U.S. gas/electric megamergers may slow as new policies tested

The 2,213-MW gas-fired P.H. Robinson power plant in Galveston County, Tex., can take advantage of converging energy market trends by exchanging power for gas supplies, or vice-versa, as market conditions warrant. Photo courtesy of Houston Industries Power Generation.

The so-called "BTU convergence," spawned by electric power deregulation dogging the heels of earlier gas industry deregulation, is at the heart of an unprecedented series of proposed mergers between natural gas pipe- lines/distribution companies and electric utilities.

Gas and electric companies seeking to join forces are experiencing some growing pains along the way, as regulators take a close look at the altogether new, converged BTU business sector that is emerging.

Selling energy and related services by the BTU promises to be the largest competitive U.S. enterprise spawned by the wave of deregulation that started in the 1970s.

With annual revenues approaching $300 billion, the BTU business will be larger than either airlines or telecommunications (OGJ, Sept. 16, 1996, p. 16). As a result, regulators will want to be extra cautious to make sure they don't inadvertently create a monster of anti-competitive giants with the potential to dominate energy markets-particularly regional ones.

Yet despite huge profit potential down the road, making money as combined power-gas companies may prove elusive at first, insiders say. That's partly because acquiring companies are paying a premium for those they seek to acquire. And because the market is so new, nobody's sure how best to tap the profit potential.

Merger mania

The pace of merger activity picked up considerably last year, when several states and the federal government moved ahead on policies to bring competition to the electric power industry.

California, New Hampshire, Massachusetts, and Rhode Island have passed legislation allowing any company to compete with utilities in electric power sales, and about 30 states are looking into action of some kind.

In Washington, the Federal Energy Regulatory Commission approved Order 888, providing open access to transmission for competitive power sales at the wholesale level and by yearend 1996 had proposed new guidelines for electric utility mergers-the only kind of merger over which FERC has clear jurisdiction.

As regulators forged ahead, five giant gas-electric mergers exceeding $1 billion in value were proposed (see table, p. 20), most of these in the last few months of the year. And first quarter 1997 may bring still another pairing. Valero Corp., San Antonio, wants to pick a partner by or before Feb. 15. Suitors include utilities Pacific Gas & Electric Co., San Francisco; Entergy Corp., New Orleans; and Cinergy Corp., Cincinnati; and oil and gas firms Conoco Inc. and Enron Corp. Valero in December disclosed its intent to seek a partner for its gas business; the company wants to spin off its refining arm as a stand-alone company (OGJ, Dec. 9, 1996, p. 25).

On the regulatory front, Enron Corp. hopes to have approval by midsummer of its proposed $4 billion merger with Portland General Corp. Enron won preliminary approval from the staff of the Oregon Public Utility Commission, but finds the panel's conditions unacceptable.

Also hoping for approval this year are PanEnergy Corp., Houston, and Duke Power Co., Charlotte, N.C., in a $7.5 billion deal-the largest yet in the budding BTU business. On the West Coast, Pacific Enterprises, parent of Southern California Gas Co., is pursuing a $5.2 billion merger with Enova Corp., parent of San Diego Gas & Electric Co. In Texas, Houston Industries Inc. proposed a $3.8 billion merger with NorAm Energy Corp., Houston, while Dallas-based Texas Utilities Co. seeks to acquire Enserch Corp., Dallas, in a deal valued at $1.7 billion. Both NorAm and Enserch have gas exploration and production, pipeline, and marketing arms, but their core business is gas distribution.

Analysts agree these unions are just the beginning of a much bigger trend, as companies jockey for position to market electricity and other forms of energy directly to consumers on a national scale.

"We expect a lot more cross-industry consolidations," wrote Barry Abramson and Carol Coale of Prudential Securities in a research report on recent mergers. "In order to be able to offer the full range of products and services, companies want to become the 'total energy provider.' This means they must have the capability to deliver natural gas and electricity, as well as services related to both these energy sources."

