Dynegy

(DYN)

could face another ratings downgrade following a report it artificially inflated its trading volume in the fourth quarter and that the

Securities and Exchange Commission

is widening its probe into the firm.

And while Dynegy could probably survive a downgrade to junk status as fellow energy-trader

Mirant

(MIR)

has done, the move could potentially reduce earnings by as much as 20% to 40% over the next 12 months, according to some estimates.

The SEC is currently reviewing two trades that Dynegy recorded last fall in which the company sold and instantly repurchased electricity, according to

The Wall Street Journal.

Normal Course

Executives at Dynegy said the company executed the Nov. 15 trades at the request of customer

CMS Energy

, to test an online trading system that had been having problems with large transactions.

But the

Journal

said the trades were designed to improve the company's public image in the aftermath of

Enron's

collapse. While experts say such transactions occur regularly in the industry, they helped to boost trading volumes at the firm and may have given a false impression about Dynegy's profitability.

This news comes on the heels of an announcement Wednesday that the SEC has opened a formal probe into a previously reported five-year gas supply contract known as "Project Alpha." That deal provided an $80 million tax benefit in 2001 and resulted in about $300 million in net cash flow during 2001.

Since the informal probe was first announced two weeks ago, shares of Dynegy have fallen almost 60%. The stock is down 23% this week alone but was rebounding slightly Thursday.

Rating's the Thing

"I'm looking more at Moody's downgrade as a driving factor rather than the SEC probe," said Mark Easterbrook, an analyst at RBC Capital Markets.

Standard & Poor's rates Dynegy's corporate credit two notches above junk status while Moody's Investors Service has placed the firm's debt one rung above junk status.

"I think they can survive; the question is how they survive. Putting up letters of credit and various other collateral would impair their trading operations to a significant degree," Easterbrook said.

Dynegy said two weeks ago that it would be able to withstand a credit downgrade, noting that it has $1.4 billion of resources with which to do business. Meanwhile, analysts point to Mirant as a company that has been downgraded to junk status but continues to trade.

Counterparties

Still, the additional collateral that Dynegy would be forced to put up and the loss of business from counterparties who are unwilling to trade with a non-investment-grade firm, could be damaging.

"It's not going to go into bankruptcy in my opinion, but it will have difficulty trading," Easterbrook said, adding that earnings could be reduced anywhere from 20% to 40% over the next 12 months.

Dynegy is expected to report earnings per share of $1.96 in 2002 and $2.36 in 2003, but analysts say those numbers are at risk.

"To the extent that a below investment-grade rating would result in a higher cost of capital for new investment, I think there would be some limitations on future growth in their business until they can get that resolved," said Thomas Hamlin, an analyst at Wachovia Securities.

Still, Hamlin noted that Dynegy is "very different" from Enron in that its trading operations make up a much smaller portion of its business.

"Over 80% of its business is asset-related; it's about delivering gas to end customers who use it," he said. "When Enron lost its investment-grade rating, it lost its principal asset, which was working capital. Dynegy

owns pipelines, gas storage, power plants

and a liquids business. Losing their investment grade would have an impact, but it's not the whole business."

Despite that, Dynegy has taken a big hit to credibility in recent weeks and investors will be closely watching any moves by

ChevronTexaco

(CVX) - Get Report

, which owns a 26.5% stake in Dynegy's stock and has a preferred security of $1.5 billion, according to Easterbrook.

"The rating agencies have said they view Dynegy's close relationship with Chevron as a positive factor in their current ratings, Hamlin said.

Chevron had not returned a call seeking comment by the time of publication.

Dynegy fell 10 cents, or 0.90%, to close at $11.05 Thursday.