**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                   |   |                                                                                                             |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                             |   |                                                                                                             |
| **ý**                                                                                                                                                       |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |
|                                                                                                                                                             |   |                                                                                                             |
| **For the quarterly period ended  March 31, 2004**                                                                                                          |
|                                                                                                                                                             |   |                                                                                                             |
| **o**                                                                                                                                                            |   | **TRANSITION  REPORT PURSUANT OR TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                             |   |                                                                                                             |
| **For the transition period from**          **to**           |

 

**Commission file number 333-40478**

 

**AES RED OAK, L.L.C.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                                       |   | **54-1889658**                           |
|------------------------------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                    |   | (I.R.S. Employer  Identification Number) |
|                                                                               |   |                                     |
| **832 Red Oak Lane, Sayreville, NJ**                                               |   | **08872**                                |
| (Address of  principal executive offices)                                          |   | (Zip Code)                               |
|                                                                               |   |                                     |
| Registrant’s telephone number, including  area code:  **(732) 238-1462** |

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

Yes o No ý

 

Registrant is a wholly owned subsidiary of The AES Corporation.  Registrant meets the conditions set forth inGeneral Instruction H(I)(a) and (b) of Form 10-Q and is filing the QuarterlyReport on form 10-Q with the reduced disclosure format authorized by GeneralInstruction II.

 

 

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**AES RED OAK,L.L.C.**

**TABLE OF CONTENTS**

 
| **PART I.**       |   | **FINANCIAL INFORMATION**                                                                                                                            | 1      |
|-------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| **Item 1.**       |   | **CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**                                                                                          | 1      |
|              |   | **Condensed Consolidated Statements of  Operations, Three Months Ended March 31, 2004 and 2003**                                                | 1      |
|              |   | **Condensed Consolidated Balance Sheets, as  of March 31, 2004 and December 31, 2003**                                                     | 2      |
|              |   | **Condensed Consolidated Statement of Changes  in Member’s Capital (Deficit), Period from December 31, 2003 through  March 31, 2004** | 3      |
|              |   | **Condensed Consolidated Statements of Cash Flows for the Three Months  Ended March 31, 2004 and 2003**                                         | 4      |
|              |   | **Notes to Condensed Consolidated Financial Statements**                                                                                             | 5      |
| **Item 2.**       |   | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                                                      | 11     |
| **Item 3.**       |   | **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                                       | 18     |
| **Item 4.**       |   | **CONTROLS AND PROCEDURES**                                                                                                                          | 18     |
|              |   |                                                                                                                                                 |   |
| **PART II.**      |   | **OTHER INFORMATION**                                                                                                                                | 19     |
| **Item 1.**       |   | **LEGAL PROCEEDINGS**                                                                                                                                | 19     |
| **Item 2. ** |   | **CHANGES IN SECURTIES AND USE OF PROCEEDS**                                                                                                         | 19     |
| **Item 3.**       |   | **DEFAULTS UPON SENIOR SECURTIES**                                                                                                                   | 19     |
| **Item 4.**       |   | **SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS**                                                                                             | 19     |
| **Item 5.**       |   | **OTHER INFORMATION**                                                                                                                                | 19     |
| **Item 6.**       |   | **EXHIBITS AND REPORTS ON FORM 8-K**                                                                                                                 | 20     |
|              |   | **SIGNATURES**                                                                                                                                       | 21     |

 

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**PART I****. FINANCIAL INFORMATION**

 

**Item 1****.  CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

**AES RED OAK, L.L.C. AND SUBSIDIARY**

**AN INDIRECT, WHOLLY OWNED SUBIDIARY OF THE AESCORPORATION**

**CondensedConsolidated Statements of Operations,**

**Three Months Ended March 31, 2004 and 2003**

**(Unaudited)**

***(dollars in thousands)***

 
|                                  |   | **Three  Months  Ended  March 31,** |   |
|---------------------------------------|--------|------------------------------------------|--------|
|                                  |   | **2004**                                 |   | **2003** |   |
| OPERATING REVENUES                    |   |                                     |   |   |   |
| Energy                                |   | $                                        | 11,628 |   | $ | 11,021 |   |
|                                  |   |                                     |   |   |   |
| OPERATING EXPENSES                    |   |                                     |   |   |   |
| Fuel costs                            |   | 323                                      |   | 635 |   |
| Fuel conversion volume rebates        |   | 1,029                                    |   | 1,603 |   |
| Corporate management fees             |   | 408                                      |   | 399 |   |
| Other operating expenses              |   | 2,268                                    |   | 1,344 |   |
| Depreciation expense                  |   | 2,851                                    |   | 2,896 |   |
| Taxes and insurance                   |   | 748                                      |   | 521 |   |
| General and administrative costs      |   | 177                                      |   | 247 |   |
| Total operating expenses              |   | 7,804                                    |   | 7,645 |   |
| Operating income                      |   | 3,824                                    |   | 3,376 |   |
|                                  |   |                                     |   |   |   |
| OTHER INCOME (EXPENSE)                |   |                                     |   |   |   |
| Interest income                       |   | 61                                       |   | 77 |   |
| Other income-interim rebates          |   | —                                   |   | 603 |   |
| Interest expense                      |   | (8,478                                   | )      | (8,614 | ) |
| Other expense - letter of credit fees |   | (261                                     | )      | (251 | ) |
| Total other income (expense)          |   | (8,678                                   | )      | (8,185 | ) |
| NET LOSS                              |   | $                                        | (4,854 | ) | $ | (4,809 | ) |

 

See notes to condensed consolidated financialstatements.

 

1

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**AESRED OAK, L.L.C. AND SUBSIDIARYAN INDIRECT, WHOLLY OWNED SUBSIDIARY OF THE AES CORPORATIONCondensed Consolidated Balance Sheets,March 31, 2004 and December 31, 2003 *(dollars in thousands, except share amounts)***

 

***(Unaudited)***

 
|                                                                                                        |   | **March 31,  2004** |    | **December 31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
| **ASSETS:**                                                                                                 |   |                     |    |                        |   |
|                                                                                                        |   |                     |    |                        |   |
| Current Assets:                                                                                             |   |                     |    |                        |   |
| Cash                                                                                                        |   | $                        | 26      |                        | $      | 38 |   |
| Restricted cash at cost, which approximates  market value                                                   |   | 33,393                   |    | 34,837                      |   |
| Receivables                                                                                                 |   | 4,089                    |    | 4,070                       |   |
| Receivable from affiliate                                                                                   |   | —                   |    | 51                          |   |
| Prepaid and current assets                                                                                  |   | 2,064                    |    | 628                         |   |
| Total current assets                                                                                        |   | 39,572                   |    | 39,624                      |   |
|                                                                                                        |   |                     |    |                        |   |
| Land                                                                                                        |   | 4,240                    |    | 4,240                       |   |
| Property, plant, and equipment – net of  accumulated depreciation of $18,681 and $15,830, respectively |   | 406,765                  |    | 408,963                     |   |
| Deferred financing costs – net of  accumulated amortization of $3,331 and $3,128, respectively         |   | 15,374                   |    | 15,577                      |   |
| Other assets                                                                                                |   | 256                      |    | 219                         |   |
| Total assets                                                                                                |   | $                        | 466,207 |                        | $      | 468,623 |   |
|                                                                                                        |   |                     |    |                        |   |
| **LIABILITIES AND  MEMBER’S CAPITAL:**                                                                 |   |                     |    |                        |   |
|                                                                                                        |   |                     |    |                        |   |
|  Current Liabilities:                                                                                  |   |                     |    |                        |   |
| Accounts payable                                                                                            |   | $                        | 2,645   |                        | $      | 398 |   |
| Accrued liabilities                                                                                         |   | 1,754                    |    | 956                         |   |
| Accrued interest                                                                                            |   | 2,757                    |    | 2,759                       |   |
| Liabilities under spare parts agreement                                                                     |   | 2,997                    |    | 4,520                       |   |
| Payable to affiliate                                                                                        |   | 148                      |    | 131                         |   |
| Bonds payable-current portion                                                                               |   | 5,219                    |    | 5,230                       |   |
| Notes payable                                                                                               |   | 1,246                    |    | —                      |   |
| Other current liabilities                                                                                   |   | 35,000                   |    | 35,000                      |   |
| Total current liabilities                                                                                   |   | 51,766                   |    | 48,994                      |   |
| Bonds payable                                                                                               |   | 369,751                  |    | 370,132                     |   |
| Liabilities under spare parts agreement and  other                                                          |   | 2,041                    |    | 2,017                       |   |
| Total liabilities                                                                                           |   | $                        | 423,558 |                        | $      | 421,143 |   |
|                                                                                                        |   |                     |    |                        |   |
|  Member’s capital:                                                                                |   |                     |    |                        |   |
| Common stock, $1 par value-10 shares  authorized, none issued or outstanding                                |   | $                        | —  |                        | $      | — |   |
| Contributed capital                                                                                         |   | 56,798                   |    | 56,775                      |   |
| Member’s deficit                                                                                       |   | (14,149                  | )       | (9,295                      | )      |
| Total member’s capital                                                                                 |   | 42,649                   |    | 47,480                      |   |
| Total liabilities and member’s capital                                                                 |   | $                        | 466,207 |                        | $      | 468,623 |   |

