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Rating Action:

Moody's downgrades AES Red Oak's rating to B2; outlook revised to stable

05 Nov 2010

$347 million debt affected

New York, November 05, 2010 -- Moody's has downgraded the rating on AES Red Oak's $347 million of senior secured bonds outstanding to B2 from B1 and revised the outlook to stable from negative. The downgrade reflects the company's limited financial flexibility and liquidity constraints, notwithstanding the high degree of cash flow stability provided by its tolling agreement. The company's tenuous financial condition is largely the result of significant penalties assessed on the plant due to its continuing inability to meet the aggressive heat rate and dispatchable capacity guarantees in the tolling agreement.

Downgrades:

..Issuer: AES Red Oak, L.L.C.

....Senior Secured Regular Bond/Debenture, Downgraded to B2 from B1

Outlook Actions:

..Issuer: AES Red Oak, L.L.C.

....Outlook, Changed To Stable From Negative

RATINGS RATIONALE

The company resolved the pressing liquidity concerns that resulted in the last year's revision of the outlook to negative by executing a new $8 million subordinated loan agreement in January with AES Corp., which replaced the previous $3 million loan agreement with Corp. and the $5 million working capital facility with Union Bank of California, both of which expired last year. The new agreement expires in 2015. However, its liquidity position remains very narrow. The company is heavily reliant on its external lines of credit because of the seasonality of its cash flows and the narrowness of its financial margins, coupled with a lack of significant unrestricted internal sources of liquidity. Over 50% of the capacity payments under its tolling agreement are received in just four months, between July and October. As of June 30, the company's annual cash low point, it had no unrestricted cash and just $1.7 million in its revenue account, and it had drawn $7.5 million under the loan agreement. Though it also had $8 million in cash restricted for its upcoming debt service payment and $22 million in cash in its debt service reserve fund, equal to six months principal and interest, the $500,000 of excess borrowing availability it had would not have been sufficient to cover even a relatively small increase in operating and maintenance costs or capex. (As of November 1, it had repaid all but $1.5 million of the loan agreement draw.) While AES Corp. could choose to provide the project with additional funds if necessary, and in fact the subordinated loan agreement provides for up to an additional $8 million at AES Corp.'s discretion, there is no assurance that they would be willing to do so given the project's marginal profitability.

Senior coverage (excluding opening cash balances and availability under lines of credit) declined to 1.04x in 2009 from 1.3x in each of the two prior years because of increases in both capex and debt service, though it is expected to rebound to 1.2x in 2010 as a result of a reduction in both net capex and debt service. However, after the payment of subordinated management fees to AES Corp. and fuel conversion volume rebates and non-dispatch penalties to the project's offtaker, TAQA Gen X, net coverage is projected to be approximately 20 bps lower. As a result, the company is not projected to generate any excess cash flow. In fact, since its first full year of operations in 2003, it has never generated a significant amount of excess cash flow, with net debt service coverages never exceeding 1.1x.

As a result of the company's poor financial performance in 2009, it deferred the $1.8 million in subordinated management fees payable to AES Corp. However, it did make the $7.3 million in fuel conversion volume rebates and non-dispatch penalties. It paid the deferred management fees earlier this year along with 40% of the 2010 management fees, and it currently expects to pay the full amount of this year's fuel conversion volume rebates and non-dispatch penalties prior to year end. Moody's notes that the rebates are payable quarterly after debt service. This limits any benefit the company might derive from deferring these payments in our opinion, particularly in light of the seasonality of the company's cash flows. Furthermore, we believe that failure to pay fuel conversion volume rebates in a timely manner could potentially constitute an event of default under the tolling agreement, which would permit the offtaker to terminate the agreement if it so chose, though we note that it would be unlikely to do so under current market conditions.

