Energy Merchant Turmoil

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					Energy Merchant Turmoil
                                                     Merchant companies may struggle to stay in business for years
Peter Rigby, Standard and Poor’s
                                                     after their ‘worst-case’ scenarios became their ‘base case’ realities.

In less than a decade, US energy merchant companies have gone from                         and marginally profitable, at best. And the economy appears to need
the cradle to the graveside, if not the grave itself.                                      much less electricity than many expected, due in part to a shrinking
    In just two years, well over $100 billion of energy merchant market                    manufacturing sector.
capitalization has disappeared as almost everything that could have                            Finally, the short but tumultuous history of competitive power
gone wrong with the nascent energy merchant industry did. In the last                      suggests that the industry must intrinsically contend with low and risky
year, three companies have filed for bankruptcy. Bond spreads suggest                      margins, much as petroleum refining does.
that investors expect more of the same.                                                        Based on current data, both the energy merchant sector and the
    Credit ratings for a dozen companies owning over 200,000 MW of                         credit prospects for the debt that financed the sector’s growth will be
generation worldwide have fallen from investment grade (in most                            subject to further downward pressure. Indeed, it is difficult at this point
cases) to low, noninvestment grade levels. Many believe that it is too                     to construct a credible optimistic forecast.
early to dismiss the energy merchants, arguing that matters have
improved from a year earlier when these 12 companies were struggling                       The Longevity of Plants
with almost $25 billion of debt maturing in 2003. By the beginning of                      An interpretation of Michael Porter’s competitive industry analysis
December 2003, that sum had fallen to about $800 million maturing                          model suggests that competitive power generation faces inherent
by year-end as the energy merchants, with the reluctant assistance of                      obstacles to realizing the substantial profits whose allure drew so many
their banks, pushed many maturities out several years (see Figure 1,                       companies into the sector. The structure of the competitive power, or
following page.)                                                                           merchant energy, model indicates a fiercely competitive and fragmented
    Were the well-publicized 2003 debt reschedulings wise decisions?                       environment in which profit margins are painfully narrow.
Who can tell? What seems apparent, at least at this juncture, is that                          Unless something changes, such as an unlikely public policy shift
significant economic and business factors indicate that through the                        back to vertically integrated utility structures, the competitive power
remainder of the decade, energy merchants could well have to struggle                      industry will have to contend with low and uncertain returns. That so
to remain in business. Energy merchants face nearly $65 billion of                         many investments in unregulated power generation have fared so poorly
loans coming due by the end of 2010 out of a total debt burden of                          reinforces the point.
$125 billion – as indicated by ratings in the single B category or lower.                      In particular, two inherent qualities of merchant energy, which
Based on current data, it is unlikely that unsecured lenders to bankrupt                   include the activities of merchant generation and energy marketing and
energy merchants will see anything near par recovery, though secured                       trading, suggest that the industry may be doomed to long-term mediocre
lenders may, on the basis of recent bank loan ratings forecasting                          performance. First, while the construction costs and the often
recovery, fare better.                                                                     protracted difficulties of siting and permitting of new power plants would
    Why the gloomy forecast? In short, almost every worst-case scenario                    seem to be viewed as obstacles to their wholesale development and
that these companies and their lenders considered possible, but                            construction, some 200,000 MW of new capacity built since 1999
remote, has become its base-case scenario.                                                 indicates that these obstacles may not have been as formidable as
    Business positions, always risky, have deteriorated, and financial                     originally believed. The lesson to be drawn is that the sector knows how
profiles are generally much worse than two years ago. The independent                      to overcome these problems and regularly does so. Hence, the barriers
power industry built more generation, most of it gas-fired, than the                       to entry are low for new power generation.
market could possibly use. Natural gas prices, low for many years during                       The second quality of merchant energy keeping industry returns low
the gas bubbles of the 1980s and 1990s, have now moved to levels                           is the near permanence of power plants. Most facilities built during the
that potentially threaten natural gas’ status as “fuel of choice.”                         last 50 years or even longer still operate. Generating companies may
    Contrary to the assumptions of many market and feasibility                             disappear, either through bankruptcy or through consolidation, but their
studies, the retirements of older coal
plants and nuclear plants did not occur.
Indeed, many older plants have                   Peter N. Rigby is a director of utilities, energy, and project finance at Standard & Poor’s. With over 25 years of experience
displaced their new gas-fired combined           in energy, he is a frequent speaker and writer on power and energy issues and one of the firm’s principal contacts for
cycle competitors. Energy marketing and          ratings in the power, energy, and project finance sectors. Mr. Rigby holds a B.S. in petroleum and natural gas engineering
trading proved to be expensive to pursue         and a B.A. in arts and sciences from The Pennsylvania State University, and an M.B.A. from the University of Michigan.