 

See notes to condensed consolidated financialstatements.

 

2

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**AES RED OAK, L.L.C. AND SUBSIDIARY**

**AN INDIRECT, WHOLLY OWNED SUBSIDIARY OF THE AESCORPORATION**

**CondensedConsolidated Statement of Changes in Member’s Capital (Deficit)**

**Period from December 31, 2003 throughMarch 31, 2004**

***(dollars inthousands)***

***(Unaudited)***

 
|                           |   |              |   |        |   | **Additional**  |   |        |   |      |    |
|--------------------------------|--------|-------------------|--------|-------------|--------|-----------------|--------|-------------|--------|-----------|---------|
|                           |   | **Common  Stock** |   | **Paid-in** |   | **Accumulated** |   |        |   |
|                           |   | **Shares**        |   | **Amount**  |   | **Capital**     |   | **Deficit** |   | **Total** |    |
|                           |   |              |   |        |   |            |   |        |   |      |    |
| BALANCE DECEMBER 31, 2003 |   | —            |   | $           | — |            | $      | 56,775      |   | $         | (9,295  | ) | $ | 47,480 |   |
| Contributed capital            |   | —            |   | —      |   | 23              |   | —      |   | 23        |    |
| Net loss                       |   | —            |   | —      |   | —          |   | (4,854      | )      | (4,854    | )       |
| BALANCE MARCH 31, 2004    |   | —            |   | $           | — |            | $      | 56,798      |   | $         | (14,149 | ) | $ | 42,649 |   |

 

See notes to condensed consolidated financialstatements.

 

3

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**AES RED OAK, L.L.C. AND SUBSIDIARY**

**AN INDIRECT, WHOLLY OWNED SUBSIDIARY OF THE AESCORPORATION**

**CondensedConsolidated Statements of Cash Flows for the ThreeMonths Ended**

**March 31, 2004 and 2003**

***(dollars inthousands)***

***(Unaudited)***

 
|                                                      |   | **Three  months Ended  March 31** |   |
|-----------------------------------------------------------|--------|----------------------------------------|--------|
|                                                      |   | **2004**                               |   | **2003** |   |
|                                                      |   |                                   |   |   |   |
| **OPERATING ACTIVITIES:**                                 |   |                                   |   |   |   |
| Net income (loss)                                         |   | $                                      | (4,854 | ) | $ | (4,809 | ) |
| Amortization of deferred financing costs                  |   | 203                                    |   | 203 |   |
| Depreciation                                              |   | 2,851                                  |   | 2,896 |   |
| Change in                                                 |   |                                   |   |   |   |
| Accounts receivable - trade                               |   | (19                                    | )      | 149 |   |
| Accounts receivable - from affiliates                     |   | 51                                     |   | (34 | ) |
| Prepaid expenses                                          |   | (190                                   | )      | (63 | ) |
| Other assets                                              |   | (37                                    | )      | (31 | ) |
| Accounts payable                                          |   | 2,247                                  |   | (344 | ) |
| Accrued liabilities                                       |   | 798                                    |   | 97 |   |
| Accrued interest                                          |   | (2                                     | )      | — |   |
| Payable to affiliates                                     |   | 17                                     |   | (18 | ) |
|                                                      |   |                                   |   |   |   |
| Net cash provided by (used in) operating  activities      |   |                                   |   |   |   |
|                                                      |   | 1,065                                  |   | (1,954 | ) |
| **INVESTING ACTIVITIES:**                                 |   |                                   |   |   |   |
| Payments for capital additions                            |   | (653                                   | )      | (1,014 | ) |
| Payments under long-term spare parts agreement            |   | (1,499                                 | )      | — |   |
| Restricted cash                                           |   | 1,444                                  |   | (21,559 | ) |
|                                                      |   |                                   |   |   |   |
| Net cash used in investing activities                     |   | (708                                   | )      | (22,573 | ) |
|                                                      |   |                                   |   |   |   |
| **FINANCING ACTIVITIES:**                                 |   |                                   |   |   |   |
| Payment of principal on bonds payable                     |   | (392                                   | )      | (467 | ) |
| Securities from Williams under power purchase  agreement  |   | —                                 |   | 25,000 |   |
| Contributions from parent                                 |   | 23                                     |   | — |   |
|                                                      |   |                                   |   |   |   |
| Net cash provided in financing activities                 |   |                                   |   |   |   |
|                                                      |   | (369                                   | )      | 24,533 |   |
|                                                      |   |                                   |   |   |   |
| **NET (DECREASE) INCREASE IN CASH  AND CASH EQUIVALENTS** |   | (12                                    | )      | 6 |   |
|                                                      |   |                                   |   |   |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF PERIOD**       |   | 38                                     |   | 23 |   |
| **CASH AND CASH EQUIVALENTS, END OF  PERIOD**             |   | $                                      | 26     |   | $ | 29 |   |
|                                                      |   |                                   |   |   |   |
| **SUPPLEMENTAL DISCLOSURE:**                              |   |                                   |   |   |   |
|                                                      |   |                                   |   |   |   |
| Interest paid                                             |   | $                                      | 8,047  |   | $ | 8,614 |   |

 

See notes to condensed consolidated financialstatements.

 

4

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**AES RED OAK, L.L.C. AND SUBSIDIARY**

**AN INDIRECT, WHOLLY OWNED SUBSIDIARY OF THEAES CORPORATION**

**Notesto****CondensedConsolidated Financial Statements**

 

**1.****                                      ORGANIZATION**

 

AESRed Oak, L.L.C. (the “Company”) was formed on September 13, 1998, in the Stateof Delaware, to develop, construct, own and operate an 832-megawatt (MW)gas-fired, combined cycle electric generating facility (the “Facility”) in theBorough of Sayreville, Middlesex County, New Jersey. The Company was considereddormant until March 15, 2000 (hereinafter, inception), at which time itconsummated a project financing and certain related agreements. OnMarch 15, 2000, the Company issued $384 million in senior secured bondsfor the purpose of providing financing for the construction of the Facility andto fund, through the construction period, interest payments to the bondholders(see Note 6). In late September 2000, the Company consummated an exchangeoffer whereby the holders of the senior secured bonds exchanged their privatelyplaced senior secured bonds for registered senior secured bonds.

