CONVERGENCE OF NATURAL GAS AND ELECTRICITY INDUSTRIES MEANS CHANGE, OPPORTUNITY FOR PRODUCERS IN THE U.S.

Vinod K. Dar
RCG/Hagler, Bailly Inc., Jefferson Gas Systems Inc.
Arlington, Va.

The accelerating deregulation of natural gas and electricity distribution is the third and most powerful wave of energy deregulation coursing through North America.

The first wave (1978-92) provided the impetus for sculpting competitive markets in energy production. The second wave (1986-95) is now breaking to fashion competitive bulk logistical and wholesale consumption markets through open ' access on and unbundling of gas pipeline and storage capacity and high voltage transmission capacity. The first two waves, however, affect substantially less than 50% of the final price of energy paid by millions of middle market and tens of millions of residential gas and electricity consumers.

The third wave, the deregulation of gas and electric retail markets through open access and nondiscriminatory, unbundled local gas and electric distribution tariffs, began in the early 1990s. It will gather momentum for the next 5 years and crest at the turn of the century, affecting and molding almost $300 billion/year in retail energy sales.

This profound strategic event will totally transform the North American energy industry over the next 10-15 years, destroying many balance sheets along the way while presenting vast new opportunities for creating, capturing, and preserving values on the frontiers of change.

STRATEGIC IMPLICATIONS

The transformation will have these strategic implications: (1) the convergent evolution of the gas and electric industries; (2) severe margin compression along the energy value chain from wellhead to busbar to the distribution pipes and wires; and (3) the rapid emergence of cyberspace retailing of energy products and services (see figure). (66117 bytes)

Gas/electric convergent evolution is of particular interest to gas producers (OGJ, Jan. 2, p. 27). While it will certainly put pressure on wellhead gas prices, it will also create opportunities for those producers who selectively integrate forward along the gas/electric value chain and invest in gas-fired generation.

Convergence is being caused by competition at the meter and collaboration at the combined-cycle gas turbine. At the meter, the convergence is made possible by the (1) impending demolition of the scores of regulatory and franchise Berlin Walls that have separated gas and electricity consumption and thwarted effective marketing; (2) unimagined proliferation of choices for energy consumers, large and small; and (3) emergence of highly creative and talented unregulated retail merchants of energy.

There are no truly long term, separate markets for gas, electricity, or oil. There is a market for energy, which today is astonishingly balkanized, inefficient, and burdened with regulatory excesses and inflated rate bases.

The decisions of consumers are severely circumscribed by an energy delivery system where gas and electric distribution are compartmentalized monopolies. As monopoly vanishes over the next several years, choices and the ability to exercise choice will proliferate and empower all consumers. Then gas and gas-using technologies and electricity and electro-technologies will strive vigorously against each other for the prize: customer loyalty and consumer dollars spent on obtaining the services energy can provide.

Gas and electricity will also have to compete with technologies that are a substitute for fuel and matter, thus reducing both the need for energy products and pollution management. Examples include biomimetic materials, programmed metals, and molecular fabrication, all of which greatly reduce the requirement to tear and bend metal and shape plastics. This, in turn, reduces energy consumption and also wasted matter-for which pollution is just another name.

As falling electricity prices and continuing innovation in electro-technologies put pressure on and begin to displace gas, the latter will be forced to find new uses, compress the innovation cycle for appliance technologies, and displace oil from transportation markets. The gas industry will seek to more creatively market natural gas vehicles (NGVs) and build a fueling infrastructure by acquiring and converting filling stations so the familiar local gas station may also become an NGV station.

Moreover, the gas industry will have to become far more aggressive than it has been in marketing and financing advanced industrial and large commercial gas combustion technologies to force fuel oil out of its stationary-application redoubts and respond to new electro-technologies. The oil industry can and will fight back with continued advances in gasolines and diesels, flat or falling real prices for heavy fuel oil, and persuasive advertising and promotions.

Interindustry trade between the gas and electricity industries will grow substantially in the next 10 years. Clearly, the gas industry will use more electro-technology and electronic equipment to improve its own productivity, but this can only be a minor part in the increased collaboration.

