SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CR... ,
 ---------------------- Forwarded by Mark Koenig/Corp/Enron on 01/04/2001 
08:41 AM ---------------------------


firstcall.notes@tfn.com on 01/04/2001 11:27:59 AM
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Subject: SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CR... 
(Part 1 of 2)


                          FIRST CALL RESEARCH NETWORK

08:07am EST 04-Jan-01 Salomon Smith Barney (Raymond Niles 212-816-2807) AES 
DYN
SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CR... (Part 1 of 
2)

SALOMON SMITH BARNEY                                             Industry Note

Power & Natural Gas
SQUEEZING BLOOD FROM A STONE: SEEKING CLARITY IN THE CALIF. CRISIS

January 4, 2001    SUMMARY
                   * California utilities (PCG, EIX) threaten bankruptcy in
Raymond Niles        face of cash squeeze and decision by California Public
212-816-2807         Utilities Commission to grant a 7%-15% rate increase
ray.niles@ssmb.com   versus the 20%-30% hoped for by the utilities. Two key
                     points:
                   * (1) Based on the companies' statements, we think there
                     is material risk that the California utilities will
                     declare bankruptcy, although this still remains the least
                     likely outcome, in our view.  We maintain our 3H 
(Neutral,
                     High Risk) rating on PCG at the present time.
                   * (2) We recommend investors hold the course on Energy
                     Merchants and Competitive Generators.  Favorable 
long-term
                     fundamentals remain in place.  Ultimately, we think a
                     market-oriented solution will favor these companies, but
                     anticipate near-term uncertainty as the California
                     situation plays itself out.  Companies with most to least
                     California exposure are: CPN, SOE, DYN, NRG, DUK, REI,
                     AES, ENE.
TWO MESSAGES TO INVESTORS

(1) Worry about the California electric utilities:  PCG and EIX.  Material
bankruptcy risk exists for these companies.  Although we do not think it is 
the
most likely outcome, we think the risk of a bankruptcy has been heightened by
the small rate increase proposed by the California Public Utilities 
Commission.
Even if bankruptcy does not occur, we think that the California utilities will
continue to be challenged by weak balance sheets and ongoing cash flow 
concerns
if adequate rate increases are not enacted.

(2) Hold the course on the Energy Merchants and Competitive Generators.  The
long-term fundamentals for these companies remains firm, in our view.  For the
generators, we forecast 20%-25% higher power prices, nationwide, in 2001 vs.
2000.  At the same time, we see the "spark spread", or the spread between 
power
(revenues) and gas (costs) widening by several percentage points during the
same time period.  Both of these factors are positive for earnings.  For the
marketers, the opportunity to hedge and manage energy price risk has only been
heightened by the turmoil in California.  We also remain bullish on these
companies.

Exposures of Generators to California Power Markets (Megawatts)

 Company       Rating/Px     Total         California    % of Total
 AES#          1-H $52       29,798         4,100        13.8%
 CPN#          1-H $42         5,912        1,355        22.9%
 DYN#          1-H $51         8,804        1,400        15.9%
 NRG#          1-H $28       13,500         1,586        11.7%
 SOE#          1-H $28       14,622         3,185        21.8%
 ENE#          1-H $80         3,000             60        2.0%
 DUK*#         2-M $83         9,285        3,615        38.9%*
 REI*$#        3-M $43       12,869         3,767        29.3%*
*DUK and REI also have extensive regulated utility operations, so there
corporate financial exposure to California is far less than the percentages
indicated

WHAT LIES AHEAD?  POINTS TO CONSIDER:

(1) Someone must pay for the cost of power in California.  Currently, natural
gas prices are around $20 per mcf or million BTU's, which equates to
electricity prices north of $200 per megawatt-hour.  This reflects the cost of
burning gas to create electricity, and does not consider other costs, such as
pollution emissions, operating and maintenance costs, and the capital costs of
plant investment.

(2) The long-term problem in California (and elsewhere in the country) will 
not
be solved without the construction of new power plants.  All the bellyaching 
in
the world about high wholesale power prices will not solve the problem, which
is:  California does not have enough power plants.  The wholesale price of
electricity reflects supply and demand.  There are not enough electrons in the
state's power grid.  More electrons will come either from new plants (power
generation) or marketing (shipping more electricity into the state).  We also
think concomitant infrastructure must be enhanced, such as natural gas 
pipeline
and electric transmission capacity.

(3) The generators and marketers are solving the problem.  Companies such as
Dynegy, Enron, El Paso Energy, Duke Energy, Calpine, Southern Energy, AES, NRG
Energy and others are either building the plants and/or marketing the power 
and
natural gas that will, in the long run, "solve" California's power crisis.  In
fact, the high prices they are receiving for power and gas are both the
incentives and the reward for them to do so.  In our view, if sufficient new
generating capacity is built in California, the wholesale price of power will
fall.  We think if policies were enacted today to facilitate the construction
of new plants, by 2002 power prices could be materially lower than they are
today.