 

TheFacility consists of three Westinghouse 501 FD combustion turbines, threeunfired heat recovery steam generators, and one multicylinder steam turbine.The Facility produces and sells electricity, as well as provides fuelconversion and ancillary services, solely to Williams Power Company, Inc.,(“Williams Energy”), formerly Williams Energy Marketing & Trading Company,under a 20-year Fuel Conversion Services, Capacity and Ancillary Services PurchaseAgreement (the “Power Purchase Agreement”). The term of the Power Purchase Agreement is twenty years from the lastday of the month in which commercial operation commenced, which wasSeptember 2002.  The Companyreached provisional acceptance on August 11, 2002, risk transfer onAugust 13, 2002, and took the position that the Facility was commerciallyavailable on September 1, 2002. Williams Energy disputed the September 1, 2002, commercialoperation date and informed the Company that it recognized commercialavailability of the facility as of September 28, 2002.  On November 4, 2003, a settlement wasreached and a commercial operation date of September 28, 2002 was agreedupon.

 

TheCompany is a wholly owned subsidiary of AES Red Oak, Inc. (“Red Oak”), which isa wholly-owned subsidiary of The AES Corporation (“AES”). Red Oak has no assetsother than its ownership interests in the Company and AES Sayreville, L.L.C.Red Oak has no operations and is not expected to have any operations. Red Oak’sonly income is distributions (if any) it receives from the Company and AESSayreville, L.L.C.

 

Theequity that Red Oak provided to the Company was provided to Red Oak by AES,which owns all of the equity interests in Red Oak. AES files unauditedquarterly and annual audited reports with the Securities and ExchangeCommission under the Securities Exchange Act of 1934, which are publiclyavailable, but which do not constitute a part of, and are not incorporatedinto, this Form 10-Q.

 

TheCompany owns all of the equity interests in AES Red Oak Urban RenewalCorporation (“AES URC”), which was organized as an urban renewal corporationunder New Jersey Law. As an urban renewal corporation under New Jersey law,portions of the Facility can be designated as redevelopment areas in order toprovide certain real estate tax and development benefits to the Facility. AESURC has no operations outside of its activities in connection withthe Facility.

 

**2.****                                      BASISOF PRESENTATION**

 

In the Company’s opinion, all adjustments necessary for a fairpresentation of the unaudited results of operations for the interim periodspresented herein are included. All such adjustments include accruals of anormal and recurring nature. Certain reclassifications have been made toprior-period amounts to conform to the 2004 presentation. The results ofoperations for the three-month periods presented herein are not necessarilyindicative of the results of operations to be expected for the full year orfuture periods.

 

5

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The Company generates energy revenues under the Power PurchaseAgreement with Williams Energy. During the 20-year term of the agreement, theCompany expects to sell capacity and electric energy produced by the Facility,as well as ancillary services and fuel conversion services. Under the PowerPurchase Agreement, the Company also generates revenues from meeting(1) base electrical output guarantees and (2) heat rate rebatesthrough efficient electrical output. Revenues from the sales of electric energyand capacity are recorded based on output delivered and capacity provided atrates as specified under contract terms. Revenues for ancillary and otherservices are recorded when the services are rendered.

 

Upon its expiration, or in the event that the Power Purchase Agreementis terminated prior to its 20-year term or Williams Energy otherwise fails toperform, the Company would seek to generate energy revenues from the sale ofelectric energy and capacity into the merchant market or under new short orlong-term power purchase or similar agreements. Due to recent declines in poolprices, however, the Company would expect that even if successful in findingalternate revenue sources, any such alternate revenues would be substantiallybelow the amounts that would have been otherwise payable pursuant to the PowerPurchase Agreement. There can be no assurances as to whether such efforts wouldbe successful.

 

These financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q andRegulation S-X. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles (“GAAP”) forcomplete financial statements. The accompanying condensed consolidatedfinancial statements are unaudited and they should be read in conjunction withthe audited financial statements and notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.

 

**3.****                                      BONDSPAYABLE**

 

On March 15, 2000, the Company issued $384 million in seniorsecured bonds for the purpose of providing financing for the construction ofthe Facility and to fund, through the construction period, interest payments tothe bondholders. In September 2000, the Company consummated an exchangeoffer whereby the holders of the senior secured bonds exchanged their privatelyplaced senior secured bonds for registered senior secured bonds.

 

The senior secured bonds were issued in two series: 8.54% seniorsecured bonds due 2019 (the “2019 Bonds”) in an aggregate principal amount of$224 million and 9.20% senior secured bonds due 2029 (the “2029 Bonds”) inan aggregate principal amount of $160 million. Principal repayment of the2019 Bonds commenced with the quarterly payment on August 31, 2002. Annualprincipal repayments on the Bonds are scheduled as follows:

 
| **Year**                                            |   | **Annual  Payment** |          |
|-----------------------------------------------------|--------|---------------------|---------------|
|                                                |   |                |          |
| 2004 (remaining subsequent to  March 31, 2004) |   | $                   | 4.8 million   |   |
| 2005                                                |   | $                   | 5.1 million   |   |
| 2006                                                |   | $                   | 7.1 million   |   |
| 2007                                                |   | $                   | 6.1 million   |   |
| 2008                                                |   | $                   | 8.1 million   |   |
| Thereafter                                          |   | $                   | 343.8 million |   |
|                                                |   |                |          |
| Total                                               |   | $                   | 375.0 million |   |

 

6

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Principal repayment dates on the 2019 Bonds are February 28,May 31, August 31, and November 30 of each year, with the finalpayment due November 30, 2019. Quarterly principal repayment of the 2029Bonds does not commence until February 28, 2019.

 

The company made a principal payment of $392,000 in February 2004.

 

**4.**                                      **CONCENTRATIONOF CREDIT RISK IN WILLIAMS ENERGY AND AFFILIATES**

 

Williams Energy is currently the Company’s sole customer for purchasesof capacity, ancillary services, and energy and its sole source for fuel.  Williams Energy’s payments under the PowerPurchase Agreement are expected to provide all of the Company’s operatingrevenues during the term of the Power Purchase Agreement.  It is unlikely that the Company would beable to find another purchaser or fuel source on similar terms for its Facilityif Williams Energy were not performing under the Power Purchase Agreement.  Any material failure by Williams Energy tomake capacity and fuel conversion payments or to supply fuel under the PowerPurchase Agreement would have a severe impact on the Company’s operations, andmay result in a default on the Company’s debt. The payment obligations of Williams Energy under the Power PurchaseAgreement are guaranteed by The Williams Companies, Inc.  The payment obligations of The WilliamsCompanies, Inc. under the guarantee are capped at an amount equal toapproximately $510 million.  Beginningon January 1 of the first full year after the commercial operation date,this guaranty cap is to be reduced semiannually by a fixed amount which isbased on the amortization of our senior secured bonds during the applicablesemiannual period. As of March 31, 2004, the guarantee was capped at$507.6 million.

 

Theminimum capacity payments provided for under the Power Purchase Agreement havebeen the Company’s primary source of operating revenues, representing $62.0million of total revenues of $64.2 million in 2003.  The minimum cash flow from Williams under the power purchaseagreement is approximately $3.8 million per month for October through Mayand $7.9 million per month from June through September.

 

During2003, the Company’s first full year of operations, net cash provided byoperating activities was $14.8 million. The Company currently anticipates that the plant will be dispatched infuture periods to a similar degree as it was during 2003, that operating cashflow will be comparable to 2003 in 2004 and that operating cash requirementswill be similar in 2004 and 2005 as they were during this first year ofoperation.  The Company also believesthat cash flows from the sale of electricity and/or minimum capacity paymentsunder the Power Purchase Agreement, and funds available to be drawn under thedebt service reserve letter of credit or the power purchase letter of credit,will be sufficient to fund operating expenses and debt service costs.

 

TheCompany’s dependence upon The Williams Companies, Inc. and its affiliates underthe Power Purchase Agreement exposes the Company to possible loss of revenuesand fuel supply, which in turn, could negatively impact its cash flow andfinancial condition and may result in a default on its senior securedbonds.  There can be no assurances as tothe Company’s ability to generate sufficient cash flow to cover operatingexpenses or its debt service obligations in the absence of a long-term powerpurchase agreement with Williams Energy.

