DALLAS — The Arizona Power Authority is preparing to issue $25 million of taxable revenue bonds for upgrades to the Hoover Dam as operators seek ways to keep producing electricity and delivering water in a worsening drought.

Proceeds of the sale will reimburse the federal government for improvements to the dam that forms Lake Mead on the Arizona-Nevada border and provides power and water to cities in the Southwestern United States.

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The lake, which is near the lowest level since it began generating electricity 78 years ago, is expected to drop another 2.4 meters in 2014.

The big drop is because the Bureau of Reclamation, which operates the dams on the Colorado River, needs to withhold 1 billion cubic meters of water from Lake Powell upstream during the 2014 water season to comply with current law. That would represent the smallest release since Lake Powell was dedicated in 1966.

Since 2000, total Colorado Basin storage has ranged from a high of 94% of capacity to a low of 50% of capacity at the beginning of water year 2014.

"One wet year can significantly increase total system reservoir storage, just as persistent dry years can draw down the system storage," said Katrina Grantz, an engineer at the Bureau of Reclamation.

The past decade has been the driest period in the last 100 years of historical records for the Colorado River Basin, according to the Western Area Power Administration, which operates the electric grid for the western United States.

The Arizona Power Authority, a nonprofit created in 1944 to market the state's approximately 19% share of the electrical output from the Hoover Dam, sets its rates to recover the cost of the power.

APA plans to use the bond proceeds to pay off a $25 million line of credit with JPMorgan Chase Bank that was used to pre-pay APA's share of the costs of improvements to the dam.

"We are proactively addressing the effect that current drought conditions in the Colorado River Basin are having on water flows and power generation at Hoover Dam by helping to reduce Hoover Dam fixed operating costs," said Donald Porter, principal at the J. Donald Porter Co., financial advisor for APA.

The line of credit is subordinate to APA's 2001 and 2014 bonds and is structured with a three-year term-out, beginning the first business day of June, according to S&P. The agreement also stipulates that no additional bonds be issued, whether on parity with or subordinate to the 2001 or 2014 bonds, while the loan is outstanding.

JPMorgan is senior manager on the deal, with executive director Matt Levin as lead banker. RBC Capital Markets is co-manager, led by managing director Christine Pihl, who was executive director at JPMorgan before joining RBC in 2013.

Levin was managing director with Janney Montgomery Scott before joining JPMorgan in 2010.

Pihl has served as lead banker for large issuers that include the Southern California Public Power Authority, Salt River Project, Anaheim Public Utilities, Energy Northwest, Bonneville Power Association, and public utility districts throughout the region.

Michael Gazda, interim acting executive director of APA, said that the bonds were expected to go to market March 26.

James P. Marlin, partner at Norton Rose Fulbright, serves as bond counsel on the deal. Marlin has worked on various financings for power districts, cities, water authorities and state and local authorities in New York and New Jersey.

In terms of water and power deals, the APA issue is relatively small, but highly rated at AA by Standard & Poor's, and Aa2 by Moody's Investors Service. Outlooks are stable.

APA and the other 14 Hoover contractors prepay their obligations for improvements to the dam to decrease their cost. The Bureau of Reclamation is required to accept the prepayments, as long as all are received at the same time.

"In our view, the issuance of the series 2014 bonds with a final maturity date of Oct. 1, 2045 introduces moderate credit exposure as a result of contract renewal risk related to APA's power sales contracts with its 29 wholesale customers," wrote Standard & Poor's analyst Paul Dyson. "These contracts expire on Sept. 30, 2017."

The Arizona Power Authority and other wholesale operators at the dam are currently planning for their post-2017 contracts under a new power allocation.

While drought has forced WAPA to buy additional power to compensate for lost hydroelectric capacity at some dams, power from Hoover Dam is sold only as it becomes available, the agency said. Take-and-pay contracts require APA customers to receive any power delivered to them, but do not obligate APA to provide firm power in low-water years.

Recognizing drought as a risk factor, Moody's Investors Service maintained its Aa2 rating on Arizona Power Authority's debt.

"Drought conditions that have reduced water levels in Lake Mead could impact the plant's ability to produce power -- though recent capital improvements have resulted in additional operating flexibility," said Moody's analyst Laura Schumacher.

To keep Hoover Dam's generators spinning as the lake level falls, operators are installing five wide-head turbines that will draw water from greater depths. The fifth turbine is expected to be ready by 2016, officials said.

At the same time, the Southern Nevada Water Authority is boring a three-mile tunnel to draw water from greater depths in Lake Mead. The so-called Third Intake for Las Vegas and other cities is part of a $2.3 billion capital improvement program. The Third Intake is expected to be completed this year.

While drought means further drawdowns on the Colorado, the dam's turbos can continue to produce power as that water flows downstream. The threat comes if the water level falls too low and air damages the turbines.

About 30% of the energy from Hoover Dam goes to the Metropolitan Water District of Southern California, which also provides drinking water to nearly 19 million people across 26 cities and water districts.

"The elevation of Lake Mead and generation from Hoover tends to correlate, but the relationship is not direct given downstream water requirements," according to S&P's Dyson. "For example, generation could increase at Hoover during a dry water year in which Lake Mead's elevation declines, if water demand increases and more water passes through Hoover's turbines. In addition, efficiency improvements to the turbines have increased output."

At the Glen Canyon Dam that holds back Lake Powell, power generation could cease if the water level falls 30 meters below its level of August 2013, officials said.

"Models predict precipitation may decline by 20-25% over most of California, southern Nevada, and Arizona by the end of this century," according to a recent NASA report. "Precipitation declines combined with booming urban populations will present a significant challenge to Western water managers in the near future."

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