By Ann de Rouffignac
OGJ Online
Falling electricity prices are creating controversy about a looming electricity glut in the US.
Stock prices of most energy companies and especially the power producers have followed the forward prices down. The change is most evident in the West, where prices have dropped sharply from record highs.
In June of this year, the Palo Verde electricity futures contract for July 2002 delivery traded at $240/Mw-hr. That same contract is trading at $60/Mw-hr now, below a cap imposed by federal regulators.
The contract for September 2001 delivery at the California-Oregon Border was trading at $275/Mw-hr in May. It was down to $45/Mw-hr just last week. Falling prices indicate supply and demand are coming into balance much quicker than previously anticipated, some industry analysts surmise, but producers have taken a more reassuring line.
With thousands of megawatts of power scheduled to come on line in the next 2 years and hundreds of million of dollars at stake, the world is rapidly dividing between the Chicken Littles and the Pollyannas. Operators such as Calpine Corp., San Jose, Calif., and Duke Energy Inc., Charlotte, NC, have recently reassured financial analysts falling electricity prices won't affect them.
Independent power producer Calpine isn't backing off from plans to have 70,000 Mw of generation operating by 2005. Despite falling prices, Calpine expects power demand to grow 2.7%/year, with about 180,000 Mw being added to the nation's fleet of power plants by that time. The company also expects 20,000 Mw of "environmentally unfriendly and inefficient" generation will be retired.
With a projected imbalance lasting until 2005, the company says it has plenty of time to execute on its "first mover" strategy. Only two regions, Texas and New England, will come close to having a balanced market, says Paul Posoli, senior vice-president, Calpine Energy Services, who suggests power plant building plans of other companies will get scrapped, as lenders tighten up on credit.
Even under balanced conditions, Calpine's newer more efficient fleet will make money, despite a falling spark spread, he says. Based on a heat rate of 7,000/btu/kw-hr, the spark spread for Calpine's power plants is $16/Mw-hr on $4/Mcf gas. The spark spread of higher heat rate plants could approach zero at $4/Mcf, Posoli says.
Duke Energy Corp. is also optimistic. "There are too many negative reports about North American growth. We see the upside," said Richard Priory, CEO of Duke in a recent conference call. "The fundamentals are still sound in this business." Priory says peak electricity demand is still expected to increase on average at 2.4%/year, resulting in a 25% increase in demand by the end of the decade.
Dynegy Inc. is not afraid the sky is falling, but the slowing economy has caused the Houston company to temper rosy demand forecasts. Steve Bergstrom, president, says the slow down "signals a trend" towards lower electricity demand.
Statistics collected by the US Energy Information Administration show a strong rise in residential and commercial electricity sales in the first four months of 2001 helped offset a steep decline in industrial sales, compared to year earlier period. Total electricity sales were up 3.9% over the same period a year ago.
Residential sales were up 10.4% to 405.3 billion kw-hr in the first 4 months of 2001, while commercial sales were up 5.8% to 334.2 billion kw-hr. But industrial sales were down 4.4% to 34.6 billion kw-hr.
"That [slowing GDP growth] is the one thing that has changed," says Bergstrom. "Our strategy was never to be the biggest generator in the world." Bergstrom says. Dynegy expected construction to peak about now and decline going forward.
Electricity also cyclical
The controversy is rooted in the market's changing view of electricity. The electricity market is exhibiting characteristics of a cyclical commodity such as real estate or oil and gas, says Gerald Keenan, partner with PriceWaterhouseCoopers. But electricity is an immature product and the dynamics of the cycles are not that clear.
"It's very murky," Keenan says. "This is the first cycle we have been through." Some investment decisions made in the West last October "don't look so good now," he says, and decisions made in the Midwest 2 years ago look even worse.
Midwest electricity prices were very volatile until a lot of new capacity, especially peaking power units, came on line. Prices have since fallen so much it has become hard for peakers to make money running only 3 days/year, he says, despite optimistic earnings forecasts.
"It will take a few more cycles until the players truly understand this business," Keenan said. Keenan says there will be a shake out in the industry, if and when the US goes into an extended period of no growth or a recession. Players with the financial staying power will make it through, while others might be consolidated.
Recalling the excesses of the real estate market in the 1980s, Keenan says many players had every excuse for why the market wasn't overbuilt. And it wasn't too long ago, he says, investors were convinced the NASDAQ wasn't overvalued.
Likewise, "everybody is dumb, fat, and happy today in the gas business," he says. "But 3 to 4 years ago some spent money, leveraged up, and were not disciplined. Those that had cash, like Apache and Anadarko, survived well. Those that didn't, got squeezed."
He predicts the power industry will experience similar cycles. Cash short, over-leveraged companies that don't have enough long-term power purchase agreements could get in trouble. "The electricity industry is not immune from the basic laws of supply and demand. The surplus is inevitable," said Keenan.
Falling forward prices
Declining forward curves and spark spreads suggest a balanced market and the potential for an electric power glut to some industry observers, but others don't regard them as particularly good market indicators.
"They [forward markets] are volatile, have limited liquidity, and only represent a portion of a generator's revenue potential," according to Simmons & Co. International, Houston. Simmons analysts say forward prices weakened in the summer because of weak spot market prices, rather than a change in the supply and demand fundamentals.
"We believe capacity margins that factor in demand growth and capacity addition expectations on a regional basis are a more important indicator of the balance between supply and demand in the power market," they say in a recent analysis of the market.
Dynegy's Bergstrom points out the forward curves barely moved even when a heat wave boosted demand in the Midwest and Northeast recently. "The shorts in the market are utilities. They won't buy until next summer even if it [electricity] were free," he says. "There are all these sellers and no buyers."
Bergstrom isn't too "exercised" over the falling forward prices, noting averages make a poor yardstick. "When you look at regions of the country, some are oversupplied some undersupplied," he says. "Averages are dangerous. If you take California out, the reduction in spark spread is not that great."
Calpine officials don't put much stock in the forward curves either. "They represent what people buy and sell in standard blocks of energy," says Posoli. "What about sales of ancillary services or capacity that are not reflected in the curves?"
Calpine's system approach to locating several plants in a regional market can provide hourly flexibility and firm power that commands a premium price not reflected in the forward curves, he says. Duke's Priory says the big spark spread "blow out" isn't sustainable anyway.
He says spreads had to come down to reflect more supply and moderating demand. Duke is unruffled because most of its portfolio is hedged, "We've got 90% of our 2001 and 2002 portfolio forward hedged," Priory says. "For 2003, 70% of our portfolio is hedged."
Senior energy analyst Michael Carter at Resource Data International, Boulder, Colo., also points out when the price of natural gas, the major cost of production, drops so precipitously electricity prices will fall too. The price of gas jumped to $10/Mcf last winter on the NYMEX, but now is trading in the $3.30/Mcf range.
"The bottom is not dropping out of the electricity market. We are just getting down to more reasonable prices for power," Carter says.