 

**5.****                                      POWERPURCHASE AGREEMENT**

 

TheCompany and Williams Energy have entered into a Power Purchase Agreement forthe sale of all capacity produced by the Facility, as well as ancillaryservices and fuel conversion services. Under the Power Purchase Agreement,Williams Energy has the obligation to deliver, on an exclusive basis, allquantities of natural gas required by the Facility to generate electricity orancillary services, to start-up or shut-down the plant, and to operate theFacility during any period other than a start-up, shut-down, or requireddispatch by Williams Energy for any reason. The term of the Power PurchaseAgreement is 20 years from the first contract anniversary date, which is the lastday of the month in which commercial

 

7

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availability occurred.  As partof the arbitration settlement with Williams Energy, described below, theCompany recognizes September 28, 2002 as the commercial availability date.

 

TheCompany entered into arbitration with Williams Energy to resolve certaindisputes regarding the date of commercial operation and the properinterpretation of certain provisions of the Power Purchase Agreement relatingto the amounts claimed by the Company to be payable by Williams Energy.  Williams Energy has withheld or offset fromamounts invoiced by the Company amounts that Williams Energy believes wereimproperly invoiced based on Williams Energy’s interpretation of the Power PurchaseAgreement.  The arbitration related todisputed amounts of approximately $7.6 million, which included a $594,000payment extension option dispute and a $7 million commercial operation startdate dispute. On November 4, 2003, the Company and Williams Energy settledthis dispute.  Under the settlement,Williams made a cash payment to the Company of $4,050,153 on November 14,2003, which included $225,055 of interest from October 2002 to the paymentdate, and the commercial operation date was agreed to be September 28,2002. The related revenue had been substantially recorded inSeptember 2002, with the remaining amount recorded in the fourth quarterof 2003.  This payment settled allpayment obligations between the parties for the month of September 2002 withrespect to the commercial operation date under the Power PurchaseAgreement.  From the Company’sperspective, the cash payment had the economic effect of recognizing acommercial operation date prior to September 28, 2002. The Company is alsodisputing approximately $500,000 of merchant price, testing gas and othercharges with Williams Energy that the Company contends is owed by WilliamsEnergy. This was not part of the above arbitration.

 

TheCompany provided Williams Energy a letter of credit (Power Purchase AgreementLetter of Credit) in the amount of $30 million to support specific paymentobligations should the Facility not achieve commercial operation by the daterequired under the Power Purchase Agreement. Upon the commencement ofcommercial operations in September 2002, the stated amount of that letterof credit was reduced to $10 million. The repayment obligations with respect toany drawings under the Power Purchase Agreement Letter of Credit are a seniordebt obligation of the Company.

 

Thepayment obligations of Williams Energy under the Power Purchase Agreement areguaranteed by The Williams Companies, Inc. The payment obligations of The Williams Companies, Inc. under theguaranty are capped at an amount equal to approximately $510 million.  Beginning on January 1 of the firstfull year after the commercial operation date, this guaranty cap is to bereduced semiannually by a fixed amount which is based on the amortization ofour senior secured bonds during the applicable semiannual period. As ofMarch 31, 2004 the guarantee was capped at $507.6 million.

 

Pursuantto Section 18.3 of the Power Purchase Agreement, in the event thatStandard & Poors or Moody’s rates the long-term senior unsecured debt ofThe Williams Companies, Inc. lower than investment grade, The WilliamsCompanies, Inc. is required to supplement The Williams Companies, Inc.guarantee with additional alternative security that is acceptable to theCompany within 90 days after the loss of such investment grade rating.  According to published sources, The WilliamsCompanies, Inc.’s long term senior unsecured debt has been rated belowinvestment grade since 2002 by both S&P and Moody’s.

 

Dueto the downgrade of The Williams Companies, Inc. to below investment grade, theCompany and Williams Energy entered into a letter agreement datedNovember 7, 2002 (the “Letter Agreement”), under which Williams Energyagreed to provide the Company (a) a prepayment of $10 million within fivebusiness days after execution of the Letter Agreement (the “Prepayment”); (b)alternative credit support equal to $35 million on or before January 6,2003 in any of the following forms: (i) cash, (ii) letter(s) of credit with theCompany as the sole beneficiary substantially in the form of the Power PurchaseAgreement Letter of Credit, unless mutually agreed to otherwise, or (iii) adirect obligation of the United States Government delivered to a custodialsecurities account as designated by the Company with a maturity of not morethan three years; and (c) replenish any portion of the alternative creditsupport that is drawn, reduced, cashed, or redeemed, at any time, with an equalamount of alternative credit support. In the Letter Agreement, the Company and Williams Energy acknowledgedthat the posting of such alternative credit support and Williams Energy’sagreement and performance of the requirements of (a), (b), and (c), as setforth in the immediately preceding sentence, would be in full satisfaction ofWilliams Energy’s obligations contained in Section 18.3 of the PowerPurchase Agreement.  In the LetterAgreement, the Company and

 

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Williams Energy expressly agreed that the posting of the Prepayment orany alternative credit support either now or in the future or any other termsset forth in the Letter Agreement is not intended to and did not modify, alter,or amend in any way, the terms and conditions or relieve The Williams Company,Inc. from any obligations it has under its guarantee of the payment obligationsof Williams Energy under the Power Purchase Agreement.  The guaranty remains in full force andeffect and the Company retains all of its rights and remedies provided by thatguaranty.

 

Underthe terms of the Letter Agreement, the Company is obligated to return thePrepayment to Williams Energy upon the earlier of (i) The Williams Companies,Inc. regaining its investment grade rating or Williams Energy providing asubstitute guaranty of investment grade rating; (ii) the beginning of ContractYear 20; or (iii) the posting of alternative credit support by Williams Energyas set forth below.  In the case ofitems (i) and (iii) above, except to the extent, in the case of item (iii),Williams Energy elects to have all or a portion of the Prepayment make up a combinationof the alternative credit support required to be posted pursuant toSection 18.3(b) of the Power Purchase Agreement, Williams Energy shallhave the right to recoup the Prepayment by set-off of any and all amounts owingto the Company under the Power Purchase Agreement beginning no earlier than theJune in the calendar year after the occurrence of item (i) or (iii) andcontinuing thereafter until the Prepayment has been fully recovered.  In the case of item (ii) above, WilliamsEnergy shall have the right to immediately set-off all amounts owing to theCompany under the Power Purchase Agreement after the occurrence of item (ii)and continuing thereafter until the Prepayment has been fully recovered.  Except to the extent Williams Energy electsto include the Prepayment as part of the alternative credit support, the amountof alternative credit support posted by Williams Energy pursuant to the LetterAgreement shall be initially reduced by the amount of the Prepayment, andWilliams Energy shall thereafter increase the alternative credit supportproportionately as Williams Energy recoups the Prepayment set-off on thepayment due date of amounts owing to the Company.

 

Ifthe Company does not return the Prepayment to Williams Energy as set forth inthe preceding paragraph, then the Company shall be considered in default underthe Letter Agreement and Williams Energy shall be entitled to enforce any andor all of its contractual rights and remedies as set forth in the PowerPurchase Agreement, including, but not limited to, drawing on the Letter ofCredit previously posted by the Company in favor of Williams Energy.

 

WilliamsEnergy made the Prepayment on November 14, 2002 and provided an additional$25 million of cash to the Company on January 6, 2003 as the alternativecredit support.  As allowed by theLetter Agreement, Williams has elected to have the $10 million Prepaymentincluded as part of the alternative credit support.  In the event that Williams regains and maintains its investmentgrade status, provides a substitute guaranty of investment grade rating, orposts a letter of credit, the Company will be required to return the $35million alternative credit support to Williams Energy in accordance with theterms of the Letter Agreement as described above.

