Pipeline Deal Could Deepen Dynegy's Distress

Dynegy , the Houston energy company that announced a deep restructuring and an earnings warning this week, stands to lose as much as $200 million from a natural gas pipeline deal that was struck with Enron in the middle of this year.

The energy company hasn't volunteered details of the pipeline transaction, or outlined any other deals in which Enron owes Dynegy money. Instead, Dynegy has merely stated that Enron owes it $75 million after subtracting its own obligations to Enron. As a result, any evidence of undisclosed Enron blowback could further unnerve Dynegy investors, who already have severely penalized the stock following Enron's collapse. Dynegy shares slipped 80 cents Tuesday to $20.90.

Spokesman Steve Stengel declined to say how much of a loss Dynegy expects to book from the pipeline transaction, but he said his company had included the deal when it calculated its net exposure to Enron. Enron didn't respond to a request for comment.

Capacity

In the pipeline transaction, Dynegy envisioned that Enron would pay it $2.75 million a month until 2014, according to a person familiar with the pricing. But with Enron having filed for bankruptcy protection on Dec. 2, Dynegy now will struggle to collect anything close to the full amount Enron owes under this agreement.

Monday, Dynegy said its net exposure to its onetime rival was $75 million after taxes. That comes to $105 million before taxes, using Dynegy's latest corporate tax rate. Dynegy, like other energy companies, has repeatedly turned down requests to publicly isolate the amount it's owed by Enron. Dynegy agreed to buy Enron in early November, but pulled out of the merger at the end of the month.

The pipeline deal could raise questions about the way Dynegy does business, and it could lead to greater scrutiny of its books. After Enron's collapse, auditors are expected to clamp down on the aggressive accounting practices that allegedly became widespread at energy traders.

It appears that the pipeline deal was one in which Dynegy was eager to book gains. The company booked as much as $50 million of upfront revenue from the pipeline arrangement, according to the person familiar with its details. At the same time as the pipeline deal was done, Dynegy also recorded revenue of about $50 million from a related agreement to buy electricity from the Scriba, N.Y.-based Independence Station power plant, this person adds.

The 1,042-megawatt plant is owned by power-plant operator Sithe Energies. The pipeline capacity that Dynegy agreed to take on from Enron can be used to supply Independence with natural gas. Independence can use that gas to produce the electricity that Dynegy had contracted to buy.

New York-based Sithe declined to comment.

Swap Meet

How did Dynegy get into this deal? In the first half of 2001, Enron and Sithe worked to restructure a complex deal originally set in the mid-'90s. As part of this deal's recasting, Enron agreed to assume from Sithe obligations to pay regulated tariffs for capacity on five natural gas pipelines through 2014.

However, because these tariffs were uneconomically high, Enron didn't want to keep them. It sought to pass them on. After negotiations, Dynegy agreed on June 30 to pay the high regulated tariffs. But in return, Enron had to pay Dynegy $2.75 million a month. This offsetting payment brought the net cost of the pipeline capacity down to a level that Dynegy thought reasonable.

Dynegy, however, is almost certainly not receiving the $2.75 million anymore, now that Enron is under bankruptcy protection. If so, it's having to pay the regulated tariffs with no offsetting cushion. Over 14 years, those Enron payments are worth $465 million.

Using a discount rate of 8%, to give them a net present value for gain-booking purposes, the remaining payments come to about $260 million. Absent a full explanation from Dynegy, it's reasonable to assume that the company may have to record something close to that figure as a loss, though, of course, Dynegy would expect to recoup some fractional amount in Enron's bankruptcy proceedings.

The Lost $260 Million? Enron's pipeline deal with Dynegy
Step 1	Enron wants out of long-term deal with Sithe
Step 2	To get out, Sithe says Enron must assume uneconomic pipeline obligations
Step 3	Enron agrees, but would rather pass on the obligations
Step 4	As part of a power deal with Sithe, Dynegy agrees to take the obligations from Enron
Step 5	But Dynegy also demands a partially offsetting payment from Enron of $2.75 million a month
Step 6	Enron agrees
Step 7	Discounted Enron payments worth about $260 million to Dynegy
Step 8	Dynegy agrees to buy Enron, but later pulls out of the deal
Step 9	Enron files for bankruptcy protection, payment stream to Dynegy in doubt.
Step 10	Dynegy says net Enron exposure is $75 million after taxes
Source: Detox

If the end loss is as much as $200 million, Dynegy must owe Enron a considerable sum of money to get its net exposure down to the estimated $105 million before taxes. If Dynegy does owe Enron large sums, it may be for sizable gas purchases from Enron, which made markets in natural gas and other energy commodities.

Dynegy is probably hoping that it can include the $260 million amount when it comes to settle its debts with Enron in any bankruptcy proceedings. But it's not yet clear that the courts will allow trade creditors such as Dynegy to use this so-called netting, because it may put them ahead of nontrade creditors.

Upfront

The person familiar with the deal also alleges that Dynegy booked revenue from this pipeline capacity in the second quarter of this year. Once Dynegy assumed the capacity obligations, it recorded profits by modeling gas purchases and sales at different points on the pipeline, this person claims. The company recorded $25 million to $50 million of gains by doing this, the person adds. Dynegy didn't comment on whether it booked upfront profits from this deal. The pipeline companies in these capacity arrangements included: ANR Pipeline, CMS Panhandle Eastern Pipe Line and Great Lakes Gas Transmission.

Separate from the pipeline deal, Dynegy also agreed at the end of June to pay the Independence Station fees of about $70 million a year to produce power, which Dynegy intends to market. This deal isn't affected in any way by Enron's collapse.

But, again, Dynegy may have been too enthusiastic in booking upfront profits from this so-called tolling agreement. This person says Dynegy structured the deal so that it could book some $50 million in trading profits in the second quarter. It did this partly by using an internal model that factored in power prices in the distant future, this person claims.