All-Out Fear Unwarranted

All-Out Fear Unwarranted

Location: New York
Author: Ken Silverstein, EnergyBiz Insider, Editor-in-Chief
Date: Tuesday, November 4, 2008

Electric and gas utilities are not insulated from the financial turmoil now rankling global credit markets. But those businesses are relatively well positioned to endure the potential hardship that could befall other industries. That's because they have solid cash flows and limited refinancing needs in the short run.

That's the conclusion that Standard & Poor's has drawn in its report on the utilities sector and the credit crisis. The ratings agency reviewed the cash position, pending debt maturities and available revolving credit capacity of varied utilities. It found that their risks are manageable given their current liquidity and expected expenditures.

"These fundamentals indicate that most, if not all, companies should be able to refinance pending maturities despite the currently unsettled credit markets," write Richard Cortright and Kenneth Farer, analysts for Standard & Poor's Ratings Service.

The companies that it follows have a total debt of $505 billion. Of that, roughly $105 billion is due by 2010. As of June 30, 2008, those same utilities showed $31 billion in cash and short-term investments. Beyond that existing money, S&P goes on to say that the industry has about $110 billion available to it in the form of revolving credit -- money that was arranged earlier on favorable borrowing terms but which expires by 2012.

Fear undoubtedly persists because of the fall of Lehman Brothers. Constellation Energy, which lost critical financial support as a result of the investment banking firm's demise, was the first utility victim. In a related event, Reliant Energy also suffered a liquidity crisis, which forced it to seek new capital to survive.

But S&P says that those two events do not warrant all-out fear. It points to two stalwarts, Duke Energy and American Electric Power, which it says successfully tapped into bank lines of credit after some investment banks were brought to their knees: Duke drew down $1 billion off its $3.2 billion facility so as to ensure it has enough liquidity while AEP borrowed $1.4 billion under its existing line of credit.

While the ratings agency says that the regulated electric utility sector must spend an estimated $180 billion to upgrade its infrastructure and to install pollution controls, it now says that much of this outlay will have to be deferred until credit eases. It does add a word of caution, pointing to a 2007 Black & Veatch study that says as much as 60 percent of the generation, transmission, and distribution infrastructure is at least near the end of its service life.

"In the meantime, the companies will instead direct expenditures, on a much lower scale, to maintaining what in many instances is a rapidly aging and increasingly unreliable infrastructure rather than on the more expensive option of building new plant," say S&P's authors.

Recession Ready

As for the unregulated merchant generators, S&P says that most do not have major debt obligations coming due in the short run. Nor do they have huge capital expenditures in the works. Most such plans are confined to environmental spending and maintenance, it adds, which can be funded from operating cash flows or through project finance.

To be sure, the risks to both regulated and unregulated utilities are still pervasive. While the federal government has worked to prop up the financial sector, any further weakening of the banking system could erode the liquidity that is necessary to trade commodities. Without the necessary reserves, participation in power and gas markets would suffer.

That's the series of events that led in September to Berkshire Hathaway's proposed takeover of Constellation. When Lehman Brother's collapsed, Constellation lost its key funding source. As its collateral dried, it faced a downgrade in its credit ratings that would have served to increase its borrowing costs. If more capital is required to back trades, then the risk-reward ratio becomes too great to motivate participation.

"It is virtually certain that the current crisis will lead to a decline in liquidity in the power and gas markets given the inability and/or unwillingness of financial institutions to assume additional risk or take on new positions," says a separate S&P report on unregulated power generators written by Swami Venkataraman. "The fallout of such a decline in liquidity is unclear at this time, but it may result in independent power producers seeing fewer counterparties to trade with in the power markets."

Clearly, these are stressful times. But utility analysts are quick to point out that utilities are under a different type of strain than they were during the last economic downturn in 2001-2003. In the previous slump, many of the unregulated power generators had projected unabated electricity consumption and therefore went on a spending spree to accommodate that expected future demand. When the bottom fell out, many were unable to make their debt payments.

Today, the unregulated power sector has stable contracts that generate reliable cash flows. Therefore, they, along with the regulated utilities that are able to pass along higher costs to their customers, are well-equipped to handle a recession. "The utility sector, generally, should be able to refinance any debt that comes due," says Barry Abramson, Wall Street analyst with Gabelli in Rye, N.Y. "They should be able to borrow for growth as well. Long run, they should do okay despite all the pressures."

The ongoing economic chaos has disrupted the American economy, leaving the utility sector scathed in the process. While analysts express concern that a prolonged recession would take a much bigger toll, they remain confident that industry has the financial resources to weather this storm.