 

**6.****                                      COMMITMENTSAND CONTINGENCIES**

 

*Construction Agreement* - The Company enteredinto an Agreement for Engineering, Procurement and Construction (EPC) services,dated as of October 15, 1999, between the Company and WGI (as thesuccessor contractor), as amended for the design, engineering, procurement,site preparation and clearing, civil works, construction, start-up, trainingand testing and to provide all materials and equipment (excluding operationalspare parts), machinery, tools, construction fuels, chemicals and utilities,labor, transportation, administration and other services and items(collectively and separately, the “services”) of the Facility. Under a guarantyin the Company’s favor, effective as of October 15, 1999, all of WGI’s obligationsunder the construction agreement are irrevocably and unconditionally guaranteedby Raytheon. In 2001, as a result of WGI’s bankruptcy filing, the Company madea demand on Raytheon to perform its obligations under the Raytheon guaranteeand WGI, Raytheon and the Company entered into agreements pursuant to whichRaytheon became responsible for the construction of the Facility*.*

 

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Underthe construction agreement, in lieu of the Company’s retainage, Raytheon isentitled to post a letter of credit in the amount of the then currentretainage.  As of March 31, 2004,Raytheon had provided a letter of credit of approximately $30.8 million.  The Company may draw on this letter ofcredit in the event that Raytheon fails to pay us any amount owed to us underthe construction agreement.  As ofMarch 31, 2004, the Company had drawn $447,000 on this letter of creditfor interim rebates which Raytheon then resumed paying until their notice ofFinal Acceptance.

 

Provisional acceptance has been granted and the Facility has commencedcommercial operations, however, Raytheon must perform certain agreed uponcompletion items in order to obtain final acceptance. Raytheon gave notice ofFinal Acceptance on July 22, 2003 based on its July 8, 2003performance test.  On July 31,2003, the Company received a letter from the project’s independent engineerstating that it could not support Raytheon’s claim of final acceptance and itdid not consider the July 8, 2003 performance test valid.  In making this assessment, the independentengineer cited, among other reasons, (i) modifications made to certainequipment in performance of the July 8 performance test which wouldadversely impact the operations of the plant and other pieces of equipment and(ii) Raytheon’s failure to demonstrate compliance with guaranteed emissionslimits.  On August 1, 2003, theCompany rejected Raytheon’s claim of final acceptance.  This rejection was based upon Raytheon’sfailure to meet the conditions for final acceptance provided for in the EPCcontract. On August 7, 2003, the Company received a response from Raytheonin which Raytheon claims that the Company’s rejection of the final acceptanceis invalid and improper.  The Company iscurrently considering its options for resolving this dispute.

 

*Land Development Plan* – The Company enteredinto an agreement with the Borough of Sayreville by which the Company willdevelop and implement a plan to replace trees which were removed duringclearing of the Facility site.  The LandDevelopment Plan is required for final site approval.  The estimated cost of the plan is approximately $425,000.  The Company is in the process of selecting acontractor to perform the service and no payments have been made as ofMarch 31, 2004.  On July 23,2003, the project was secured by a letter of credit issued by Union Bank ofCalifornia for $425,000 with the Borough of Sayreville as the beneficiary.  This irrevocable standby letter of creditcurrently has an expiration date of June 30, 2004 and represents theamount potentially due if there is a failure of AES Red Oak, LLC to take actionregarding the plan. The Company is currently reviewing its options to addressthis expiration date.

 

**7.****                                      NEWACCOUNTING PRONOUNCEMENTS**

 

InJanuary 2003, the Financial Accounting Standards Board  (“FASB”)issued FIN No. 46, Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51 (“FIN No. 46”).  In October 2003, FASBStaff Position No. 46-6, “Effective Date of FIN No. 46, Consolidation of VariableInterest Entities” deferred the effective date of FIN No. 46 for variableinterests held by a public entity in a variable interest entity (“VIE”) thatwas created or acquired before February 1, 2003 to the end of the firstinterim or annual period ending after December 15, 2003.  InDecember 2003, FASB issued FIN 46 (revised December 2003),Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51(“FIN 46(R)”), which clarified some requirements and incorporated several staffpositions that the Company was already required to apply.  In addition,FIN 46(R) deferred the effective date for VIEs that were created or acquiredbefore February 1, 2003 and were not considered special purpose entities(“SPEs”) prior to the issuance of the interpretation until the end of the firstreporting period ending after March 15, 2004.  FIN 46(R) defines aVIE as (i) any entity in which the equity investors at risk in such entity donot have the characteristics of a controlling financial interest, or (ii) anyentity that does not have sufficient equity at risk to finance its activitieswithout additional subordinated financial support from other parties.  Itrequires the consolidation of the VIE by the primary beneficiary.  Theadoption of FIN 46(R) requires the Company to include disclosures for non SPEVIEs created or acquired on or after February 1, 2003 in its condensedconsolidated financial statements related to the total assets and the maximumexposure to loss resulting from the Company’s interests in VIEs.  Theadoption of FIN 46(R) did not have a material effect on our financial position,results of operations, or cash flows.

 

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**Item 2****. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**Cautionary Note Regarding Forward-LookingStatements**

 

Someof the statements in this Form 10-Q, as well as statements made by us inperiodic press releases and other public communications, constitute“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Certain,but not necessarily all, of such forward-looking statements can be identifiedby the use of forward-looking terminology, such as “believes,” “estimates,”“plans,” “projects,” “expects,” “may,” “will,” “should,” “approximately,” or“anticipates” or the negative thereof or other variations thereof or comparableterminology, or by discussion of strategies, each of which involves risks anduncertainties. We have based these forward-looking statements on our currentexpectations and projections about future events based upon our knowledge offacts as of the date of this Form 10-Q and our assumptions about future events.

 

Allstatements other than of historical facts included herein, including thoseregarding market trends, our financial position, business strategy, projectedplans and objectives of management for future operations of the facility, areforward-looking statements. Such forward-looking statements involve known andunknown risks, uncertainties and other factors outside of our control that maycause our actual results or performance to be materially different from anyfuture results, performance or achievements expressed or implied by theforward-looking statements. These risks, uncertainties and other factorsinclude, among others, the following:

 

•                  unexpected problems relating to theperformance of the facility,

 

•                  the financial condition of third parties onwhich we depend, including in particular, Williams Power Company, Inc.,(“Williams Energy”), formerly Williams Energy Marketing & Trading Company,as fuel supplier under the power purchase agreement we entered into withWilliams Energy for the sale of all electric energy and capacity produced bythe facility, as well as ancillary and fuel conversion services (the “PowerPurchase Agreement”), and The Williams Companies, Inc., as the guarantor ofWilliams Energy’s performance under the Power Purchase Agreement,

 

•                  delays in, or disputes over, the finalcompletion of our facility,

 

•                  continued performance by Williams Energy (asguaranteed by The Williams Companies, Inc.) under the Power Purchase Agreement,

 

•                  the ability of The Williams Companies, Inc.or its affiliates to avoid a default under the Power Purchase Agreement bycontinuing to maintain or provide adequate security to supplement theirguarantee of Williams Energy’s performance under the Power Purchase Agreement,

 

•                  our ability to find a replacement powerpurchaser on favorable or reasonable terms, if necessary,

 

•                  an adequate merchant market after theexpiration, or in the event of a termination, of the Power Purchase Agreement,

 

•                  capital shortfalls and access to additionalcapital on reasonable terms, or in the event that the Power Purchase Agreementis terminated,

 

•                  the degree to which Williams Energy requeststhat we run or “dispatch” the facility, including the possibility that WilliamsEnergy will not request that we run or “dispatch” the facility at all,

 

•                  inadequate insurance coverage,

 

•                  unexpected expenses or lower than expectedrevenues,

 

•                  environmental and regulatory compliance,

 

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•                  terrorists acts and adverse reactions toUnited States anti-terrorism activities, and

 

•                  additional factors that are unknown to us orbeyond our control.

 

Wehave no obligation to publicly update or revise any forward-looking statement,whether as a result of new information, future events or otherwise.

 

**General**

 

We are a Delaware limited liability company formed on September 13,1998 to develop, construct, own, operate and maintain our Facility. We weredormant until March 15, 2000, the date of the sale of our senior securedbonds. We obtained $384 million of project financing from the sale of thesenior secured bonds.

