(FORTUNE Magazine) – You'd think that by now--in this annus horribilis for the once highflying energy-trading sector--all the bad news would have come out. The sham trades that boosted revenues have been exposed. The stocks have been crushed, with companies such as Mirant, Dynegy, Calpine, and AES down about 90% over the past year. The rating agencies have downgraded much of the industry's debt to junk status. The SEC and the Federal Energy Regulatory Commission (FERC) are investigating several companies. In November the New York Stock Exchange notified Dynegy, which ranked No. 30 on last year's FORTUNE 500, that its shares may be delisted. In fact, many of the largest energy traders, including Dynegy and El Paso, have publicly announced that they will abandon trading altogether--which is where they made most of their money. Instead the plan is to revert to the old-fashioned model--generating power, transporting natural gas, and exploring for hydrocarbons. It may not be as sexy as the old "asset lite" strategy popularized by Enron--and copied by the rest of the industry--but the hope is that at least it will allow the companies to survive.

Guess what: It might not work. The reason? Debt. During the boom times--and anticipating a glorious new era of deregulation--power companies borrowed a stunning $600 billion. They used that money in part to bulk up their speculative trading operations. But mostly they used it to buy entire power companies or construct natural-gas-fired power plants.

That bill is coming due. Starting next year and continuing through 2006, a whopping $90 billion of debt has to be either repaid or renegotiated, according to Standard & Poor's. Few of the companies appear able to repay it; the collapse of energy trading has put them in a severe cash crunch, and several are close to bankruptcy. Speculative trading is no longer profitable, of course, but far worse is the fact that power plants aren't generating much cash flow either. The overbuilding has helped lower the cost of energy--and the economic downturn has meant that the country simply isn't using as much power. Power prices are severely depressed.

Welcome to the next great debt disaster. "The debt bubble in this industry is massive," says Karl Miller, a former energy executive who is now a senior partner at Miller McConville & Co., a private firm that is buying distressed assets. Starting next year many energy firms teetering on the edge of Chapter 11 are going to fall into it. Once again the brunt of the losses could land on some of the nation's largest banks. For instance, J.P. Morgan Chase, which has acknowledged lots of bad telecom and cable loans, says it has another $2.2 billion in exposure to merchant energy companies. "People have been focused on the bankruptcies of Enron, Global Crossing, and WorldCom," says Miller, "but this sector is the sleeping giant."

What set the wheels in motion for the energy meltdown? The same thing that got the telecom disaster going--botched deregulation. The federal government had already deregulated oil and natural gas when it turned its attention to electricity in the 1990s. For decades local utilities were essentially regulated monopolies. The utilities owned the power plants and the lines they used to provide service to corporations and consumers. To hold the monopoly in check, state or local boards set caps on what the utilities could charge customers. With deregulation, local utilities had to compete to provide power to their area--and customers could shop around for the cheapest power. Still, it was left to each state to decide how--and when--to deregulate its retail electricity market.

Enter the big energy-trading companies. Most of them were already operating in the deregulated oil and natural gas markets--and had seen how open markets created profit opportunities for them. Now they believed they could do the same with electricity. The wind, they believed, was at their backs--not only was electricity about to be deregulated, but thanks to the booming economy there was also growing demand for power. Furthermore many utilities operated outdated coal-fired and nuclear power plants that needed to be phased out. And the big banks--not just J.P. Morgan but also Citigroup, Bank of America, and Bank One--were eager to lend. It wasn't long before Calpine and Duke Energy (among others) began constructing power plants.

In theory, once a power plant was up and running, the company that had built it would sign long-term contracts for up to 80% of the plant's output, guaranteeing electricity to its customers at a fixed price. And how would the energy firm ensure that it could supply the electricity at that price? That's where trading came in: The firm could sell its excess power in the marketplace--and it could apply hedging techniques to lock in a price for its biggest expense, natural gas, which would also protect against volatility. Indeed, hedging was the original impetus behind energy trading. Hedging, however, is not a high-margin business.

Speculative trading--that is, making leveraged bets on both the demand and the price movements of electricity--can be hugely profitable, assuming you're on the right side of the trade. Of course, that kind of trading has nothing whatsoever to do with guaranteeing the delivery of electricity, but by the late 1990s nobody was too worried about that. Speculative trading was generating such big profits for the merchant energy firms that it became, in effect, the tail that wagged the dog.

It wasn't long before problems began to surface. First, even though the feds had deregulated wholesale electricity, the states did not uniformly race to deregulate their local retail markets. By the end of 1996, the year the feds deregulated the wholesale market, only three states passed laws freeing up their electricity markets. (One of them, however, was California.) Second, it turned out that electricity was simply different from other commodities. Unlike corn or wheat--or natural gas--it can't be stored. It must be generated and delivered on demand. Because of the nature of electricity (it's a physics thing), it's not easy to move it from the Northeast Corridor to Los Angeles at three in the afternoon on a Tuesday in July. For that same reason electricity prices can be far more volatile than those of most other commodities. An unexpectedly hot summer afternoon can cause demand to spike quickly. Electricity typically runs $30 to $40 per megawatt hour. (A megawatt hour is essentially enough power to provide electricity to 1,000 homes.) But on a single day in June 1998, in the middle of a spectacular heat wave in the Midwest, local utilities bought electricity for between $900 and $3,500 per megawatt hour, which they then had to resell to customers at a much lower fixed price.

