Synfuel Earnings at Risk? (DTE, TE, DQE, WPS, SO)

A.G. Edwards published a useful and informative report today that highlighted the exposure that some utilities have to synfuel earnings, writes Sandy Cohen. Unfortunately I am unable to provide a link, but the report is worth trying to get if you have an interest either in a) Synfuel issues in general, or b) the earnings prospects of DTE, DQE, PGN, SO, TE or WPS.

[Editor: Here's a quick explanation of synfuel: synfuel is the production of various types of fossil fuel that is "synthetically" produced (like coal-bed methane, which turns coal into gas, or shale oil production, which is a way to extract oil from certain shale formations), for which the US government, in its wisdom, elected to provide substantial tax credits for. Often the cost of producing oil or gas through these technologies is greater than the revenue, without the tax credits. It has become a major industry and allows several billion dollars a year of taxes to be shelterd by various corporations and partnerships. It repsents over 25% of the earnings of several utilities cited in the post, and a HUGE amount of accumulated cash flow, that will be created post 2007.]

The report was published because oil prices have reached a level at which if that price level were to be sustained, the benefits from the tax advantages of synfuel tax credits would start to phase out. Thus, should oil prices rise further, and then besustained at that higher level, the above referenced companies would face the potential for reduced valuation and/or reduced earnings between now and 2007.

A.G. Edwards highlights in this report the portion of earnings that results from the tax credits associated with synfuels (in order of importance to earnings: DTE, TE. DQE, PGN, WPS and SO). It also highlights the portion of A.G. Edwards' valuation that is represented by full utilitization of synfuel tax credits (in order of importance to value: DTE, TE, PGN, DQE, WPS, and SO).

The report also outlines the average oil prices for the calendar year at which the credits begin to phase out ($52 in 2005), and the average calendar year price level of oil at which the credits are completely phased out ($65 in 2005).

A.G. Edwards also uses this report as an opportunity to highlight the IRS audits that are ongoing, and to try to evaluate the risks of those audits to each utlity that may be involved in the audits. As a reminder, the IRS FIELD offices have continually tried to audits various aspects of the synfuel tax credit program (always trying to reduce or eliminate the credits permitted), while the IRS NATIONAL office (the more political beast) has always over-ruled the Field offices. A.G. Edwards puts the utilities in the following order of RISK (from high to low) to their valuation based on dependence on the credits, the status of audits, and the FASB issue of what can and cannot be reported: PGN, TE, DQE, DTE, WPS and SO.

This is a report well worth reading in detail, and keeping as a reference.

Comments

[SeekingAlphaEditors]

Sandy, a reader e-mailed in the following question: "Sandy mentions that a huge amount of cashflow will be created post 2007. Why does he say post 2007?"

[sandycohen]

The cash flow from the synfuel tax credits starts to come to the companies that have recorded these credits AFTER the credits expire ... after 2007.

So ... until 2007, EARNINSG are created, in the form of tax credits (non-cash) that reduce a company's tax bill through 2007. Then, after 2007, the EARNINGS benefit goes away, but cash flow starts to be reported (do not ask me how or why, it is an acounting thing, not my strength).