The major part will be in refining molecules into electrons via the impressive advances just ahead in combined-cycle gas turbine plants as electricity generators. These facilities in their various guises as merchant, dedicated, industrial on-site and as (non-pipeline quality) gas field onsite plants ranging from 20 megawatt (niche) to 200 me watt (commodity) will dominate new generating capacity for at least 10 years.

Some of this new capacity will be for incremental needs, and the rest will, unfortunately, displace existing electricity generating capacity - including from old, inefficient, utility-owned, gas-fired plants. It is difficult to assert whether total gas use will actually grow very much if new gas generating plants knock out a substantial base of old gas generating plants and electricity seizes market share from gas at the final consumers' meters. Discontinuous change makes forecasting overall gas demand in the years ahead a very dicey proposition since the old models and assumptions are no longer reliable.

The new gas-fired generating units (basically jet engines), especially the merchant plants, will produce electricity at dramatically less cost than that produced by either utility peaking turbines or industrial gas cogeneration facilities even 3 years ago. By the end-1990s, gas generators coming on line will be deployed to be nicely profitable at a benchmark, long-term, wholesale electricity market price of 3.5/kw-hr, fob the high voltage transmission network.

Several factors will make this possible: a compressed construction cycle of 14-16 months, compared with the current 22-30 months; continued rapid advance in the heat rates of gas turbines; manufacturing process improvements; standardized engineering and construction practices; and reduced operation and maintenance costs as automated operations dramatically reduce the need for labor.

MERCHANT PLANTS

A merchant power plant is one whose:

• Output is not dedicated, for the life of the debt financing, to one or two utilities or very big industrial consumers.

• Functioning does not require a steam host or status as a "qualifying facility" under federal regulations.

• Revenues will come from a changing mix of short and long term customers, several of whom will be unknown at inception.

• Business purpose will be to arbitrage the differences in values between natural gas (and later, other fuels) and electricity in bulk energy markets.

• Valuation will depend on how successfully the sponsor or owner can congeal this gas/electric value arbitrage through superior technology, operations, fuel management, and power marketing, including subleasing conversion capacity to other companies.

• Size is likely to range between 100 megawatts and 200 megawatts for grassroots facilities built in the next 5 years.

While the first wave of merchant plants will be grassroots projects, the second wave will include (1) restructured and marked-down cogeneration/independent power producer (IPP) facilities whose initial equity and a portion of the debt have been wiped out by deregulation and (2) gas-fired generating units divested from the rate base of electric utilities.

CONVERGENCE AND PRODUCERS

Even with declining retail prices, final consumers of gas and electricity will likely spend more than a quarter trillion dollars on these two energy services alone in the year 2000. These dollars will course through the gas/electric delivery system with every participant battling for a portion.

This struggle could leave the U.S. gas producing industry with revenues of $40-50 billion/year, depending on what happens to U.S. gas deliverability, competition from Canadian production and other imported gas supplies, and bow brutally wellhead prices are squeezed by competition at the retail meter. Competition will intensify with distance from the meter: The further upstream in the delivery system, the less gas and electricity are products and services and the more they are rank commodities.

Producers confined to selling only spot deliverability or production at the wellhead will obtain the lowest prices except during unusually cold or hot days or weeks, when they will be in a position to name their price. Producers who accept the challenge of differentiating their molecules at the wellhead and capturing a part of the value chain margin between wellhead and busbar or between wellhead and retail meter will obtain much higher prices.

In the new industry, buyers will pay more for molecules that are attached to features such as longevity (i.e., the assurance of a known quantity of deliverability for some years ahead), reliability, proximity of the gas field to high voltage transmission lines in large states, and options on price certainty, especially for 5-10 years.

Moreover, all but the smallest independents (those with less than $50 million in assets) will have to attach themselves financially or contractually or in a combination to the gas/electric value chain, since what occurs at the retail meter will profoundly affect the wellhead. Those not participating in the value chain run the risk of being frozen out and being treated essentially as swing suppliers, cheap storage, or purveyors of discount gas.

In addition, producers will have to substantially increase their capital spending on finding, production, and information technology to continually drive down costs and overhead expenses in real terms for reserve replacement, deliverability creation, and production. This will be important for defending operating margins since the real price of gas at the wellhead will probably decline over the next 10 years or, at best, stay constant.

