Martini Chat: Where's the Juice After Enron's Meltdown?

Energy firms like Duke, El Paso, Dynegy and Mirant could profit from Enron's collapse.
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The following is an excerpt from this week's Martini Chat, an hourlong, online program on market and current events at 5 p.m. EST every Thursday, hosted by TheStreet.com columnist Chris Edmonds and reporter Eric Gillin. To participate, visit TheStreet.com just before the show begins, and click on the invitation.

Eric Gillin:

Speaking of different, things in the energy business are certainly shaken up. Enron is on the canvas, Calpine is staggering and Halliburton seems to have taken a barrage of punches that has dizzied the company. Is there any juice left in the energy world?

Chris Edmonds:

That's a good question, and one that investors are keenly focused on as a result of the rapid-fire news that has hit the oil, gas and power sectors in the last several weeks. First Enron, then Halliburton and now Calpine and El Paso. If that's not bad enough, crude oil and natural gas prices are near recent lows and power prices are trending lower.

I must add one thing for those following the Enron saga: As of ten minutes ago, Andrew Fastow is reportedly still in the country.

So, what is the future of the energy business? With us to discuss that subject are two energy pundits. Joining us from New York is Jay Dobson, the managing director and electric power analyst at Deutsche Banc, and from Houston, Bryan Dutt, principal and portfolio manager at Ironman Energy Capital.

Bryan, let me begin with you. The first news out of the chute this week was Halliburton's growing asbestos noose. I know you've worried about the asbestos exposure for some time. How bad is the current situation, and how much worse can it get?

Bryan Dutt:

Unfortunately, Halliburton will probably settle like other companies. It's bad. Unless we run out of lawyers, we won't run out of lawsuits or judgments against Halliburton. Halliburton is in a severe situation, and the company needs tort reform in order to get out.

Chris Edmonds:

Bryan, do you find it at all strange that the Bush administration, with its ties to the energy industry and with Cheney's ties to Halliburton, hasn't tried to push tort reform harder and faster?

Bryan Dutt:

It's going to be a politically delicate situation for the administration. The Bush administration was close to Enron, and that kind of helped that situation. I don't think Cheney can come out and help Halliburton. If anything, they would prefer to let other political forces try to alleviate the situation. I don't think this administration will go out and make a special effort for Halliburton. If anything, that kind of effort would probably hurt Halliburton.

Chris Edmonds:

Jay, the other news this week was heightened questions about Calpine and the challenges it faces, both on its balance sheet and in its growth projections. Two conference calls and ten points later, it looks like the stock may have stabilized. I know Calpine is one of your top picks. As a bull on the stock, what's your thesis, and have your nerves been tested over the past couple of weeks?

Jay Dobson:

Certainly my nerves have been tested. The thesis remains that you have a company with a solid model. I, along with other investors, was intoxicated on high commodity prices. The model basis is adding new generating capacity. When you think of the long-run marginal cost that this company can produce, which is, by and large, lower than any other provider in the market place, it's a solid model. This is a commodity business, although we're short supply, and the growing economy next year will prove that. You're probably looking at a 10 to 15 times multiple for commodity-type players. In near to intermediate terms, this company is probably trading at six times realistic numbers for next year, and that's far too cheap.

Chris Edmonds:

There are some balance sheet issues here. One that seems to weigh on the street and really took the stock for a wild ride yesterday is the zillion dollars and zero converts that are put-able to the company in April. The company bought back over $125 million worth on the market yesterday. Do you expect them to try to finalize the redemption of these before April?

Jay Dobson:

Yes, they'll try. It was a solid decision. It made solid sense for the company, but they have to alleviate this as a worry. People don't realize this is a capital-intensive industry like the railroads or the papers companies. It was designed to have access to the capital markets. If you don't have access to capital markets on a sustainable basis, you have a big problem. I don't believe that's the case, but I suspect these guys will act in the first quarter. They have to get this out of the way.

Chris Edmonds:

Bryan, conversely, you think that Calpine will continue to face challenges. Part of your concern relates to the growth projections of the company, but a significant part of your bearish stance relates to its natural gas assets. What is happening there, and why is it such a concern?

Bryan Dutt:

Addressing the natural gas issue, they purchased Encal Energy, a Canadian natural gas producer, earlier this year when Canadian gas prices were substantially higher, in the $7.50 to $8 price range. Right now it's roughly in the $3.90 to $4.00 price range in Canadian dollars. I don't understand how the company is not facing a write-off this year, if not next. Furthermore, the top management at Encal recently left and joined a competing firm. I don't think Calpine has any expertise in managing a natural gas or oil company. You just don't buy those assets and let them manage themselves. You have to run them. They've clearly overpaid, and now they have a management issue.

Chris Edmonds:

Jay, there is a real concern about liquidity at Calpine in light of the skittishness banks are likely feeling now as a result of the Enron debacle. Will Calpine find it more difficult to meet its capital needs, both to redeem the converts coming due in April and to fund its development plan?

Jay Dobson:

Certainly the natural gas side would. The trading and the marketing are necessary in a commodity business. It's necessary to maximize the value of your assets. They paid a healthy price for the Encal purchase. The idea that they'll have to take some writedowns will certainly be resolved sooner rather than later. The number will not be as big, but it will be taken down. This company is using that gas in their own plants. It's a physical hedge to their raw commodity. They'll be the second- or third-largest natural gas purchaser in the nation, and this is a physical hedge to that exposure. In thirteen or fourteen years, I have only seen one or two companies be able to turn in a commodity business like oil or gas and be able to be successful. The trading business isn't a concern, but the natural gas side is.

