Energy merchants rallied for the first time in weeks Wednesday after telling federal regulators they weren't involved in

Enron

-like transactions. But other dubious trading activities have thrown into question the profit potential of the energy trading business, according to Prudential Securities analyst Carol Coale.

Coale cut her 2002 and 2003 earnings estimates and price targets on

Dynegy

(DYN)

and

Reliant

(REI) - Get Report

and also reduced price targets for

Williams

(WMB) - Get Report

and

Duke Energy

(DUK) - Get Report

on Thursday.

"We remain skeptical of so-called round-trip trading having no impact on company profits, as we believe it afforded false price visibility to which other trading positions could be booked," she said.

A wash trade occurs when one trader sells power at a set price and instantaneously repurchases the power at the same price. Although the transaction does not result in a profit, it does boost trading volumes, giving the impression of greater profitability.

Several companies such as Reliant and

CMS Energy

(CMS) - Get Report

have admitted to booking revenue from these transactions, even though none was generated.

Coale noted that the revelations of questionable trades have also scared off counterparties, or the companies that energy traders do business with, and said that threatens to put a dent in earnings this year.

As a result, she cut her 2002 earnings estimates on Dynegy to $1.61 from $2.03 and lowered her 2003 estimates to $1.72 from $2.46. On Reliant, 2002 estimates were cut to $2.39 from $2.60.

In addition, she lowered her price target on Dynegy to $11 from $24. Duke's target was cut to $42 from $44, Reliant was cut to $18 from $27, and Williams was cut to $22 from $27.

While many energy companies have revealed to the U.S. Federal Energy Regulatory Commission that they did not use the same tactics that Enron used to boost profits during California's energy crisis, the FERC recently widened its probe to include wash trades. The agency issued a broad order Wednesday demanding that energy companies declare in a sworn statement whether they used such techniques in 2000 and 2001.

"Traditional valuation metrics do not appear to apply to the current performance of the energy merchant stocks," Coale said in a research note. "Instead, stocks appear to be event-driven, making it extremely challenging

and opportunistic for investors, given the unpredictability of the news."

While there is money to be made in Duke, due to its already stable credit standing, and in Williams and

El Paso

( EP), on the basis of their improving liquidity, the recent rally in the group may prove to be short-lived, Coale said, as investors continue to discount certain stocks with a partial or zero valuation for the trading business.

Dynegy, which jumped 6% Wednesday, had slipped 1.1% to 9.13 in early afternoon trading on Thursday. Williams was down 0.6% to $17.60, but Duke was gaining 1.6% to $35.56 and Reliant was up 6.9% to $17.02.