                                                                                   Positioning for Growth                                                     47
Energy Merchant Turmoil

   Company (Source: Standard and Poors)                                            Credit Ratings Change                        Credit Measures
                                                                                 Dec 2003                 May 2001   Leverage         FFO/Interest      FFO/Debt
   Aes Corp                                                                            B+                   BB          95%               1.20              3.9%
   Allegheny Energy, Inc.                                                              B                    A           72%               1.04              6.0%
   Aquila, Inc.                                                                        B                    BBB         64%               0.60             -3.2%
   Calpine, Corp.                                                                      B                    BB+         79%               1.30              4.0%
   Dynegy, Inc.                                                                        B                    BBB         63%               4.10            17.1%
   Edison Mission Energy (EME)                                                         B                    BBB-        75%               2.20            10.9%
   El Paso Corp.                                                                       B                    BBB+        74%               2.32              8.6%
   Mirant Corp.                                                                        D                    BBB-        71%               1.00              2.8%
   National Energy & Gas Transmission Inc. (NEGT)                                      D                    BBB        135%               1.80              3.4%
   NRG Energy, Inc.                                                                    B+                   BBB-        67%               N/M               N/M
   Reliant Resources, Inc.                                                             B                    BBB+        59%               1.30              2.5%
   The Williams Companies, Inc.                                                        B+                   BBB+        76%               1.70              9.6%
   FFO/Interest = (funds from operations + interest) / interest
   FFO/Debt = (funds from operations after interest) / total debt
   N/M: Not meaningful as NRG Energy, Inc. is coming out of bankruptcy

      Figure 1     Energy Merchants Rated Single-B or Lower

power plants remain. While plants may be mothballed, they can easily                         lines may be available, the older and much smaller lines around
return to service if market conditions improve. Prior to the sector’s                        population load centers create bottlenecks preventing potentially
capacity expansion, most market studies and the developers and                               cheaper power from reaching markets. The broad absence of market-
lenders who relied upon them assumed that older coal plants and                              based transmission operations constrains merchant power sales
nuclear power plants would be retired. They weren’t.                                         opportunities, a problem that FERC has attempted to address with its
    Indeed, the opposite happened. New owners acquired the older                             Standardized Market Design.
plants, invested in upgrades and retrofits and dramatically increased                            Finally, merchant generation, in some parts of the country competes
plant efficiencies and availabilities. In addition to the economic forces                    against generation held in rate base by vertically integrated utilities.
that have kept older plants in service, some regulated utilities that still                  The resulting competitive advantage in favor of rate base supported
own generation have persuaded regulators to allow unused power plants                        generation makes it difficult for merchant power to recover its capital
to stay in their rate base to provide reliability and backup in the future.                  costs, especially in the overbuilt generation market that dominates
    Consequently, merchant power competes in a world where new                               much of the United States.
entrants can easily clear entry obstacles, and their power plants rarely                         Consequently, in a market characterized by the absence of long-term
disappear. Such is the foundation for a fragmented industry.                                 contracts, energy merchants find it difficult to earn the stable returns
                                                                                             that regulated industries earn or the high profits that industries with
One of the Many Poor                                                                         high entry barriers enjoy.
Competing in the fragmented merchant power industry largely condemns
its participants to thin and risky margins. The primary reason for this is                   Poor Industry Fundamentals
that public policy in the United States prevents merchant power plant                        A destructive consequence of operating in a fragmented industry
owners from owning significant or controlling market share. Hence, the                       with low barriers to entry is a susceptibility to “boom-bust” cycles,
market structure forces merchant power into a “price taking” position.                       not unlike the mining and chemical industries. Moreover, the
    In practice, the ability to transport electricity is limited. Unlike other               lumpiness with which new generation enters the market and its
commodities, electricity does not typically transport far from its source.                   longevity may threaten extended time frames at the bottom of the
Therefore, because power generation cannot always reach the most                             merchant business cycle. Now at what appears to be the end of a
desirable markets, it tends to compete regionally instead of nationally.                     build-out period, energy merchants may have to confront surplus
    A negative reinforcement to this regional focus has been the lack of                     reserve margins for years. Should that happen, energy merchants
investment in transmission facilities in the United States for the last 20                   will continue to find that poor industry fundamentals and depressed
years, as well as a governance structure that has on occasion restricted                     operating margins will frustrate capital recovery. And without the
access to transmission and customers. Another problem is that many                           liquidity on the balance sheet necessary to sustain these companies
developers have built new generation away from load centers and out of                       through the bottom of the cycle, some may be forced to leave
sight of potential public opposition. While bulk capacity transmission                       the business.

