July 19, 2010
As the recession is coming to an apparent end, the utility industry is beginning to realign. While a number of deals are transpiring, they are less indicative of a broader trend and more about companies building their competitive future positions.
Energy demand will continue to lag its prerecession levels. So, many companies are faced with the choice of hanging on to assets that are not fully productive or selling plants to those who view them as part of their wider expansion plans. Others, meanwhile, are merging so as to gain size, scale and diversity.
The jockeying has begun. Weak demand has eroded power prices, enabling well-positioned companies to bid on relatively inexpensive assets. And one company's risk is another's opportunity: PPL Corp.'s bid for E.ON AG's regulated utility operations in Kentucky and Tennessee, for instance, is an attempt to dilute its unregulated -- or merchant generation -- holdings that are subject to market prices.
Likewise, Pepco's decision to sell its merchant power plants to Calpine Corp. reflects a reemphasis on its core utilities and its transmission expansion, says Standard & Poor's. Xcel Energy, meanwhile, is buying two gas plants from Calpine and has plans of putting them in its rate base. The ratings service adds that even the merger of two independent power producers like Mirant and RRI Energy is an effort to "mute" commodity risks.
"The business prospects for the merchant power sector continue to be battered by the one-two punch of increased natural gas supply (weaker forward prices) and the recessionary nagging impact on customer demand (less usage and excess capacity)," says a report by S&P.
As companies rethink their business plans in a post-downturn setting, S&P says that credit quality is among the many factors that the merchants are considering. The goal is to be able access debt markets at reasonable rates so as to expand to meet the needs of a carbon constrained society and to comply with environmental regulations.
Despite years of volatile prices and economic uncertainty, the merchant generation sector had locked in before the tailspin longer term hedging contracts. That has enabled those companies to remain viable and to preserve their "stable outlooks."
The downturn 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
The turnaround occurred in the final quarter of 2009 -- a trend that S&P's economists say is continuing this year. Those experts are expecting a 2.4 percent increase in the gross domestic product in 2010.
If those predictions hold, 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 the prices they offer 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 an S&P report on merchant generation. "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."
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 within two years, says S&P. That would expose those independent power producers to paying potentially higher commodity prices and therefore reducing their earnings.
Consider Calpine: It is paying Pepco $1.65 billion for 18 natural gas-fired unregulated power plants in the Mid-Atlantic region. With the demand for power expected to gradually escalate and with environmental regulations presumed to get tougher and to favor natural gas, Calpine says that it has entered into an enviable long-term strategy.
Likewise, Mirant says that its hedging strategy has also cushioned it from the effects of relatively low commodity prices. That tactic has put it in the position of now being able to join as equals with RRI Energy. The combined entity, called GenOn Energy, would be one of the largest independent power producers in the country with 24,700 megawatts of generating capacity. It would be an all-stock deal valued at $3.1 billion.
"The merger will create real and immediate value to the significant cost savings we expect to achieve as a merged entity," says Edward Muller, Mirant's chairman and chief executive, in a conference call. "We will have a stronger balance sheet, ample liquidity and increased financial flexibility. This will further improve financial stability and enable the combined company to navigate better through industry cycles and commodity price fluctuations."
By allowing the independent power producers to realign and to seize upon some of the uncertainty in the marketplace, regulators are increasing the odds that they will be around for the long run. As such, the merchant operators would be expected to continue to modernize power generation and to efficiently run those plants.
In a carbon constrained economy, those attributes will pay off. And if they can properly manage their business and commodity risks, they should be able to reach their potential, benefiting their shareholders and maintaining their credit outlooks.
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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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