Christopher Edmonds

Return to Article

Get Out the Sweaters, and Your Wallet

Christopher Edmonds

For one longtime energy pundit, the California energy crisis brings back memories.

John Olson, director of energy research at Sanders Morris Harris, a Houston-based investment firm, says the two California utilities -- PG&E (PCG Quote - Cramer on PCG - Stock Picks) and Edison International (EIX Quote - Cramer on EIX - Stock Picks) -- are on the verge of insolvency.

"These companies are on the razor's edge of bankruptcy," he says, noting that, without government support, shelter from creditors is an attractive option. "If the [California] legislature and governor are not more accommodating, it might make good sense for them to go into bankruptcy."

And while insolvency isn't the ending anyone is hoping for, there is chatter in California that bankruptcy filings from PG&E and Edison wouldn't be the end of the world.

Problem is, Olson suggests, politicians and ratepayers don't appreciate the havoc inflicted by Chapter 11 bankruptcy proceedings, especially involving utilities. He cites the Columbia Gas Systems bankruptcy in 1991 as an example.

"Columbia thought they could get out of bankruptcy in a year," says Olson. "They put $2 billion of rate base into bankruptcy. The vultures came in, and it took them four years to get out."

That is nothing compared to California. If both PG&E and Edison filed for bankruptcy, that would be $33 billion of rate base (the annual amount consumers pay of for power) in bankruptcy. "We are talking about the two largest taxpayers in the state," says Olson. "And, we are talking about a federal bankruptcy judge that doesn't take orders from the governor or the CPUC [California Public Utilities Commission] or the legislature."

While Olson thinks that strong political will on the part of California Gov. Gray Davis and the legislature could forge a solution to the problem, he doesn't believe such will exists. Instead, the pols are looking for someone to blame and punish. "The legislature is out there bent on doing some of these companies a lot of damage."

Olson believes the solution, regardless of bankruptcy, will include higher rates for California consumers. "This is a three- to five-year tunnel for ratepayers," Olson opines. "I just don't see any way around it unless Gov. Davis issues a standing order for blankets and sweaters."

He believes the solution should not be a government takeover of generation facilities or the utilities. "The option for a state energy company would be very hard to implement," Olson says. "You don't have any staff that knows how to deal with [electric-power] issues."

Yet the long-term solution also involves more power supply in California, and a lot of it, Olson said. "What California needs is about 15,000 megawatts of new generation and long-term contracts."

That, Olson argues, bodes well for companies that can provide generation on a fast track. He cites Calpine (CPN Quote - Cramer on CPN - Stock Picks), Duke (DUK Quote - Cramer on DUK - Stock Picks), Dynegy (DYN Quote - Cramer on DYN - Stock Picks) and Reliant (REI Quote - Cramer on REI - Stock Picks) as examples of developers that will power up California. "They have the turbines and they have the people that can put plants on the ground, some in as a little as six months. They've done it before."

So, how does California play out? Olson isn't optimistic. "If somehow these companies stay out of bankruptcy and maintain a fairly healthy business profile, they will have had a miraculous rebirth. That is a long shot right now."

Fueling Regeneration

Olson also sees one sleeper as a significant beneficiary of the West Coast conundrum.

El Paso Energy (EPG Quote - Cramer on EPG - Stock Picks) owns half the natural gas pipeline capacity into the Golden State, the fuel of choice for new power generation. And with natural gas in short supply in the West, El Paso stands to benefit. "Since El Paso has 3.4 billion cubic feet of pipeline capacity into California, they can do a lot of good moving their own gas and marketing it into the state," Olson says. Gas prices in California have been more than three times the national average as demand has soared and pipeline capacity is limited.

Olson also says the soon-to-be-completed merger with Coastal (CGP Quote - Cramer on CGP - Stock Picks) creates a premier energy company. "They will have the best overall business model for the next five to 10 years," he says.

The power of the model is the marriage of Coastal's proven exploration and production capabilities with El Paso's transportation, trading and marketing operations. "In a seller's market, it is good to have hard assets to support your soft assets," says Olson. "With the merger, El Paso will be in a premier position to trade around its assets."

Olson rates El Paso buy and has a 12-month price target of $80. His firm has not provided banking services to the company.

( Read more about Olson's thoughts on the natural gas markets.)

Enron Overvalued?

A value guy, Olson doesn't like lofty price-earnings ratios anywhere, and that includes Enron (ENE Quote - Cramer on ENE - Stock Picks). "It's been way too expensive for me for ages," he says.

Olson's thoughts on the energy giant -- on the eve of the company's annual analyst love fest in Houston -- are somewhat contrarian. According to data from Zacks Investment Research, of 15 analysts who cover the company, 12 rate the stock either strong buy or buy. Olson rates the stock hold.

Olson doesn't necessarily think Enron is overrated, simply overvalued. "They trade at 44 times earnings, and the rest of the pack trades at about 20 times," he says. "They would argue they are unique. I would say nothing in life is that unique."

He says that Enron would rather be compared to an investment bank than a traditional energy company. And while Olson isn't sure that is appropriate, Enron is even more expensive using that metric. "Maybe they compare to a Goldman or a Merrill Lynch or a Smith Barney. They are usually twice as profitable as Enron in terms of returns on equity and trade at only 15 to 20 times earnings."

His bottom-line: "Provided they can continue to grow at 15% a year or better and maintain the magic that gives them a high P/E, so be it," Olson says. "But if there is one pothole or air pocket out there, beware. It's hard to get to a 44 P/E, and it's a lot easier to lose as well."

While Enron's stock may continue to climb -- it traditionally does around its annual investor meeting -- that doesn't tempt Olson. "As a relative value player, I think I can get better value elsewhere, with less risk."

As for the company's response, in November, when the stock was trading near $90 I asked Ken Lay, Enron's chairman, about valuation. If anything, he suggested the company's stock was undervalued. "Some of us here and, of course, many analysts would maintain that even that 50 times earnings is undervaluing the company," he said.

California En-Light-Enment

All was relatively quiet in California on Wednesday, as lawmakers continued to meet behind the scenes with utilities, generators and others to find a solution to the power crisis and keep the utilities afloat.

A key part of any comprehensive solution is a proposal to help the utilities with the nearly $12 billion in debt amassed from buying power at high wholesale prices and selling to consumers, at a loss, at retail prices frozen at 1996 levels.

Curt Hebert, incoming chairman of the Federal Energy Regulatory Commission, or FERC, seems to support the notion of the state "securitizing" the debt though bonds. "The last thing you want is for these two utilities to go bankrupt," he said in an interview on CNBC. "A bankruptcy judge could double rates."

However, the concept currently has little support from members of California's legislature. One source close to the negotiations said there is little enthusiasm for any plan that could be construed as a bailout for PG&E and Edison. Unfortunately, without such help, any solution is likely to include utility bankruptcies. "Any solution has to address how the utilities will pay their existing bills. Otherwise, bankruptcy is their only option," says the source.

Also due at noon PST were bids from generators to the state for long-term power supplies. While Gov. Davis initially said prices should be capped at $55 a megawatt hour and would have to be fixed for the term of the contract, he has backed away from those rigid expectations in recent days. Many of the generators have said they will submit bids that do not comply with the state's specifications, with one generating source calling the guidelines unreasonable.