Eric Gillin:

Jay, it's Eric Gillin in New York. I want to back this Calpine story up to the beginning and focus on the whole Enron saga. It seems to me that part of Calpine's problem is the Enron hangover. For the non-power and energy insider, what exactly are the issues that led to Enron's demise, and how do they relate to Calpine and the other players in the merchant power space? Who are those players? Give me a 90 second primer on the independent power business. Go!

Jay Dobson:

That's actually the most interesting thing -- the size of rising costs and capital. Enron shouldn't have an implication for anyone else. They had a tremendous amount of off-balance sheet debt. Many of these trading and marketing players rely on an investment grade rating, which allows their counter-parties to take credit for granted. That's oversimplified, but when you lose that investment grade rating, your cost of capital increases tremendously, and all your counter-parties line out the door asking for collateral and real greenbacks to prove you'll repay when the trade comes up.

What happened to Enron was they had a lot more debt than they thought. You had the perception of management's integrity go into the toilet. The real issue that ripped out the rug was when S&P took the company down to below investment grade. Counter-parties are lining out the door asking for collateral on trade exposure, which generated well over half of their cash flow. You have half the cash flow going out of the door, and you have new creditors lining up. They had way more debt than they should have.

Who could be like Enron? Who has a lot of trading exposure and an investment grade rating they really rely on? When you think of Calpine, it is a split rated company. It has to post collateral on trades already. They live in a non-investment grade world as it is. It is less of an issue for them. I'd look at Dynegy and Mirant, some of those. It's not likely, but that's where people should be focused.

Eric Gillin:

The concern really is who is the next Enron, so the stocks of these merchant energy names have suffered as a result. In the wake of Enron's demise, which firms are likely to emerge as leaders among these new energy merchants?

Jay Dobson:

I think the most likely is El Paso. Duke would step up into that space. Dynegy and Mirant are likely to take market share. That's the beauty of Enron. If Microsoft went bankrupt tomorrow, their competitors wouldn't be upset. They'd be gunning for that market share, and it's the same here. There will be higher volumes and margins. This will be different now; you can see the business changing at the margin. The question will be, does Moody's or S&P raise the cost of capital so much, or do investors? Duke, El Paso, Dynegy and Mirant all stand to profit from the market share given up by Enron.

Chris Edmonds:

Bryan, Enron presented a plan to emerge from bankruptcy yesterday that my sources tell me was largely dismissed by its creditors. Do you see anyway this company ever emerges from bankruptcy, and, if so, what will the re-energized Enron look like?

Bryan Dutt:

I don't have the answer, just wild speculation. Obviously, there are billions of dollars at stake, and financial players can get involved. Whether or not they can re-structure it in time to satisfy all the legal requirements is problematic. I have no idea as to what an Enron would look like. It would be substantially smaller if they ever emerge out of bankruptcy.

Chris Edmonds:

Jay, any thoughts there? Do you ultimately think they'll end up liquidating?

Jay Dobson:

I would imagine. I haven't looked at the reorganization plan. I'd go back to the point I made earlier. Their cash flow came from the trading business. People are finding new jobs. The trading business, when it doesn't have physical assets -- and they didn't have a lot of those -- is gray matter. It's the brain between your employee's ears that is your real assets, and those people are finding new jobs, so it has less and less value. It's hard to envision.

Chris Edmonds:

That's an incredibly prescient observation. Let's get predictions going forward. Bryan, gas has gone from a peak of nearly $10 to today's prices hovering around $2. Crude has gone from the mid $30s to the mid-teens. Where do we go from here? If you were to put money into this sector, where would it be?

Bryan Dutt:

If you had a long-term horizon, say a year or more, you could buy any of the survivors. If they can survive another 6 months of depressed prices, a year from now you'll have substantially higher prices. We've had an unbelievably warm winter; we've had September 11 and natural gas prices that were abnormally high this year, which has killed industrial demand. I don't see the return of commodity prices on a short-term basis.

Chris Edmonds:

Who are the survivors on the energy, power and service spaces?

Bryan Dutt:

There are well-run Houston based companies. Two are Apache and Anadarco Petroleum. On the oil service side, there are a host of companies, but Halliburton is not one of them. Baker-Hughes is going to be a survivor. Schlumberger will be a survivor. Those are long-term, and I stress long-term, investments. As far as our portfolio, we are virtually all cash.

Chris Edmonds:

Jay, in the power sector, in the utility sector and in the independent sector, what are you looking at in 2002?

Jay Dobson:

In the really near term you're going to see distributors continuing to work. Southern Company has done well. You have to be careful because you're making a play on how long the economy will stay depressed. At the first hint of an economic improvement, the market's going to go north and these stocks are going to go south. You have to be fleet-footed here. First Energy, you can get a pretty decent yield in that one. Public Service Enterprise Group, same thing. Those are the kind of names I'd pick for the near term.

Long-term, I'd look at generators. You do have to look out six to twelve months. You need to see economic improvement that drives demand for electricity. We have acute shortage in the near term. Potentially, the Calpines, the Mirants, and the El Pasos will open up as opportunities and survivors, but that'll take six to twelve months to dig out of.

Chris Edmonds:

Gentlemen, thank you. This is clearly a subject we'll revisit as events unfold. Our guests, Jay Dobson, managing director for electric power research at Deutsche Banc, and Bryan Dutt, principal and portfolio manager at Ironman Energy Capital.

Eric, clearly a story in progress. And one that we will keep our eye on.