Calm before storm?

Although 1996 ushered in the first wave of major gas-electric merger disclosures, 1997 may bring a lull before the next wave of gas-electric "merger mania" hits.

Industry watchers say scores of other potential gas-electric merger candidates will hold off for at least 6 months in 1997-and perhaps for the rest of the year-to see how the first mega-combinations progress.

The primary reason, analysts say, is that states and FERC will be examining complex jurisdictional, rate-making, and antitrust issues being touched off by the first generation of gas-electric mergers. And while most expect the mergers to be approved, the going may not be easy.

"These are expensive propositions, and I do not underestimate the process of getting these approved by state and federal regulators," said Vito Stagliano, director of the electricity practice for Energy Security Analysis Inc., a Washington, D.C., consulting firm. "I think states are especially ill-equipped to understand mergers and assess the upsides and downsides."

Regulatory scrutiny will differ from other mergers in the industry, because most energy industry consolidations, including the gas-to-gas company mergers of recent history, are subject to the purview of the Federal Trade Commission and other agencies. Electric utility mergers are subject to FERC's jurisdiction, but even that agency isn't clear about how to handle the overlap when an electric utility joins with a gas company. It will be taking these proposals on a case-by-case basis, which could slow the process down considerably, industry observers say.

"Applying antitrust laws to the electric and gas industry is something FERC hasn't spent much time on," notes Gary Simon, senior director of global electric power for Cambridge Energy Research Associates. "They'll want to go at it very enthusiastically, so that says they'll spend a lot of time on it. Decisions are going to be difficult to reach, changing course several times."

Still, most experts are optimistic about the prospects for eventual approval of the first mergers-along with action by more states to speed the power deregulation process. "I think it's absolutely inevitable, even in states reluctant to take it on," Stagliano said. "There is not a single case history of a commodity being deregulated and the price going up as a result."

Another question dogging the would-be merged companies is what conditions may limit the combined concerns. CERA's Simon said, "My guess is that there will be some very tough conditions set, and over time, FERC will discover those conditions aren't necessary. The point is, the laws don't give you very clear standards. Antitrust laws are rather too vague as to what's too big and what's abusive market power, but concentration is not necessarily the greatest evil."

Will merged companies thrive?

But getting approval of the initial deals will be only the first challenge.

Despite the huge revenue potential, generating profits won't come easily at first.

"This whole issue will be more interesting a year from now than today," predicted Paula Rasput, president of PanEnergy's power trading services arm. "All of these combinations will have some dilution (of earnings) in them, because the acquirer is paying a premium for the acquiree."

Among the questions combined companies will have to resolve are whether to embark on national or regional marketing strategies. An organizational structure will be "an important, though undervalued" factor in the success of the mergers, according to a study by Ellen Lapson of Fitch Investor Service.

"Regulatory limits on possible utility structures have slowed the pace of mergers and at times caused combining companies to compromise business strategies and financial objectives," Lapson pointed out.

A primary impediment is the Public Utility Holding Company Act (Puhca) of 1935, which was created to discourage the high concentration of utilities in the U.S. "Essentially, what Puhca did was force utilities exclusively into the business of producing, distributing, and delivering electricity," ESAI's Stagliano explained.

Electric utilities are now experiencing a wave of consolidation of their own, but virtually none among scores of proposed electric-electric combinations have been approved to date. This is due, in part, to the previous lack of up-to-date FERC merger guidelines, and in part, to the impediments posed by Puhca.

Lapson said, "Registered holding companies are generally prohibited from common ownership of electric and gas utilities, are limited in operating nonregulated activities, are restricted in financing and on capital structures, and are subject to stricter reporting and approval requirements than other utilities."

Fitch's Lapson believes there is potential for gas concerns to become regulated utilities under Puhca. Still, companies hoping to merge are eager to see if a gas-electric combination process moves faster with regulators than electric-electric counterparts.

