March 05, 2010
The economic rebound should correlate with that of the electricity sector and particularly the unregulated component of it. But despite months of uncertainty, those "merchant" utilities played it smart by locking in longer-term contracts prior to the downturn.
That's according to Standard & Poor's Rating Service, which took a detailed look at the nation's merchant generators that are unable to pass along their costs to ratepayers but which are able to charge customers based on market rates. The result of such a strategy is that those companies generally have "stable outlooks."
The overall recovery, meanwhile, has stimulated demand that has, in turn, generated stronger cash flows and less debt for some. Others, though, have negative outlooks. The ratings agency prefers a 50-50 split between debt and equity for these companies.
"Because we believe the economic recovery is tenuous, we are taking a cautious approach in considering potential outlook revisions," writes Aneesh Prabhu, a director in Corporate and Government Ratings at Standard & Poor's. "In addition, many merchant generators began 2010 with stretched balance sheets. If commodity prices dip or expected growth in electricity demand does not pan out, cash flows and credit measures may not improve to levels that are commensurate with our expectations at current ratings."
The recession caused demand during peak periods to fall by about 1.6 percent in 2008, which corresponded to the steep decline in gross domestic product that year, the ratings service says. The pattern continued in 2009 with a 3.5 percent drop from the previous year, which, again, correlates with the 2.5 percent drop in economic output in 2008. That fall in electricity demand for two years in a row has not happened before, S&P adds.
The turnaround occurred in the final quarter of 2009 -- a trend that S&P's economists say will continue this year. Those experts are expecting a 2.4 percent increase in the gross domestic product in 2010. That upturn should spawn more electricity consumption, adds the U.S. Energy Information Administration that is predicting consumption to grow by 1.9 percent this year.
If that holds, S&P says that electricity demand should rebound from last year's lows and positively affect the cash flows of merchant operators. If consumption rises and supplies remain constant then prices will increase. As such, the gross margins that entail revenues less expenses would be greater. In an economic downturn, the opposite is true. According to S&P, average electricity prices had fallen 40-45 percent during the recession.
"A number of merchant power generators entered the recession in 2008 having hedged a large proportion of their generation at the prevailing high forward prices," says the S&P report, also authored by Beth Ann Bovino and Arthur Simonson. "As a result, not only were these companies protected from the volatility and level of prices during the past two years, but they also realized energy prices that were significantly higher than spot power prices during the second quarter of 2008 and through 2009."
Risks Present
To be sure, risks are still present. The hedging strategies that most of the merchants had taken will expire. In many cases, the contracts will end in 12 to 24 months, says S&P.
That will then expose those unregulated power generators to wholesale power price increases. The ratings agency says that it will maintain its stable outlook for those companies with hedging contracts that are near termination. But if the economy should take a nosedive, then it would revisit those issues.
Other risks also exist and namely uncertain regulations, escalating construction costs and stiffer lending standards. That's prompted those companies with plans to expand to postpone such capital expenses. Most of the planned generation units were to use natural gas, which had become relatively cheap because of oversupply and declining demand.
If the merchants can hang in there, however, their efforts may pay off; the country is short on generation over the long haul. Nearly all of such companies use best-available technologies that conform to modern pollution requirements. And unlike the early part of the decade when such facilities were built largely on speculation, developers will not any longer proceed without contracting in advance for most of the available capacity.
"Since our inception in 1984, Calpine has been an environmental leader investing in power plants that use modern emissions control technology and consistently outperform conventional fossil-fueled plants in curbing emissions that contribute to global warming," says Jack Fusco, president and chief executive of Calpine. It is building, for example, a 600-megawatt natural gas-fired facility that it says will release half the greenhouse gas emissions of the best-made coal facility.
Companies, generally, are taking less risk while they are working to attract new investors. Regulated utilities are able to pass along their costs to ratepayers, giving debt holders more certainty and shareholders the predictable dividends that they like. Unregulated power generators, by contrast, rely instead on market conditions -- a more difficult proposition but which holds greater potential for equity investors.
The peril that lenders or investors face, of course, is that electricity sales would deviate from the past and trail the growth in gross domestic product. But the biggest factor that will affect the merchant generators this year is the demand for their product. And while new efficiency efforts will help to curb electricity usage, a stronger economy should give most merchants a much needed lift.
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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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