 

We reached provisional acceptance on August 11, 2002, risktransfer on August 13, 2002, and in a settlement with Williams Energyreached on November 4, 2003, a commercial operation date ofSeptember 28, 2002 was agreed upon.

 

**Liquidity and Capital Resources**

 

Sinceachieving commercial operations under the Power Purchase Agreement withWilliams Energy, we are eligible to receive variable operations and maintenancepayments, total fixed payments, energy exercise fee payments (each as definedin the Power Purchase Agreement) and other payments for the delivery of fuelconversion, capacity and ancillary services. We have been dispatched by Williams Energy for two days in the quarterended March 31, 2004, and on a more regular basis in April and earlyMay of 2004, but can provide no assurance that this will continue.  If the facility is not dispatched, ouroperating revenues will consist of minimum capacity payments under the PowerPurchase Agreement.

 

Theminimum capacity payments provided for under the Power Purchase Agreement havebeen our primary source of operating revenues, representing $62.0 million ofour total revenues of $64.2 million in 2003. The minimum cash flow from Williams under the power purchase agreementis approximately $3.8 million per month for October through May and $7.9million per month from June through September.

 

During2003, the Company’s first full year of operations, net cash provided byoperating activities was $14.8 million. We currently anticipate that the plant will be dispatched in futureperiods to a similar degree as it was during 2003, that operating cash flowwill be comparable to 2003 in 2004 and that operating cash requirements will besimilar in 2004 and 2005 as they were during this first year of operation.  We also believe that cash flows from thesale of electricity and/or minimum capacity payments under the Power PurchaseAgreement, and funds available to be drawn under the debt service reserveletter of credit or the power purchase letter of credit, will be sufficient tofund our operating expenses and debt service costs.

 

Wehave provided Williams Energy a $10 million letter of credit under the PowerPurchase Agreement, which we refer to as the power purchase letter of credit,to support specific payment obligations under the Power Purchase Agreement. Therepayment obligations with respect to any drawings under the power purchaseletter of credit are our senior debt obligation.

 

Dueto the downgrade of The Williams Companies, Inc.’s debt to below investmentgrade, the Williams Companies, Inc. is required to supplement The WilliamsCompanies, Inc. guarantee with additional alternative security that isacceptable to us.  Since The WilliamsCompanies, Inc. debt rating fell below investment grade in 2002, Williams Energyhas provided us with $35 million of cash as alternate credit support.  In the event that the Williams Companies,Inc. regains and maintains its investment grade status, provides a substituteguaranty of Investment Grade rating, or posts a letter of credit, we will berequired to return the $35 million alternative credit support to WilliamsEnergy. Under the terms of the Letter Agreement, Williams Energy shall have theright to recoup the Prepayment by set-off of any and all amounts owing to theCompany under the Power Purchase Agreement no earlier than the June in thecalendar year after the occurrence of regaining its investment grade rating orthe beginning of calendar year

 

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20, whichever comes first. In the event we regain investment gradestatus, we will also have access to our $2.5 million working capitalagreement.  As of May 10, 2004, we hadcash balances of approximately $34 million. In the event the we are required to return the $35 million alternativecredit support to Williams, we believe that we would use all or a portion ofour current cash balances and cash generated from future operations, with anyremaining balance deducted from the monthly amounts due to us from WilliamsEnergy.  This belief is subject tocertain assumptions, risks and uncertainties, including those set forth aboveunder the caption “Cautionary Note Regarding Forward-Looking Statements” andthere can be no assurances that our operating revenues will generate sufficientcash.

 

Asof March 31, 2004, $375 million aggregate principal amount of seniorsecured bonds, issued in two tranches, were outstanding.  Quarterly principal repayments on the 2019Bonds commenced on August 31, 2002 and are due on May 31, August 31,and November 30 of each year. Quarterly principal repayment of the 2029 Bonds does not commence untilFebruary 28, 2019.  We haveprovided the collateral agent with a debt service reserve letter of credit inan initial stated amount of $22.0 million which the collateral agent may drawupon if we fail to meet our obligations under the senior secured bonds.

 

TheCompany entered into an agreement with the Borough of Sayreville by which theCompany will develop and implement a plan to replace trees which were removed duringclearing of the Facility site.  The LandDevelopment Plan is required for final site approval.  The estimated cost of the plan is approximately $425,000.  The Company is in the process of selecting acontractor to perform the service and no payments have been made as ofMarch 31, 2004.  On July 23,2003, the project was secured by a letter of credit issued by Union Bank ofCalifornia for $425,000 with the Borough of Sayreville as the beneficiary.  This irrevocable standby letter of creditcurrently has an expiration date of June 30, 2004 and represents theamount potentially due if there is a failure of the Company to take actionregarding the plan. The Company is currently reviewing our options to addressthis expiration date.

 

Asof March 31, 2004, we also had a capital commitment of $114,000 related toa road modification project.  It is alsoanticipated that we will incur capital expenditures of approximately $1.1million in 2004, related to general improvements of the facility and plannedmaintenance outages.

 

Underthe construction agreement, we were entitled to retain certain amounts fromeach scheduled payment until after final acceptance by us of the facilityunless Raytheon posted a letter of credit in the amount of payments that wouldotherwise be retained.  As ofMarch 31, 2004, Raytheon had provided a letter of credit of approximately$30.8 million and we had paid Raytheon for any amounts previouslyretained.  We may draw on this letter ofcredit in the event that Raytheon fails to pay us any amount owed to us underthe construction agreement.  As ofMarch 31, 2004 we have drawn $544,000 on this letter of credit.

 

Sincewe depend on Williams Energy for both revenues and fuel supply under the PowerPurchase Agreement, if Williams Energy were to terminate or default under thePower Purchase Agreement, there would be a severe negative impact to our cashflow and financial condition which could result in a default on our seniorsecured bonds.  Due to the current poolprices, we would expect that if we were required to seek alternate purchasersof our power in the event of a default of Williams Energy, even if we weresuccessful in finding alternate revenue sources, any such alternate revenuesources would be substantially below the amounts that would have been otherwisepayable pursuant to the Power Purchase Agreement. There can be no assurance asto our ability to generate sufficient cash flow to cover operating expenses orour debt service obligations in the absence of a long-term power purchase agreementwith Williams Energy.

 

Inaddition to the factors discussed above, and/or the other factors listed underthe “Cautionary Note Regarding Forward-Looking Statements,” if we do notreceive final rebates from Raytheon and/or the working capital agreementcontinues to be unavailable as a result of the ratings on our senior securedbonds, we could experience a negative impact on our cash flow and financialcondition.

 

The following discussion presents certain financial information for thethree months ended March 31, 2004 and 2003.

 

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**Energy Revenues**

 

We generate energy revenues under the Power Purchase Agreement withWilliams Energy. During the 20-year term of the agreement, we expect to sellelectric energy and capacity produced by the facility, as well as ancillary andfuel conversion services. Under the Power Purchase Agreement, we also generaterevenues from meeting (1) base electrical output guarantees and(2) heat rate rebates through efficient electrical output.

 

Upon its expiration, or in the event that the Power Purchase Agreementis terminated prior to its 20-year term, we would seek to generate energyrevenues from the sale of electric energy and capacity into the merchant marketor under new short- or long-term power purchase or similar agreements. Due torecent declines in pool prices, however, we would expect that even if we weresuccessful in finding alternate revenue sources, any such alternate revenueswould be substantially below the amounts that would have been otherwise payablepursuant to the Power Purchase Agreement. There can be no assurances as towhether such efforts would be successful.

 

**Operating Expenses**

 

Under an agreement with AES Sayreville, L.L.C., a wholly ownedsubsidiary of AES Red Oak, Inc. (“Red Oak”), which is a wholly-owned subsidiaryof The AES Corporation (“AES”)., we are required to reimburse all operatorcosts on a monthly basis. Operator costs generally consist of all direct costsand overhead associated with running the Facility. Additionally, an operatorfee of approximately $400,000, subject to annual adjustment, is payable on eachbond payment date.