Technology-driven independents such as Newfield Exploration and Texas Meridian Resources provide early models of what is possible and necessary. Interestingly, both are young companies. Technology turns hydrocarbon dreams into hydrocarbon values.

CAPITAL FLOWS

Continuing and refining a pattern established a few years ago, capital flows into North American gas exploration and production, reserve replacement costs, and wellhead prices will be directly linked.

Provided wellhead prices are roughly four times the gas reserve replacement costs of the most efficient (i.e., geographically focused and technology-driven) independent producers, capital will be very attracted to the as E&P business. Indeed, enough investment will occur to ensure a growing deliverability surplus.

Naturally, this surplus will cause prices to decline and may cause replacement costs to drift up because of overinvestment or overspending by producers. When the ratio of gas wellhead prices to the reserve replacement costs of the most efficient independents declines to roughly 3:1, capital markets or large-company boards will again become disenchanted with the prospects for the North American gas E&P business. Capital flows will diminish until reduced drilling yet again reduces the deliverability surplus and gas prices rise noticeably. This will lead to a rising ratio of wellhead prices to the reserves replacement costs of the most efficient producers. As this ratio nears 4:1, the capital cycle will begin anew.

To illustrate the argument, consider current numbers. During the past 18 months the most efficient producers have recorded reserve replacement costs of 25-60/MMBTU (including coal bed methane, which accounts for the lower end of the range), for a weighted average around 50/MMBTU.

Wellhead prices of around $2/MMBTU with expectations of further increases would be sufficient to ensure strong equity and bank debt markets for E&P. As annual average wellhead prices decline to $1.75/MMBTU, equity and bank debt will become progressively more difficult to obtain in 1995.

If wellhead prices fall into an even lower range ($1.50-1.60/MMBTU, annual average in the target field), capital, especially Wall Street equity, will become quite scarce.

This market behavior not only ensures continued cyclicality in wellhead prices but also limits the sustain-ability of wellhead prices much above $2.25/MMBTU and creates a long-term price band of $1.50-2.50/MMBTU (in 1995 dollars). Adjusted for inflation, it is rather likely that the price of gas in 2005 will be fairly close to the average 1994-95 level, which producers know to their chagrin is much lower, after inflation, than it was in 1985 even though demand has increased.

To improve their effective netback, producers could attach themselves to the energy value chain by:

• Owning interests in advanced gas-fired generating plants.

• Building their own small, at-the-field gas/electric "refineries" in selected markets.

• Owning a piece of an unregulated energy retailer.

• Forming strategic alliances with power producers, wholesale energy marketers, and traders.

• Selling partial ownership in their companies to companies further up the value chain.

PRODUCER FEDERATIONS

Finally, many producers may have to form a federation of competences with other producers. This would enable each to focus on maximizing the economic leverage from its own core capability while "outsourcing" several functions to trusted friends and partners in other companies with complementary competences. Culturally, this will be difficult for many independents, but the gains from federation will more than compensate for the modest loss of autonomy.

In such a federation, one independent could emphasize exploration, another proved undeveloped (PUD) reserves conversion and production, and a third capital formation while a fourth could concentrate on attaching the combined reserves and production to the value chain. A prototype of such an organization has been successfully developed by HarCor Energy, another young company.

Technology, innovation in business practices, participation in the gas/electric value chain, and alliances of competences thus become key success factors for the independent of the future. These may be somewhat alien concepts to many producers today, but given their importance in making money in the future, they will not remain unfamiliar for too long. Independents are resourceful and adaptable, which is their strength.

The final factor for success is an old and enduring one: a simple love of the game, a powerful emotional impetus to be in the oil and gas business, the romantic quest for the sunken galleon.

ISSUES OF SCALE

Large gas producers face a different set of strategic issues than the small or medium-size independents because of the scale of their investments, operations, and organizations in North America.

Large producers are beginning to realize that they cannot (1) rely on rising commodity prices in the next 10 years to improve the generally disappointing return on capital they have realized in the past 10 years, or (2) afford to be excluded from the convergence of gas and electric supply.