Gross capex is expected to increase to $13.5 million in 2010 from $10.7 million in 2009. However, $7.3 million of this amount was related to a heat rate improvement project and was funded with proceeds from a 2007 settlement with Raytheon, the project's EPC contractor, that had been restricted for this purpose. 2010 capex was also reduced thanks to a provision in the project's new Term Warranty Agreement with Siemens contract that permitted the deferral of the initial true-up outage fee under the contract. The $2.9 million in deferred costs will be payable over 48 months beginning in April 2011 and is expected to help levelize the payments due under the contract. Were it not for this deferral, however, the company would likely have been forced instead to defer its management fees again in addition to a portion of the fuel conversion volume rebates.

The company renegotiated its maintenance parts and services agreement with Siemens earlier this year, replacing it with a new Term Warranty Agreement, in the course of which a number of disputes between the parties were settled. The payments due Siemens under the new agreement will be slightly higher than those under the old agreement, but more costs will reportedly be covered, including many potential unforeseen costs, and the company will receive a number of fringe benefits according to management. The new agreement will remain in place for up to 15 years depending upon the plant's dispatch profile. Capex is expected to equal roughly $8-11 million annually going forward under the new agreement with Siemens. Historically, the company's capital expenditures have averaged about $7 million a year. The higher projected capex will put further pressure on the company's financial flexibility and liquidity position going forward.

However, the increased capex may be at least partially offset by higher revenues resulting from the recent capital improvements and higher plant capacity factors. The heat rate improvement project has reportedly resulted in a reduction in the plant's heat rate of up to 80 points (though the plant's heat rate remains 130 points above the guaranteed heat rate in its offtake contract notwithstanding the improvement) or an increase in capacity of up to 20 MWs. This additional capacity is expected to result in an increase in the fixed payments due from the offtaker of as much as $500,000, as well as an increased variable O&M payment. The company also expects to receive increased heat rate bonuses and be charged lower heat rate penalties. Further improvement in heat rate of up to 30 points is expected following next year's scheduled major outage on the third unit. It will not be possible to quantify the precise financial impact of the improvements until next year's outage has been completed, but based upon current expectations for capacity factors and gas prices, management hopes to see an improvement in cash flows of $1-1.5 million a year.

While there are certain other potential sources of improved cash flows as well related in particular to the terms of the tolling agreement, in Moody's opinion the plant's financial performance is likely to remain marginal for the foreseeable future barring a significant additional investment by AES to address the heat rate issue. At this point, Moody's in unaware of any plans to undertake this investment. Any decision to do so would probably depend on the plant's longer term economic prospects once the tolling agreement expires. Moody's notes that the debt has a seven-year merchant tail. Though the project's capacity factors have improved considerably in recent years, it is not clear to what extent this reflects increased demand and a corresponding improvement in the long-term prospects for the project, and to what extent it is due to the decline in gas prices, which has resulted in gas-fired generation displacing less efficient coal-fired generation in the dispatch stack.

The stable outlook reflects Moody's expectation that barring any unexpected operational problems, the project should continue to generate sufficient cash flows to cover its costs, including subordinated costs. The rating could face upward pressure if the project can demonstrate its ability to achieve net debt service coverages of at least 1.15x on a sustainable basis and as a result, is less dependent on external liquidity. The rating could be downgraded further if the project's financial performance deteriorates further and it is forced to defer subordinated payments to its offtaker and/or draw on the debt service reserve fund.

The principal methodology used in this rating was Power Generation Projects published in December 2008.

AES Red Oak is an 830 megawatt (MW) gas-fired electric generating project located in Sayreville, New Jersey. The project, which is owned by AES Corp., currently sells all of its capacity to TAQA Gen X LP pursuant to a tolling agreement expiring in 2022.

REGULATORY DISCLOSURES

Information sources used to prepare the credit rating are the following: parties involved in the ratings, parties not involved in the ratings.

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Please see ratings tab on the issuer/entity page on Moodys.com for the last rating action and the rating history.

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New York
Bart Oosterveld
MD-CCO Pub, Proj and Infra Fin
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Aaron Freedman
Vice President - Senior Analyst
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Moody's Investors Service
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Moody's downgrades AES Red Oak's rating to B2; outlook revised to stable
No Related Data.
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