 

**Performance Guarantees**

 

*Electrical Output*

 

Underthe construction contract, if the average net electrical output of our facilityat provisional acceptance or interim acceptance, whichever is the earlier tooccur, is less than the electrical output guarantee, then Raytheon must pay us,as a rebate and not as liquidated damages, for each day during the interimperiod, an amount equal to $0.22 per day for each kilowatt by which the averagenet electrical output is less than the electrical output guarantee.  During performance testing, our output wascalculated to be 13,370 kilowatts less than the electrical output guarantee.  Accordingly, our daily charge for thisamount has been calculated at $2,941.40 per day. Raytheon paid us this amountuntil their notice of final acceptance date of July 22, 2003, but we aredisputing this claim of final acceptance and contend that these amounts shouldcontinue to be paid until the final acceptance date.

 

Uponfinal acceptance, if the average net electrical output of our facility duringthe completed performance test is less than the electrical output guarantee,then Raytheon must pay us, as a bonus, an amount equal to $520 for eachkilowatt by which the average net electrical output is less than the guaranteeminus any interim rebates paid or to be paid by Raytheon.

 

*Heat Rate Guarantees*

 

Ifthe average net heat rate of our facility at provisional acceptance or interimacceptance, if having occurred before final acceptance, exceeds the heat rateguarantee, then Raytheon must pay us, as a rebate and not as liquidateddamages, for each day during the interim period, an amount equal to $46 per dayfor each BTU/KwH by which the measured net heat rate is greater than the heatrate guarantee.

 

Uponfinal acceptance, if the net heat rate of our facility during the completedperformance test exceeds the heat rate guarantee, then Raytheon will pay us, asa rebate, a lump sum amount equal to $110,000 for each BTU/KwH by which themeasured heat rate is greater than the heat rate guarantee minus any interimrebates paid or to be paid by Raytheon.

 

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TheCompany has not invoiced Raytheon for the three month period endedMarch 31, 2004 for electrical output and heat rate rebates. As ofMarch 31, 2004, Raytheon owed approximately $65,000 in rebates for amountsinvoiced in 2003.

 

**Recent and New Accounting Pronouncements**

 

InJanuary 2003, the Financial Accounting Standards Board  (“FASB”)issued FIN No. 46, Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51 (“FIN No. 46”).  In October 2003, FASBStaff Position No. 46-6, “Effective Date of FIN No. 46, Consolidation ofVariable Interest Entities” deferred the effective date of FIN No. 46 forvariable interests held by a public entity in a variable interest entity(“VIE”) that was created or acquired before February 1, 2003 to the end ofthe first interim or annual period ending after December 15, 2003. In December 2003, FASB issued FIN 46 (revised December 2003),Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51(“FIN 46(R)”), which clarified some requirements and incorporated several staffpositions that the Company was already required to apply.  In addition,FIN 46(R) deferred the effective date for VIEs that were created or acquiredbefore February 1, 2003 and were not considered special purpose entities(“SPEs”) prior to the issuance of the interpretation until the end of the firstreporting period ending after March 15, 2004.  FIN 46(R) defines aVIE as (i) any entity in which the equity investors at risk in such entity donot have the characteristics of a controlling financial interest, or (ii) anyentity that does not have sufficient equity at risk to finance its activitieswithout additional subordinated financial support from other parties.  Itrequires the consolidation of the VIE by the primary beneficiary.  Theadoption of FIN 46(R) requires the Company to include disclosures for non SPEVIEs created or acquired on or after February 1, 2003 in its condensedconsolidated financial statements related to the total assets and the maximumexposure to loss resulting from the Company’s interests in VIEs.  Theadoption of FIN 46(R) did not have a material effect on our financial position,results of operations, or cash flows.

 

**Results of Operations**

 

Underthe Power Purchase Agreement with Williams Energy, we are eligible to receivevariable operations and maintenance payments, total fixed payments, energyexercise fees (each as defined in the Power Purchase Agreement) and otherpayments for the delivery of fuel conversion, capacity and ancillary services.  For the quarter ended March 31, 2004,we were dispatched for only two days. During 2003, our facility was not calledon to generate in the quarter ended March 31, and was called to generateonly 14% during the calendar year. Accordingly, the minimum capacity paymentshave been our primary source of operating revenues.

 

***For the Three MonthsEnded March 31, 2004 and 2003***

 

Operatingrevenues were $11.6 million and $11 million for the quarters endedMarch 31, 2004 and March 31, 2003, respectively.  These amounts include fixed payments of $11.4 million and $10.9 million for the quarters ending March 31, 2004 and2003, respectively. The remaining amount of revenue relates to variable revenuewhich we receive when dispatched and ancillary services. We have no control overwhen the facility is dispatched, as that decision is made by Williams Energybased on several factors including market conditions.

 

Fuelpurchased from Williams Energy for performance testing was $300,000 and$600,000 in the quarters ended March 31, 2004 and March 31, 2003,respectively. The lower fuel costs relates to improved performance.

 

Thefuel conversion volume rebate was $1 million and $1.6 million for the quartersended March 31, 2004 and March 31, 2003, respectively. This costrepresents a charge paid to Williams Energy under the Power Purchase Agreementbased upon utilization of the Facility. The decrease in the expense during thecurrent three month period, compared to same period last year, is due to areduction of this charge in the second contract year, when the utilizationfactor for the prior twelve month period was less than 20%.

 

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Corporatemanagement fees were $400,000 for both the current and prior-year quarters.Corporate management fees are charged on a monthly basis based on a fixedamount which is adjusted annually for inflation.

 

Otheroperating expenses, which represent the reimbursement of operating andmaintenance expenses paid to AES Sayreville, L.L.C., were $2.3 million and $1.3for the quarters ended March 31, 2004 and March 31, 2003,respectively. The increase in the current year period relates to costs for aplanned maintenance outage, totaling approximately $1 million.

 

Taxesand insurance costs were $700,000 and $500,000 for the quarters endedMarch 31, 2004 and March 31, 2003, respectively. The increase in thecurrent period relates to a scheduled local property tax increase.

 

Otherincome–interim rebates for the three months ended March 31, 2003 wereapproximately $600,000 million.  Thisamount consists of interim rebates received from Raytheon under theconstruction agreement as a result of their failure to meet heat rate andoutput performance guarantees.  We didnot recognize any of this income for the three months ended March 31,2004.

 

Wehad net losses of approximately $4.9 million and $4.8 million for thequarters ended March 31, 2004 and March 31, 2003, respectively.

 

**Concentration of Credit Risk**

 

WilliamsEnergy is currently the our sole customer for purchases of capacity, ancillaryservices, and energy and its sole source for fuel.  Williams Energy’s payments under the Power Purchase Agreement areexpected to provide all of our operating revenues during the term of the PowerPurchase Agreement.  It is unlikely thatthe Company would be able to find another purchaser or fuel source on similarterms for its Facility if Williams Energy were not performing under the PowerPurchase Agreement.  Any materialfailure by Williams Energy to make capacity and fuel conversion payments or tosupply fuel under the Power Purchase Agreement would have a severe impact onour operations, and may result in a default on the our debt.  The payment obligations of Williams Energyunder the Power Purchase Agreement are guaranteed by The Williams Companies,Inc.  The payment obligations of TheWilliams Companies, Inc. under the guaranty are capped at an amount equal toapproximately $510 million.  Beginningon January 1 of the first full year after the commercial operation date,this guaranty cap is to be reduced semiannually by a fixed amount which isbased on the amortization of our senior secured bonds during the applicablesemiannual period. As of March 31, 2004, the guarantee was capped at$507.6 million.

 

TheCompany’s dependence upon The Williams Companies, Inc. and its affiliates underthe Power Purchase Agreement exposes the Company to possible loss of revenuesand fuel supply, which in turn, could negatively impact its cash flow andfinancial condition and may result in a default on its senior securedbonds.  There can be no assurances as tothe our ability to generate sufficient cash flow to cover operating expenses orits debt service obligations in the absence of a long-term power purchaseagreement with Williams Energy.