(4) Re-regulation would only lengthen and deepen the power crisis in
California.  Capping wholesale power prices, imposing windfall profits taxes 
or
other "punitive" measures will not cause a single new power plant to be built
or a single new electron to be sold in the state.  Such measures would dis-
incentivize new plant construction and actually lengthen the crisis.  We
already think that the threat of re-regulation has had the perverse effect of
raising wholesale power prices by dis-incentivizing sales into the state.

OUR INVESTMENT CONCLUSIONS

First, the long-term outlook for competitive energy suppliers is favorable.
They are supplying a commodity in short supply.  As long as the supply-demand
balance, and price volatility remain, we expect strong earnings visibility 
from
this core group of companies.  We especially recommend accumulating positions
in these companies ahead of the summer peak electricity earnings season.

Second, attempts to re-regulate or "punish" energy wholesalers could create
near-term volatility in the stocks; we recommend buying on such weakness.
Given our long-term view, we do not think that attempts to re-regulate will be
successful.  In fact, by doing so, policymakers would merely lengthen and
deepen the crisis that already exists.  Also, recognition that the wholesale
market is working well in other regions, such as Texas, would only stimulate a
debate that would lead to ultimate removal of any controls, in our view.

                            Price  1/3/01 2002 2002 LTG 2002
Company          SYM Rating Target Price  EST  P/E  EST PEG
                 M
Energy Merchants
Enron Corp.#     ENE 1H     $100   79.88  1.98 40.3 20% 2.0
Duke Energy #    DUK 2M     $95    82.75  5.10 16.2 10% 1.6
El Paso Energy#  EPG 1H     $80    70.25  3.70 19.0 15% 1.3
Dynegy Inc.#     DYN 1H     $70    51.31  2.25 22.8 20% 1.1

Power Producers
Southern Energy# SOE 1H     $37    27.94  1.35 20.7 25% 0.8
Calpine Corp.#   CPN 1H     $60    41.75  1.58 26.4 35% 0.8
AES Corp.#       AES 1H     $85    51.75  2.50 20.7 30% 0.7
NRG Energy#      NR  1H     $40    27.56  1.70 16.2 25% 0.6
#  Within the past three years, Salomon Smith Barney, including its parent,
subsidiaries and/or affiliates, has acted as manager or co-manager of a public
offering of this company.

WHAT'S AHEAD?  NEAR-TERM EVENTS

Near-term, we await several events.  Each of these has the potential for
creating trading opportunities in the stocks.

(1) Decision by S&P and Moody's on whether to downgrade the debt of PCG and
EIX.  They have threatened to lower the ratings on both companies to "junk"
status (i.e., below investment grade) if the CPUC does not grant a sufficient
rate increase.  We think that the 7%-15% rate increase proposed by the CPUC is
probably not sufficient to please the rating agencies, and that a debt
downgrade is likely.  We think a debt downgrade is largely priced into the
stocks, but the action still could create volatility.

(2) An emergency legislative hearing is underway.  This hearing is deciding,
among other measures, whether to impose a "windfall profits tax" or other
punitive measures on the wholesale energy suppliers.  Given what we said 
above,
we think such a move could hurt the energy suppliers, but only on a near-term
basis.  We would recommend buying on such weakness.  An action that would be
positive, in our view, would be any move by the legislature to address the 
root
cause of California's problem:  the restrictive policies that make it 
difficult
to build plants in the state (e.g.: pollution rules, siting permits, etc).

(3) Decisions by the utilities on whether to declare bankruptcy.  The 
utilities
suffer from a negative cash flow, and have incurred over $8 billion in
incremental costs to pay for power.  Their cash gross margin is negative
because they receive a low (regulated) price for retail power and pay a high
(unregulated) price for wholesale power.  The utilities' lenders are watching
carefully to see if any rate increase proposed by the CPUC is sufficient to
address this imbalance before they will lend more money on a short-term basis.
If the utilities cannot get short-term funding, we think insolvency is a 
likely
eventuality, in our view.  We still think bankruptcy is the least likely
outcome, and for that reason, a bankruptcy announcement would have a negative
effect on the stock prices of the utilities as well as the wholesale energy
suppliers.

(4) Final decision by the CPUC on their proposed rate increase.  A final
decision on the 7%-15% proposed increase will be made today.  If the CPUC
decides to go with a higher or more favorable rate increase, this would be
positive for the utilities and marketers..

(5) Credit risk to suppliers - worst case analysis.  The generators and
marketers who sell power to the California utilities have significant credit
risks associated with those exposures.  The figure below attempts to quantify
those risks, which could result in a one-time earnings hit.  The figures we
have calculated are a worst-case analysis, in our view, and any actual 
exposure
are likely to be much less.  First, these risks will only become a reality in
the case of the utilities' bankruptcy.  Second, even given this worst-case
bankruptcy scenario, the generators and marketers will likely be treated
favorably in the bankruptcy case, given their status as trade creditors (30-45
day receivables).  Third, based on our conversations with these companies, 
they
have already taken steps to mitigate these exposures by tightening credit
limits, requiring payments in cash, etc.

          12/00     MWHs Produced @     Exposure @      Potential EPS
          CA MW         40% factor      $200 Price         Exposure


Raymond Niles 212-816-2807
First Call Corporation, a Thomson Financial company.
All rights reserved.  888.558.2500


Note ID: 320970
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