uncertainty. But this is not a time to panic. Neither stock market valuations, yield spreads, nor short-term earnings trends should drive credit analysis. While current bond yields would suggest that the credit quality of the energy merchant business has collapsed, Standard & Poor's has not reached any such conclusion.

In general, the industry has managed its exposure to Enron's bankruptcy reasonably well, which Standard & Poor's attributes principally to the adequacy and proper execution of risk-management procedures. Standard & Poor's recognizes that the capital markets may influence a company's liquidity position and financial flexibility in the short term. Yet, in the face of a collapse in its equity valuation, Calpine Corp. (BB+/Stable/-) in late December issued $1 billion of convertible senior notes immediately following Standard & Poor's affirmation of its rating.

Moreover, on Dec. 20, Mirant Corp. (BBB-/Stable/--) issued $750 million of common equity, while Dynegy Inc. (BBB+/Watch Neg/A-2) issued $500 million of common equity. Clearly, access to the capital markets has not evaporated. Standard & Poor's expects that companies that choose not to access the equity and debt markets currently will proactively address the market's concerns. For example, El Paso Corp. (BBB+/Stable/A-2), Dynegy, The Williams Companies Inc., (BBB+/Stable/A-2) and Mirant have already, and in rapid-fire order, unveiled comprehensive plans to improve liquidity and strengthen their balance sheets to relieve market fear about deteriorating credit quality. These responses indicate management's acknowledgement of a market perception problem and the absolutely critical need by the market for a credible and comprehensible program to shore up credit quality.

Investors, however, must be alert to the fact that implementation of these plans could be a challenge for some energy merchants. Failure to either formulate an effective plan or to execute in the near term is likely to have materially adverse credit ramifications.

Investors must also recognize that energy traders have the additional risk that another rating agency, or agencies, could downgrade some or all of these companies. Such an action could erode counterparty confidence, trip rating triggers, and precipitate a crisis. Many of these companies incorporate various rating triggers in their commercial agreements and financial documents at the counterparties' request. Some of these triggers may precipitate termination of agreements based on a downgrade by one rating agency only, as opposed to downgrade by two or three rating agencies. Standard & Poor's does not factor the risk of downgrade by another rating agency into its ratings as it would require us to have an opinion on the criteria of another agency and the specific application of the criteria of that rating agency. Standard & Poor's has often observed that rating triggers limit flexibility of a company and can amplify the seriousness of a credit quality deterioration and contribute to a ratings cliff.

American Electric Power Co. Inc. (A-/Stable/A-2; AEP): In the absence of new relevant information, credit quality concerns continue to focus on industry restructuring in connection with electric deregulation in Texas and Ohio. Some uncertainty remains about the credit profile that will emerge from the restructuring effort. The stable outlook on AEP is subject to revision if the restructuring does not produce a financial profile that supports the current rating.

Aquila Inc. (BBB/Stable/--): In the absence of new relevant information, credit quality concerns continue to focus on the company's stand-alone credit characteristics, though its parent company, UtiliCorp United Inc., is in the process of tendering for the 20% of Aquila that it does not currently own. Standard & Poor's is examining UtiliCorp's strategies and plans for the reconstituted company in light of its intention to not spin-off Aquila, and it is possible that the combined company will not exhibit a credit profile that is consistent with the current rating.

Entergy-Koch L.P. (A/Stable/-): The company remains strong despite the current market turmoil. A significant portion of the Entergy-Koch's cash flow and earnings comes from regulated pipeline operations, and the trading operations maintain a low-risk strategy and tight risk management controls. Liquidity concerns remain low, and debt levels are modest for the rating.

Allegheny Energy Supply Co. LLC (BBB+/Stable/A-2): The company's trading and generating operations are expected to be cash positive for year 2002. Allegheny has ample liquidity in the form of cash and revolving credit capacity, which contrasts significantly with the company's calculated value at risk. Since the company's marked-to-market value is positive, any unexpected margin requirement would likely be small.

NRG Energy Inc. (BBB-/Stable/-): The company's low investment-grade rating is at risk if ratings triggers in many of its contracts were invoked. These ratings triggers would require additional liquidity in the form of cash, letters of credit or other replacement security. Mitigating this exposure are various options available to the company such as availability under its credit lines, sales of assets or sales of equity securities. In addition, XCEL Energy, its 74%-owner, has continued to support the company's business strategy.