 

**Critical Accounting Policies**

 

General— We prepare our financial statements in accordance with accounting principlesgenerally accepted in the United States of America. As such, we are required tomake certain estimates, judgments and assumptions that we believe arereasonable based upon the information available. These estimates andassumptions affect the reported amounts of assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the periods presented. The significant accounting policies which webelieve are most critical to understanding and evaluating our reportedfinancial results include the following: Revenue Recognition, Property, Plant and Equipment and Contingencies.

 

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*RevenueRecognition* — Wegenerate energy revenues under the Power Purchase Agreement with WilliamsEnergy.  During the 20-year term of theagreement, we expect to sell capacity and electric energy produced by thefacility, as well as ancillary services and fuel conversion services.  Under the Power Purchase Agreement, revenuesare generated from meeting (1) base electrical output guarantees and (2)heat-rate rebates through efficient electrical output.  Revenues from the sales of electric energyand capacity are recorded based on output delivered and capacity provided atrates as specified under contract terms. Revenues for ancillary and other services are recorded when the servicesare rendered. Amounts that are in dispute are reserved accordingly, based onthe probability that they will be realized.

 

Uponits expiration, or in the event that the Power Purchase Agreement is terminatedprior to its 20-year term or Williams Energy otherwise fails to perform, thenwe would seek to generate energy revenues from the sale of electric energy andcapacity into the merchant market or under new short- or long-term powerpurchase or similar agreements.  Due torecent declines in pool prices, however, we would expect that even beingsuccessful in finding alternate revenue sources, any such alternate revenueswould be substantially below the amounts that would have been otherwise earnedpursuant to the Power Purchase Agreement.

 

*Property,Plant and Equipment** *— Property, plant and equipment is recorded at cost.  Depreciation, after consideration of salvagevalue, is computed using the straight-line method over the estimated usefullives of the assets, which range from five to thirty-six years.  Maintenance and repairs are charged toexpense as incurred.  The depreciablelives of our property, plant and equipment by category are as follows:

 

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| **Description of Asset**           |   | **Depreciable  Life** |   | **March 31,  2004** |    |
|------------------------------------|--------|-----------------------|--------|--------------------------|---------|
|                               |   |                  |   | **(000’s)**         |    |
| Buildings                          |   | 35                    |   |                     | $       | 1,767 |   |
| Vehicles                           |   | 5                     |   |                     | 111     |   |
| Computers                          |   | 6                     |   |                     | 783     |   |
| Furniture and Fixtures             |   | 10                    |   |                     | 515     |   |
| Combustion Turbine Generator Parts |   | 9-36                  |   |                     | 45,109  |   |
| Gas Heaters                        |   | 35                    |   |                     | 1,119   |   |
| Spare Parts Inventory              |   | —                |   |                     | 13,300  |   |
| Plant                              |   | 35                    |   |                     | 362,742 |   |
| Subtotal                           |   | 35                    |   |                     | 425,446 |   |
| Accumulated Depreciation           |   |                  |   | (18,681                  | )       |
| Property, Plant and Equipment, net |   |                  |   | $                        | 406,765 |   |

 

*Contingencies*We are disputing approximately $500,000of merchant price, testing gas and other charges with Williams Energy that wecontend is owed from Williams. This was not part of the arbitration settled inNovember, 2003.

 

Ourfacility was initially designed, engineered, procured and constructed for us byWashington Group International, Inc. (“WGI”) (as the successor contractor) on afixed-price, turnkey basis. On May 14, 2001, WGI filed a plan of reorganizationalong with voluntary petitions to restructure under Chapter 11 of the U.S.Bankruptcy Code in the U.S. Bankruptcy Court for the District of Nevada in Reno(the “Bankruptcy Court”). As a result of WGI’s bankruptcy filing, onJune 20, 2001 we made a demand on the Raytheon Company (“Raytheon”) toperform its obligations under a guarantee which Raytheon had given us of WGI’sperformance obligations under the construction agreement and Raytheon becameresponsible for the construction of our facility.  As discussed above, provisional acceptance has been granted andthe Facility has commenced commercial operations, however, Raytheon mustperform certain agreed upon completion items in order to obtain finalacceptance. Raytheon gave notice of Final Acceptance on July 22, 2003based on its July 8, 2003 performance test.  On July 31, 2003, we received a letter from the project’sindependent engineer stating that it could not support Raytheon’s claim offinal acceptance and it did not consider the July 8, 2003 performance testvalid.  In making this assessment, theindependent engineer cited, among other reasons, (i) modifications made tocertain equipment in performance of the July 8 performance test whichwould adversely impact the operations of the plant and other pieces ofequipment and (ii) Raytheon’s failure to demonstrate compliance with guaranteedemissions limits.  On August 1,2003, the Company rejected Raytheon’s claim of final acceptance.  This rejection was based upon Raytheon’sfailure to meet the conditions for final acceptance provided for in the EPCcontract. On August 7, 2003, we received a response from Raytheon in whichRaytheon claims that the Company’s rejection of the final acceptance is invalidand improper.  The Company is currentlyconsidering its options for resolving this dispute.

 

**Item 3****. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Notapplicable pursuant to General Instruction H of Form 10-Q.

 

# **Item 4**. CONTROLS AND PROCEDURES

# ** **

*DisclosureControls and Procedures*Under the direction of our Chief Executive Officer and Chief Financial Officer,we evaluated our disclosure controls and procedures (as defined in theSecurities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15d –15(e)) required by paragraph (b) of Exchange Act Rules 13a – 15 or 15d – 15,and concluded that our disclosure controls and procedures were effective as ofMarch 31, 2004.

 

*Changes in Internal Controls* Based onmanagement’s evaluation that was conducted during the first fiscal quarterunder the direction of our Chief Executive Officer and Chief Financial Officer,we determined that there was no change in internal control over financialreporting during the quarter ended

 

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March 31, 2004 that has materially affected, or is reasonablylikely to materially affect, such internal control over financial reporting.

 

 

**PART II****. OTHER INFORMATION**

 

**Item 1. LEGALPROCEEDINGS**

See Note 6 to our condensed, consolidated financial statements.

 

**Item 2.**  **CHANGES IN SECURIT****IES AND USE OF PROCEEDS.**

Notapplicable pursuant to General Instruction H of Form 10-Q.

 

**Item 3.****DEFAULTSUPON SENI****OR SECURITIES**.

Notapplicable pursuant to General Instruction H of Form 10-Q.

 

**Item 4.****SUBMISSIONOF MATT****ERS TO A VOTE OF SECURITY HOLDERS**.

Notapplicable pursuant to General Instruction H of Form 10-Q.

 

**Item 5. OTHERINFORMATION**

None.

 

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**Item 6****.  EXHIBITS ANDREPORTS ON FORM 8-K**

 

**(a)****          Exhibits**

 
| 31.1   |   | Certification by Chief  Executive Officer Required by Rule 13a-14(a) or 15d-14(a) of the Securities  Exchange Act of 1934       |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                            |
| 31.2   |   | Certification by Chief  Financial Officer Required by Rule 13a-14(a) or 15d— 14(a) of the Securities  Exchange Act of 1934 |
|   |   |                                                                                                                            |
| 32     |   | Section 1350 Certifications                                                                                                |

 

 

**(b)****          Reports on Form 8-K**

 

The Company did not file any reports on Form8-K during the quarter ended March 31, 2004.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                    | **AES RED OAK,  L.L.C.** |
|-------------------------|--------------------------|
|                    |                     |
| Date: May 10, 2004 | By:                      | /s/ A.W. BERGERON |
|                    |                     | **A.W. Bergeron** |
|                    |                     | President |
|                    |                     |   |
| Date: May 10, 2004 | By:                      | /s/ PAM STRUNK |
|                    |                     | **Pam Strunk** |
|                    |                     | Chief Financial Officer |
|                    |                     |   |
| Date: May 10, 2004 | By:                      | /s/ THOMAS P. KEATING |
|                    |                     | **Thomas P. Keating** |
|                    |                     | Principal Accounting Officer |

 

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