Large volume (i.e., more than 250 MMcfd of deliveries) gas producers have not, in the main, attained a return on total U.S. E&P capital averaging even 11-12%/year during 1984-94 (since the modem gas market arose). Very large volume (i.e., more than 500 MMcfd of deliveries) producers are unlikely to have averaged even a 10%/year return over the same period. Of course, there are exceptions.

There is little prospect that the large producers as a whole can do better over the next 10 years unless they change their strategy from commodity gas production to gas-electric "manufacturing" (GEM) and become gas-electric manufacturing companies (Gemcos).

Merchant gas-fired generating plants are likely to produce an average return on capital in the low teens, after tax, in the foreseeable future and niche plants a return in the mid- or even high teens, depending on location. Niche generation is not for large producers, but merchant generation is. Integrating forward into merchant generation and wholesale power marketing could boost the marginal return on capital for large producers, including the majors, appreciably.

Merchant generation of power, using existing endowments of gas reserves and engineering talent, is one of the few real opportunities for very large producers to deploy $2-3 billion each in North America over the next 10 years in a way that both increases total return and reduces earnings volatility. It can also enable large producers to internalize the myriad physical market gas/electric arbitrage opportunities that now exist and will certainly multiply in the future.

The counter-seasonality of gas and electric peak loads in many market areas also dampens the vexing seasonality that a big gas producer faces. A comparatively modest investment of $2 billion in merchant generation plants would enable large producers to find a secure home for the gas from three projects of the size of the Ram Powell field for the life of the reserves from these deepwater discoveries.

Merchant plants provide owners of sizable gas reserves a special opportunity since the capitalized value of the gas consumed by a merchant plant over its life is likely to be four to five times the capital cost of the plant itself. It is arguably much easier for the owner of substantial gas reserves to make the incremental capital investment to create an integrated gas/electric production system while eliminating fuel risk than it is for an independent power producer, gas gatherer/processor/wholesaler; power marketing affiliate of an LDC, pipeline, electric utility, or financial institution; or special purpose start-up to make the same investment.

No doubt the initial forays into the merchant power business will come from companies other than large gas producers, but in short order most of these pioneering efforts will be shown to be "flip" projects with large owners of gas reserves becoming the final owners. These reserve owners may be the bigger independent gas producers, North American subsidiaries of the integrated majors, or the large E&P arms of substantial diversified energy companies.

Consortia of like-minded, mid-sized independents (i.e., gas producers with proven reserves worth $200-500 million each) are also candidates for forward integration into the merchant power business provided one of the producers or a credible third party is willing to act as the systems integrator and provider of the first half a million dollars of seed capital to finance early stage development.

DEMAND, MARGINS, VALUE

The collision and collaboration between the gas and electric industries will create two opposing trends.

One trend will be pressure from the electricity industry to force natural gas out of end-use markets. This will make gas more of an intermediary rather than final fuel and combine with the possibility that highly efficient, new gas-turbine merchant plants will displace existing but inefficient thermal units and related gas transportation and storage capacity. The trend will thus restrict gas demand, squeeze margins from wellhead to burnertip, and erode asset values.

The second trend will be a reaction to the first. Alert to the threat, the gas industry will be galvanized into aggressively and creatively developing new markets by delivering gas-based energy services currently commanded by liquid fuels, investing intelligently in a range of gas use technologies to improve the price/performance ratio of gas at the final meter, and learning how to turn retail energy selling into a true consumer merchandizing business. This trend will thus enhance gas demand, expand operating margins, and elevate asset values.

The net result of these trends is currently impossible to enunciate. Thoughtful gas industry strategists have only begun to define these issues and initiate programs to understand the complex interactions among energy forms in a deregulated world, energy use and market-based efficiency technologies, consumer preferences, intellectual capital, and gas/electric interindustry trade and competition.

The North American energy market is on the cusp of changing into something new and something strange over the next 10-15 years. The change will occur, as it invariably does in huge markets, first gradually and then suddenly.

Most avalanches begin slowly, often with just a boulder dislodged from a peak. Look back at the past 10 years. They were a languid dress rehearsal for the next 10. For many this change is a millennial threat. For the few, especially the U.S. independent gas producer, whose blood is perfumed with ingenuity, this coming transformation is an epochal opportunity.

The Author