There's been speculation over the possibility of Puhca repeal by Congress. William McCormick, chief executive officer of CMS Energy Corp., Dearborn, Mich., believes there will be opportunities for Puhca repeal this year but doesn't think Congress will venture into allowing full-scale retail competition.

"Because several states have already approved retail access plans and a number of others are considering them, federal legislation will likely be overtaken by the implementation of plans at the state level," McCormick told a conference sponsored by Arthur Andersen this past December.

Many believe that commodity sales will be a relatively modest portion of the new BTU business. For instance, PaineWebber believes the service side of the BTU business stands to be the most lucrative of all. And speaker after speaker on utility deregulation at Arthur Andersen's recent symposium hammered home the importance of service in the converged industry.

"To survive, the retail energy company of the future will have to start with the customer and work back," Oliver Richard, CEO and president of Columbia Gas System Inc., told the conference. He thinks both combined companies and those trying to tap the BTU market without a major merger partner must focus on developing more consumer-oriented appliances, better energy monitoring and control equipment, and supporting information technology.

Larry Dagley, senior vice-president and chief financial officer of Pacific Enterprises, said the companies that succeed in the future are "those who offer more than just an energy commodity...(but also) a broad portfolio of products and services at competitive prices."

"Closing is just the first chapter," PanEnergy's Rasput added. "We are all challenged about business going forward in vastly different ways than in the past to get earnings momentum. Precise execution by management will be pivotal to convergences."

Charles Chicchetti, partner in Pacific Economics Group, Los Angeles, at the recent Arthur Andersen conference, pointed to another frustration that could face management of combined companies. Namely, that utilities and gas companies "think" differently, because the gas sector has more than a decade of experience in deregulated markets.

On the other hand, Chicchetti noted: "Utilities seek regulatory guarantees and rewards, or they cannot bring themselves to reduce costs. Competition and utility corporate culture are separated by a vast ocean...(State) regulators seem willing to approve mergers when they can play in the game and take appropriate political credit. This is done by merger deals that simply freeze existing utility rates."

Different strategies

Although only about a half-dozen major gas-electric mergers have been proposed to date, the varied strategic directions already are becoming evident.

With only two exceptions-Enron/Portland General and PanEnergy/Duke-gas and electric mergers proposed to date have had a "defensive" orientation. For example, the Texas Utilities/Entex, Houston Industries/ NorAm, and Pacific Enterprises/Enova deals are essentially marriages of companies with similar backgrounds. All share comparable core businesses-one side an electric "distributor," the other a gas distributor. All three of the latter merging companies share complementary or overlapping service territories. While these mergers are not without strategic benefits, they also in part are designed to protect the acquiring company's service territory.

By contrast, Enron and PanEnergy's proposed mergers were the first to stray beyond traditional service areas and seek to join fundamentally different types of companies in very different home regions.

Enron seeks to acquire a midsize, regional utility with excellent proximity to an even larger market.

The Portland General acquisition would give Enron transmission assets, and a customer base 600,000 strong, right at the border of California-where deregulation is proceeding at a healthy clip. In that state, recently-enacted legislation will phase in deregulated prices for all classes of consumers starting on Jan. 1, 1998. A lively wholesale market has already formed at the California-Oregon border, known as COB, now used as the benchmark for prices on the New York Mercantile Exchange's electricity futures market.

The acquisition poses another advantage for Enron, because-unlike most California-based electric utilities-coal and hydro-based Portland General has low stranded costs in spare generating facilities.

Portland General, meanwhile, would benefit by gaining an alliance with the nation's largest natural gas and electric power marketer, in addition to co-owning Enron's mammoth pipeline system.

Enron has wasted no time and spared no expense packaging its multi-commodity offerings for mass appeal. The Houston-based pipeline created a new logo in the shape of a cattle brand, symbolizing the advent of brand name energy products and services. The company then purchased high-priced television advertising for the Super Bowl annual professional football championship game Jan. 26 in major cities across the U.S. All told, Enron will spend about $30 million in 1997 to gets its name out in front of the public.

