Ken Silverstein EnergyBiz Insider Editor-in-Chief

Companies in a position to buy have solid balance sheets in addition to an expectation that the demand for power will increase and soak up unused electricity capacity offered by merchant power plants. And if they can purchase power plants at bargain prices, the assets will likely generate greater returns. Dominion Resources, Entergy Corp. and Exelon Corp., for example, have said they are looking to buy good assets on the cheap while the investment banks are doing the same.

"Now is a good time to sell," says John Reed, CEO of Concentric Energy Advisors outside Boston that is a financial advisory and management consultancy that works exclusively in the energy sector. "It's always difficult to label something as the best time to sell. But, the market is getting comfortable with merchant risks. The ripple effect caused by Enron has worked itself out."

Reed goes on to add that the excess capacity -- the amount of power the merchant facilities could be selling but are not -- will dissipate in some parts of the country within two years. Regions such as New England, New York and California are just about primed for new generation, while other regions have an overabundance of generation that will take as long as 10 years to absorb, he adds.

In the case of North Carolina-based Duke, it plans to sell outright six power plants and parts of two others, all to LS Power Equity and for about a $330 million pre-tax gain. The natural gas-fired plants generate about 6,200 megawatts. The facilities for sale are located in Arizona, California, Connecticut and Maine. LS Power has said that the price is right and that it expects demand for power to grow -- making the investments attractive.

"Completing the exit from (Duke's merchant) business is a major object for 2006," says Paul Anderson, CEO of Duke, in a formal statement.

To win the hearts of bankers, deals must focus on improving cash flows and liquidity, as well as demonstrate a clear path to where the utility wants to go in the future. But the merchant generation market, per se, has been one of the most problematic.

Rosy forecasts in the late 1990s led to a boom in the power industry that in hindsight was not sustainable. The result was that many lenders overvalued the collateral on which they loaned capital, which allowed unregulated merchants to borrow aggressively -- expenses that they could not pass through to ratepayers. The totality of that strategy has yet to be fully realized given the total merchant debt is $65 billion, due by 2012.

Highest Flyers

The history of the merchant sector has been told: The highest flying companies in the 1990s have crashed and include not just Enron but also Mirant and Calpine, which expect to emerge from bankruptcy as healthier enterprises. Others such as NRG Energy have already gotten a second wind.

Certainly, few of the generating assets that have been taken over by lenders are current on their debt obligations. But, the banks are taking the long view and holding on to these facilities with the expectation that the demand for power will escalate and the prices they can fetch for the plants will increase.

According to Concentric's Reed, the risk profile associated with the merchant energy sector has improved. Indeed, many analysts expected both the merchants and the banks to cut and run - to sell distressed assets at fire sale prices. That has not happened. They have stepped back and are determined to let the excess capacity work itself out, he says.

Duke chose to sell off its plants because it decided it did not want to be in the merchant business. Its deep pockets permitted it to hold on to these plants and to sell at prices it deemed reasonable -- not the 20 cents on the dollar that buyers had initially sought for merchant assets in general. It's the same exercise in patience that lenders have successfully followed.

"Lenders now recognize the cyclical nature of power generation and they recognize just how susceptible to fuel prices these facilities can be," Reed says. "In the future, they are looking at several scenarios so that they can have a high comfort level that borrowers can meet their debt service even in bad markets."

When asked about what bankrupt merchants such as Calpine or Mirant will do with their distressed assets, Reed said that the same rules apply whether a company is in Chapter 11 or whether they are normally healthy. A company in bankruptcy has been given "breathing room" by the courts to get their affairs in order, enabling them to avoid selling off a wave of assets.

If creditors want to get paid, they will need to ensure that the assets of distressed companies are fully productive and bringing in cash. When the market for wholesale electricity rebounds, those assets will then operate at or near capacity and their values will subsequently increase. As such, bondholders and banks are more likely to get repaid a higher percentage of their loans. If the demand for power resumes, power prices and company revenues can remain stable or increase.

Stronger Balance Sheets

At the same time, low interest rates are allowing unregulated utility operations a chance to secure new financing. The new maturity dates are at least four years away, buying the enterprises time to take part in a potential robust recovery. Reliant Resources has refinanced $5.9 billion in bank loans, for example, while Allegheny Energy has re-financed $1.55 billion of debt.

"The credit recovery that has been in progress for the last three years since the credit meltdown of the power and gas sector in late 2002 appears to have run its course," says Fitch Ratings, in a new report. "Most companies in the sector that suffered credit deterioration have repaired their balance sheets or are far along ...," it adds, noting that high commodity prices and regulatory risks may undermine those efforts.

While the turnaround may have begun, there are lessons to be learned. Banks and bondholders that financed the unregulated projects won't get swept into any new frenzy and will scrutinize capital projects more intensely than they did in the 1990s. That will make it more difficult to raise capital because the credit standards will be a lot tougher.

Merchants have also learned hard lessons. Many have seen their credit ratings plummet as a result of overbuilding generation and taking on too much debt. The declaration of bankruptcy or taking advantage of low-interest rates have allowed many unregulated power generators to strengthen their financials, participate in an improving economy and perhaps see the value of their assets jump. Creditors and lenders appear willing to give some troubled utility operations a second chance.

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