Deregulation Not Derailed by California’s Meltdown

Branded as lawless cowboys by California politicians and consumer advocates, energy merchants rode skyrocketing electricity and natural gas prices to new stock highs during the worst of California’s energy crisis.

But in recent months these energy companies--names such as Duke, Dynegy, Reliant, AES, Mirant, Williams and El Paso Corp.--have seen their fortunes dim as California’s electricity meltdown has slowed the pace of deregulation nationwide, power prices have tumbled and the economy has faltered.

Even power plant owners and energy trading operations that have maintained healthy earnings growth have watched their stock performance fade.

And then there’s the Enron Effect.

Enron Corp., cast as the heavy by California politicians, has suffered the biggest fall of all and has helped to drag down stocks of other energy producers and traders.

Enron’s woes appear to be a special case in that they flow less from its energy businesses than from a loss of investor confidence in the company’s complex and shadowy financial structure, with a resulting cash crunch.

Nonetheless, Enron’s detractors are crowing at the rapid decline of the truest believer in electricity deregulation, the movement to take businesses controlled for decades by monopoly utilities and throw open the generation, trading and retail sale of electricity to new competitors.

But just as Enron is not dead, neither is electricity deregulation, energy experts contend. Though several states have delayed their deregulation plans and some major corporate players are tempering their enthusiasm, other states and corporations press ahead.

It’s a tough new world for energy companies that will bring profit opportunities for some and acquisitions of low-priced players, analysts say. Enron, once the most brash of the energy peddlers, has agreed to be acquired by archrival Dynegy Inc. in a $7.7-billion stock deal.

Yet when the economy and power prices improve, energy companies will see their prospects gleam again, analysts say.

“Deregulation is a train that’s not going to be derailed. It may be delayed, but it’s coming,” said Jon Kyle Cartwright, senior energy analyst with brokerage firm Raymond James & Associates.

“When the economy rebounds, we’re going to see higher energy prices again,” Cartwright said. “That means that the guys who sell power, the guys who manufacture power--they’re going to have very bright futures.”

Less than a year ago, when energy prices were headed for record territory in California and a winter of electricity shortages plagued the state, the favorite whipping boys of Gov. Gray Davis and other politicians were such energy sellers as Enron, AES Corp., Dynegy, Duke Energy Corp., Reliant Energy Inc., Mirant Corp., Williams Cos. and El Paso Corp.

All are energy companies that own power plants in California or sell electricity or natural gas in the state at prices deemed by state officials to be higher than those a truly competitive market would have produced. The energy companies have denied that they overcharged Californians, and federal regulators investigating the matter have so far ordered only limited refunds of electricity revenues.

Nonetheless, Southern California Edison Co. and Pacific Gas & Electric Co. lost so much money paying for electricity--costs they could not pass on to customers because of a rate freeze--that they became insolvent. PG&E; filed for bankruptcy protection.

California’s near-death experience in electricity markets brought state government into the power business in unanticipated ways when lawmakers passed the landmark deregulation bill in 1996.

The state became the primary electricity buyer for the big utilities’ customers and formed a power authority to build power plants and transmission lines, becoming potential competition to generation companies. State regulators blocked electricity sellers from signing up new retail customers, a program known as “direct access” that is one of the key components of electricity deregulation.

Players Refocusing on Other Operations

The energy spectacle in California caused several states to short-circuit deregulation plans or to take a much slower approach that could delay for years the opening of those markets to competition.

Energy companies also are now contending with lower electricity prices, which have plummeted since the beginning of the year, thanks to lower natural gas prices and temperate weather. And volatility has nearly disappeared, thereby cutting profit potential for energy trading firms.

The economic downturn will reduce demand for electricity, analysts said, which also will hurt earnings at a range of companies.

The pain was apparent in third-quarter results.

“After several quarters of across-the-board strong results, we are now in more of a winners-and-losers environment, as low commodity prices and a weak economy make conditions more difficult,” Merrill Lynch energy analyst Steven Fleishman said in a recent note to clients.

Some big and mid-size players have stumbled, and a few have slowed their headlong rush into unregulated businesses that had until recently held promise for these companies, many of them utilities that branched out.

A prime example is AES, which generates electricity in California, across the nation and in 26 other countries. AES said third-quarter net income fell 98% because of a sharp drop in profit from its operations in Brazil and Britain. AES reduced its earnings estimates for the year and said it will refocus on its core energy business, look for divestiture opportunities and not invest in any more telecommunications businesses, dropping its hostile $1.37-billion bid last week to take over a Venezuelan telecom firm.

Reliant Energy said its wholesale energy operation had a 15% drop in third-quarter operating income, blaming lower gas and power prices, plus legal and other costs related to the California electricity crisis. The company’s European operations lost $5 million because of lower profit brought about by deregulation in the Netherlands, and Reliant now is considering selling its European businesses.

Constellation Energy Group, which owns the utility in Baltimore and is building power plants in California and around the country, abandoned plans to spin off its trading operation after it said earnings for the year will come in at the low end of estimates.

One California firm that appeared poised to benefit from electricity shortages was Chatsworth-based Capstone Turbine Corp., which manufactures micro-turbines that supply power to a small business or a cluster of homes.

But struggling Capstone said third-quarter revenue dropped by nearly half and its net loss widened by 54% to $12.5 million as California dodged a summer of blackouts and the economy slowed.

Energy Giant Takes an Unexpected Loss

The company hired a new chief operating officer and said it would restructure and lay off an undisclosed number of employees.