The proposed PanEnergy-Duke merger takes the diversification strategy to a whole new level. It's the only merger proposed to date between a giant pipeline and a giant electric utility. Duke is regionally concentrated in the Carolinas and northern Virginia but enjoys a territory surrounded by other electrics-giving it ready access to customers for wholesale energy swaps currently driving the converged market.

While Duke has a number of nuclear plants in its service territory (see map, p. 21), most are of pre-1981 vintage that can be depreciated with little adverse effect on earnings, many analysts believe, leaving stranded costs manageable. The lower the stranded costs, the more competitive the utility stands to be in the deregulated world of the future, depending on how states rule on the issue.

In another twist on the merger, PanEnergy and Mobil Corp. joined forces last year in a strategic gas alliance aimed at tapping potential in the retail sector (OGJ, Sept. 16, 1996, p. 16). Mobil is a top U.S. gas producer, while PanEnergy's transportation system includes operating the $975 million, 729-mile Maritimes & Northeast Pipeline LLC project now under construction to bring major new supplies of gas to New England from the Sable Island area off Nova Scotia. The union also gave PanEnergy access to Mobil's large gas reserves in the Gulf of Mexico region and southwest U.S. and made the alliance one of the largest gas marketers in North America.

To the extent commodity sales of oil are handled by BTU businesses on a significant scale, the Mobil connection potentially could help the new PanEnergy-Duke combo, to be renamed Duke Energy, diversify faster than most.

Stranded costs

Far and away, the biggest issue potentially hampering deregulation is the stranded costs utilities have invested in nuclear plants and other outmoded or excess generating capacity.

Nobody has an accurate estimate of these costs, because "nobody has tried to sell those plants," said ESAI's Stagliano. But the figures are staggering, with estimates at $100-300 billion.

State regulators will have the primary role in deciding which portion, if any, of these costs utilities can recover in "transition costs" added to otherwise free-market electricity prices. California last year ruled to allow a 5-year transition fee to be charged to otherwise free-market electricity prices. Many expect this decision will set a precedent as other states try to forge deregulation policies.

FERC Order 888, which provides open access to transmission facilities under the panel's jurisdiction, rules that utilities can recover "prudently incurred" stranded costs. But FERC's jurisdiction only covers the wholesale end of the market, whereas states seem to be taking the lead on opening the market to full retail competition.

Utilities argue that virtually all costs were prudent, because they were incurred in good faith, under the direction of policy-makers who demanded more generating capacity than later proved feasible. At present, the consensus seems to be that utilities should be allowed to recover at least a portion of their stranded costs, which reduces the short-term benefits consumers may reap from competition.

Uncertainty over how much consumers may benefit from competitive power sales is a factor that could stall progress on mergers at the state level. Already, many consumer groups are arguing that deregulation will save the typical residential electricity user little or nothing-and utility executives have a hard time arguing this point. According to a survey by Washington International Energy Group Ltd., 82% of utility executives polled do not think deregulation would significantly trim the bills of typical residential consumers. As with gas deregulation, the biggest initial markets are the large-volume industrial, utility, and commercial buyers, which already have experience buying gas, coal, and oil competitively.

Nevertheless, retail energy marketing by the BTU ultimately will be a huge enterprise, and the residential customer won't be left out. Some believe that cross-mergers among telecommunications, cable, and energy companies could eventually result, because competition will be keen among companies with access to U.S. households to be a "total service" provider. And electricity reaches more households at present than either cable television or telephone service. Already, two energy companies have joined to test this concept (see related story, p. 22).

However, for the time being, most energy companies will be grappling with thorny antitrust and regulatory issues-and practicing how to "pitch" energy to a public that's never before had the opportunity to purchase retail energy competitively.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.