Light Showing at End of California Energy-Crisis Tunnel

Things were looking up for California's utilities and the state's power crisis on Thursday.

As suggested here earlier, the crisis reached a turning point Wednesday evening -- a move met with cheers on Wall Street on Thursday. But in its haste to celebrate, the Street may have overreacted.

The cheers came after three dozen companies bid to provide the state with power. Even though the average price was about 25% higher than California Gov. Gray Davis had hoped for, he embraced the bids as proof of progress toward resolving the crisis and keeping teetering utilities PG&E (PCG Quote - Cramer on PCG - Stock Picks) and Edison International (EIX Quote - Cramer on EIX - Stock Picks) out of bankruptcy.

"This is good news," Davis said at a news conference with legislative leaders Wednesday night.

An Electric Cheer

Investors cheered California as the opening bell rang Thursday. The mood was boosted further by an upgrade of both PG&E and Edison International by Merrill Lynch analyst Steve Fleishman, who raised his rating to accumulate from neutral.

While Fleishman said significant risks still exist, movement in Sacramento is encouraging. "The main reason for the upgrade of the stocks is we think the chance of constructive legislation passing that could stabilize the market and the utilities' financial situation has gone up significantly over the past week and in particular the last few days," he said.

He notes, however, the risks of insolvency are significant. "We do think there is still real risk of bankruptcy; I just think it has gone from 50-50 to 25% or less."

Back to Life? Moribund utilities bounce back

The stocks zoomed on the news. PG&E closed up $3.06, or 31%, to $13 and Edison International jumped $3.31, or 35%, to $12.69.

Shocking

While the news is good, the rally in both stocks -- clearly still on the verge of bankruptcy -- surprised a number of investors. "There was a little overreaction to Fleishman's call," said one utility fund manager. "If you listened to what he said, it was basically [that]he has a good feeling about things."

A good feeling, yes. But the fund manager isn't so sure that the state has come up with a politically feasible solution to keep the utilities out of bankruptcy. "Everyone is watching closely," he said. " I think whatever is going to happen is going to come down to the wire."

Two significant issues remain far from resolution: First, the price the state will pay for power; and, second, the plan to help PG&E and Edison crawl out from under their massive debt. Failing to resolve either likely would lead to bankruptcy for both utilities.

And time is short. The chairwoman of the Senate Committee on Energy, Utilities and Communications, Debra Bowen, indicated just how short. "[This] has to be resolved by Feb. 1."

The Price Is Right

The good news is the significant movement on price in the past two days. Wednesday afternoon, Bowen's committee removed the $55 MwH cap on state power purchases from proposed energy legislation, and replaced it with language saying power will be purchased at the "lowest possible price."

While the bids received in Wednesday's Internet power auction provided an average price of $69 per megawatt hour, very few bids were for "on peak" supply, the kind of power needed to keep California from continuing rolling blackouts, when power demand is at the highest level.

That leaves the auction's success in question. "Although the question of price is obviously critical, it is by no means the only determining factor," said Credit Suisse First Boston analyst Paul Patterson. "Information regarding the quantity of power actually bid, the breakdown of offers for base-load, peak, and off-peak power, and provisions for ancillary services were not revealed. These are exceedingly important issues that need to be known to adequately determine the success of any auction."

The California Department of Water Resources will negotiate contracts with suppliers this week, hoping the Legislature provides long-term authority for the agency to act as the state's power broker. Merrill Lynch's Fleishman suggested today that the average price for all power will settle around $80 per megawatt hour, which would likely require a small rate increase, although not greater than the recent surcharge approved by the California Public Utilities Commission.

While price ultimately remains an issue, the willingness of both Davis and the Legislature to relax their price requirements is encouraging. "The governor and other state legislators were pleased with the results," says Deutsche Bank Alex. Brown analyst Jay Dobson. "The auction results will further accelerate the state towards a long-term solution in the electricity crisis."

Securitization or Bailout?

The more problematic issue continues to be state support for long-term financing of PG&E and Edison's nearly $12 billion in short-term debt. While Davis seemed more open to state support for securitizing the debt, the Legislature remains sharply divided on the matter. "Securitization will be a horrible fight," said the fund manager. "However, without it, there can't be a solution and the utilities will go bankrupt."

Among the proposals floating around Sacramento on Thursday night was one from Democratic Assembly Speaker Robert Hertzberg to allow utilities to issue $12 billion in state-backed bonds in exchange for relinquishing ownership of their hydroelectric generation assets to the state.

Republicans oppose that plan, arguing the state has no business in the power-generation business. Instead, a Republican proposal being bandied about the capitol rotunda would give the state options to purchase equity in the two utilities at a future date and fixed price, in exchange for state assistance.

Whatever the proposal, a number of legislators remain opposed to any form of state support. "Anything that even hints of a bailout will be tough to pass," says the fund manager. "Remember, the debate over securitization of [utilities' unrecouped investments in power plants] when deregulation was first passed was a bloodbath. This will be even worse."

Problem is -- without it -- power at any price may be meaningless.

Deadlines Loom

The Feb. 1 deadline inches closer as both PG&E and Edison have large payments due to power suppliers, and the state's emergency $400 million appropriation to purchase power will quickly run dry.

In addition, the Bush administration extended the emergency order forcing suppliers to continue selling natural gas and power in California until Feb. 7, but made it clear that that was the last extension the feds would grant. Bush has called this a California problem that needs a California solution.

Finally, the utility fund manager says that if a solution that provides security for PG&E and Edison's creditors isn't crafted soon, an unlikely participant may cause the whole plan to unravel. "It doesn't have to be a major money center bank that pushes [the utilities] into bankruptcy," he said. "There are a number of small -- couple of million-dollar creditors -- that could force these companies to file. Many of those companies are on the brink themselves because of the utilities' problems."

No question, there's a light showing at the end of the tunnel. But it's still a long ways away.