The biggest surprise came from Enron, which broke a run of 16 profitable quarters, reporting a $635-million net loss for the third quarter because of a $1-billion charge from failed investments in water and telecommunications. The Houston-based energy giant also revealed that two of its off-balance-sheet investment partnerships, headed until July by its chief financial officer, led to $35million of the losses and chipped $1.2billion off shareholder equity in the third quarter.

Investors began this month to dump the stock, and Enron’s credit rating eroded amid lawsuits, news of a probe by the Securities and Exchange Commission into conflicts of interest and attempts by management to soothe fears.

Enron Chief Financial Officer Andrew Fastow, who ran the two partnerships, was pushed out and the firm lined up new financing and went looking for new investors.

Enron has used an opaque grid of off-balance-sheet partnerships to shelter assets and debt to help the company’s push into a variety of deregulated markets in recent years. But analysts and investors fear that Enron is hiding money-losing assets in the partnerships; management has been tight-lipped about the purpose and holdings of the investment vehicles.

Takeover rumors swirled last week around Enron before Dynegy announced the deal Friday, underscoring predictions of general industry consolidation because of low stock prices.

Some Firms Thriving, but Not Their Stocks

Some companies are still going strong, although their stocks remain depressed.

That includes companies on the receiving end of potshots from California’s politicians and utility regulators such as Duke Energy, Dynegy, Mirant, NRG Corp. and Williams, as well as San Jose-based Calpine Corp., which was repeatedly praised by Davis for playing a constructive role during the crisis.

Calpine, for instance, said third-quarter profit and revenue doubled because the electricity producer increased sales by adding power plants. And yet its stock is down 55% from a 52-week high of $58 reached in March.

“These are the energy merchants that seem to have the best grasp on the market and on risk management,” said Chris Ellinghaus, power and natural gas analyst with Williams Capital in New York. Many of these companies are diversified geographically and by the fuel they use to generate electricity and had locked in favorable contracts that protected them when power prices fell this summer, he said.

ABN Amro utility analyst Paul Patterson said investors have turned away from these companies, even the healthy ones, because the business “isn’t as exciting as it used to be.”

“People go on earnings momentum. It’s kind of like having your dessert first,” Patterson said. “Once the best is over, you lose your appetite.”

One company trying to adapt to deregulation’s devolution in California is Commonwealth Energy Corp., which has survived a run-in with the California Public Utilities Commission and the suspension in California of direct access, Commonwealth’s primary business of selling electricity directly to consumers and businesses.

Commonwealth Energy was one of the more than 300 companies that flocked to California to sell retail electricity to the customers of Southern California Edison, PG&E; and San Diego Gas & Electric Co. All but about a dozen of the electricity sellers failed, and Commonwealth enjoyed initial success peddling low-priced power from renewable sources.

But the Tustin-based company and its founder, Fred Bloom, ran afoul of the PUC for faulty billing practices and Bloom’s failure to disclose that he had been ordered to stop selling unregistered securities by five states.

Commonwealth Energy settled the matter by paying about $350,000 and reimbursing customers. Bloom was banished from the firm as part of the settlement, and an all-new management team set about diversifying away from deregulated businesses, said Ian Carter, the company’s chairman and chief executive.

The firm, which recently became registered as a public company but can’t sell stock until January, is earning a profit, largely because it has been able to resell contracted energy for more than it paid.

To maintain its growth, the company is turning away from deregulation and toward providing back-office services for regulated companies, generators and municipalities, Carter said.

For the fiscal year ended July 31, Commonwealth Energy posted revenue of $183 million, up 84%, and income of $60.5 million, compared with a loss of $8.6 million in the previous fiscal year.

“We certainly don’t consider ourselves a casualty of deregulation or direct access,” Carter said, noting that the company still sells electricity to 55,000 California business and residential customers and to cities, including Santa Monica and Palmdale.

“We realized that we needed to diversify and we needed to do that fairly quickly,” Carter said. The company has nearly 40,000 retail customers in Pennsylvania and will be entering Texas, Michigan, New Jersey and Ohio, he said.

Seven states have delayed their push toward open markets, and some of those that remain on track, such as Texas, have run into unforeseen glitches that delay the process of giving electricity customers choices beyond their traditional utilities.

Deregulation marches on in power trading and generation.

The Electric Power Supply Assn., a Washington-based trade group, said last week that competitive power supplies account for slightly more than a third of the nation’s generation capacity, up from 8.5% in 1997. Wholesale power trading could approach 7 billion megawatt-hours this year, up from 2.6 billion in 1999, the group said.

Federal regulators are in the middle of determining how to reallocate control of electricity transmission lines into only a few regional operators, perhaps owned by new for-profit companies other than utilities.

This process shows that the Federal Energy Regulatory Commission remains determined to open electricity markets despite the problems in California, said Lawrence J. Makovich, senior director of the North American power practice at Cambridge Energy Research Associates.

“We’ve got major parts of the electricity business moving backward, and California is the prime example,” Makovich said. “But when you look at other places in the country, what you see is a continuing evolution to a much more market-based power situation.”

David Jermain, a principal in the national utility practice of Andersen LLP, said California will remain on the sidelines for years, paying higher prices than those produced by competitive markets. It also must contend with a number of pending lawsuits.

“California is in for a long-term state of chaotic confusion,” Jermain said. “It’s such a complicated mess that you’re going to have to let the court system play through.”