Then came the California energy crisis in the summer of 2000--the moment when everything came to a head. With prices soaring more than $1,400 per megawatt hour, energy-trading firms raced in. As we have since discovered, their primary interest was not to help assuage the situation but rather to exacerbate it. After all, speculators make money when prices are most volatile--and most of the firms were now dominated by a speculative mindset. Enron employed its now infamous "Fat Boy" and "Death Star" strategies, which were clearly designed to game the system. FERC recently released transcripts of phone conversations between employees at Williams and AES from that same period, in which employees at the two companies discussed prolonging a work outage at one of the plants to take advantage of higher prices that the state was paying to replace the missing power. (Williams and AES say they did nothing wrong. Williams says the transcripts reveal nothing more than an "improper" conversation between employees.)

Some energy companies began doing "roundtrip" or "wash" trades, in which traders bought and sold power at the same price merely to boost revenues. These wash trades accounted for 23%, or $5.3 billion, of revenues at CMS Energy between 2000 and 2001. Several energy firms gave false or inaccurate price data to publications that compile price benchmarks--which were used by utilities to lock in prices for long-term contracts with power generators. And on, and on.

It is this series of scandals--all of which came to light in the wake of Enron's collapse last December--that has brought the energy-trading industry to its knees. And most of the moves taken by both the industry and its regulators have been designed to help put the scandals behind it. For instance, in November, Williams agreed to pay California a $417 million settlement for its role in the energy crisis--and to make changes to its $4.3 billion contract. The need to put the scandals behind them also explains why so many energy companies have announced that they will abandon the trading business--or at least the speculative trading business. (Most of them plan to continue trading as a hedging strategy, which, you'll recall, was its original purpose.) Of course, this decision has been made much easier by the fact that in the current environment, trading simply isn't very profitable anymore.

Meanwhile regulators are also working to fix the problems. The Financial Accounting Standards Board has outlawed certain aggressive accounting techniques that merchant energy companies used to goose revenues and profits. But Pat Wood III, the chairman of the FERC, concedes that there is much that still needs to be done--in no small part because the feds still don't fully understand what took place in California. "We're at the low point in the transition from the old world to the new," he says, "but we're eager to get through to a thoughtful resolution and move forward."

Fearing regulators may not move fast enough to save them, top energy firms are also taking drastic steps. A group of 31 chief risk managers from firms including Mirant and American Electric Power banded together to push the industry toward greater disclosure and to work for the adoption of new trading and marketing standards. They hope the move will restore the confidence not only of investors but also of the credit-rating agencies and lenders. Ultimately, though, speculative trading may fade completely from the energy firms and wind up--surprise, surprise--in the hands of Wall Street traders, where speculation is a way of life. Already Bank of America is planning to start energy-trading operations, while Goldman Sachs is beefing up its own desk.

Still, all the moves by the big energy companies to save themselves will be for naught if they can't figure out a way to pay back or refinance their debt. Just look at the numbers: Between now and 2006, Reliant Resources, which has a debt ratio of 52%, has to refinance almost $6 billion; CMS has $4 billion in debt coming due in that same time (its debt ratio is 70%); and Calpine owes $7.3 billion (its debt ratio is 72%). For a sense of how grim the situation is, take a look at the deal Williams struck last July with Lehman Brothers and Warren Buffett's Berkshire Hathaway. In return for a one-year $900 million loan, the energy concern agreed to a 30% interest rate and pledged $2 billion of assets as collateral. With all due respect to the Oracle of Omaha, these are terms that loan sharks command.

It will take a miracle to save some of these companies from bankruptcy--but there is one key difference between them and the telecom companies that have gone bust. Most of the telecom debt was spent laying thousands of miles of fiber-optic cable. By some estimates half of the cable has never been used. But, says Jerry L. Pfeffer, energy industries advisor at the law firm Skadden Arps, "this industry has never come close to the degree of oversupply that you saw in telecom." He adds, "We'll see groups come in and buy the assets. Buyout firms, financial investors, and European utilities are interested, but they're still waiting because they don't think we've hit bottom."

Other likely buyers will be the same stodgy, boring utilities that these former highfliers mocked in the late 1990s. "I think the local regional utilities will definitely have an interest in some of these assets," says Nancy DeSchane, head of trading at Duke Energy. "The demise of significant players doesn't mean energy won't be available in the marketplace."

Ultimately the energy industry is likely to go back to its roots: It will be a low-margin business dominated by power generators and local utilities that trade with one another and hedge against volatility. "We're back to a physical market where the participants are trading excess power they generate," says Amy Burns, vice president of bulk power trading for the Tennessee Valley Authority. Suddenly, that doesn't sound so bad.

REPORTER ASSOCIATE Ann Harrington

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