PG&E National Energy Group Inc. (NEG): The company's exposure to trigger events in its various contracts could be significant; however, NEG has adequate liquidity to fund these potential liabilities should a downgrade occur. The company experienced its own liquidity crisis in early 2001 given the bankruptcy filing of its utility affiliate, Pacific Gas & Electric Co. As a result, NEG has been forced to operate with substantial available liquidity. The company has demonstrated an ability to do what is necessary to maintain investment-grade ratings on a stand-alone basis.

Dynegy (BBB+/Watch Neg/A-2): The company remains on CreditWatch with negative implications as Standard Poor's evaluates pending litigation related to the failed Enron merger, counterparty confidence, liquidity needs, and the firm's plan to shore up its balance sheet with equity issuance and asset sales. Importantly, Dynegy raised about $500 million in common equity through a stock sale on December 20, 2001.

Calpine Corp. (BB+/Stable/--): The company has demonstrated that even at sub-investment grade in this extraordinary market, it still has access to the capital markets by issuing $1 billion of convertible securities this week. Calpine mitigates merchant risk through its strategy of covering two-thirds of its capacity under long-term contract.

Duke Energy Corp. (A+/Stable/A-1): The company has sufficient financial resources and flexibility to mitigate the effect of the current market stress resulting from a loss of investor confidence if this constraint on access to the capital markets persists for several more months. At its current rating level, Duke has ample cushion before triggers, would present a risk to bondholders.

Dominion Resources Inc. (BBB+/Stable/A-2): The company has sufficient financial resources and flexibility to mitigate the effect of the current market stress resulting from a loss of investor confidence if this constraint on access to the capital markets persists for several more months. However, Standard & Poor's is reviewing the asset quality of the company's Dominion Fiber Ventures LLC, an off-balance-sheet funding vehicle created in early 2001 to hold the share of Dominion's telecommunications assets. Standard & Poor's is assessing the likelihood that Dominion might have to supply support to repay the $665 million of senior notes due in 2005, if an equity offering of the entity to the public is not feasible at that time.

Mirant Corp.: Standard & Poor's today affirmed the ratings on Mirant and its affiliates. The outlook is stable. For full details, see press release dated today. Reliant Resources Inc. (BBB+/Watch Neg/--): The company's Credit Watch listing reflects the pending $2.9 billion acquisition of Orion Inc. The exposure to Enron, which is moderate, should be reduced through an orderly realignment of trading partners. Ratings downgrade triggers exist only in trading contracts (as they do for all trading companies) and, should it be required, Reliant Resources has adequate capacity to provide letters of credit to post additional collateral.

TXU Corp. (BBB+/Stable/A-2): The company is challenged to reduce its high leverage over the next year; however, the company has implemented a debt-reduction program in conjunction with the corporate restructuring required by Texas law. The company has adequate credit capacity to post additional collateral in the form of letters of credit should a ratings downgrade trigger trading contract requirements. A severe ratings downgrade plus a significant drop in the price of TXU common stock would cause early payment of debt issued by the joint venture limited partnership, Pinnacle One Partners L.P. Should this structure unwind, TXU may be required to fund any shortfall in the principal repayment

The Williams Companies Inc. (BBB+/Stable/A-2): Williams has announced a plan to strengthen its balance sheet by selling $1 billion of mandatory convertible preferred securities in 2002, reducing capital spending by $1 billion and selling assets, using the proceeds to reduce debt. In addition to a stronger financial profile, the company's credit benefits from ample liquidity provided by $2.2 billion of bank facilities supplemented by over $500 million of cash. This provides sufficient capacity should a ratings downgrade trigger a call for additional collateral on energy trades. Other than the ratings downgrade trigger associated with the Williams Communications Group Inc. (WCG) share trust, the magnitude of debt obligations which also contain ratings downgrade triggers is not great. The share trust has issued $1.4 billion of debt, part of the financing package put in place to spin off that company to shareholders. It is fully anticipated that either WCG will be able to refinance that debt without the share trust structure, or will be able to sell assets sufficient to pay down most if not all of the debt. Should this structure unwind, Williams may be required to fund any shortfall in principal repayments.

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