           48                                            w w w. U t i l i t i e s P r o j e c t . c o m
                                                                                                               Finance & Forecasting

Declining Manufacturing                                                          retard recovery prospects because of the inherent volatility of
It is unlikely that the US economy will provide much help to the energy          merchant power revenues.
merchants. Over the years, the historical correlation between GDP                    The second credit measure that points to distress is the “funds
and electricity demand has been weakening. Electricity demand in                 from operations to interest” ratios (FFO/interest). Most coverage levels
megawatt-hours since 1990 has grown at an annualized rate of 1.8                 for the 12 trailing months prior to mid-2003 are below 1.6x1 and well
percent per year while GDP in real 1996 dollars has grown more                   below the sector median of just over 3x1.
rapidly at about 3 percent per year (4.9 percent in nominal dollars).                The most telling measure is the “funds from operations after
Peak demand has grown faster at about 2.2 percent per year, but still            interest expense to debt” ratio (FFO/debt). Weak and declining
at a rate slower than GDP.                                                       FFO/debt ratios are empirically among the clearest indicators of
                                                                                 financial distress as cash flow is declining or debt is rising, or both.
                                                                                 Eight of the 12 companies have FFO/debt ratios of 6 percent or less
                                                                                 and all are below 17 percent. By comparison a solid investment grade
                                                                                 electric utility traditionally enjoys a FFO/debt ratio of at least 25 percent.

                                                                                 Outlook for Debt
                                                                                 As matters now stand, the energy merchant business model is under
     ... the energy merchants must find a                                        siege. The shared strategy of rapid and debt-funded growth premised
                                                                                 upon rapid deregulation of the US electricity industry and open
                                                                                 competition has not played out.
    way to reduce their crushing debt                                                 Against this backdrop the energy merchants must find a way to
                                                                                 reduce their crushing debt burdens and do so fairly quickly if they are

      burdens and do so fairly quickly if                                        to survive. But the task promises to be formidable, even for those
                                                                                 with “nonmerchant” power. Lenders may look at upcoming maturities
                                                                                 in light of the possibility of excess reserve margins through the
                  they are to survive.                                           decade and decide to retreat from the energy sector, especially if their
                                                                                 overall lending portfolios improve with a strengthening economy.
                                                                                 Hence, energy merchants will likely have to either slowly grow their
   Electricity demand has grown more slowly than GDP in part because             way out of their debt problems through an improving economy or,
the US economy has become more efficient over the last decade.                   failing that, look to reorganization strategies in bankruptcy to improve
But the more influential demand driver probably lies with the economy            their financial positions.
becoming more service-oriented as manufacturing moves offshore.                       Structurally, the nascent competitive power industry resembles
Electricity demand per dollar of GDP has been steadily declining since           other capital-intensive industries in which assets tend to remain in
1990 at the latest.                                                              service for a long time and where barriers to entry are not difficult to
                                                                                 overcome. These factors are the traditional basis for fundamentally low
Poor Credit Fundamentals                                                         and uncertain returns occasionally punctuated by a brief surge of great
By almost every measure, the 12 energy merchants exhibit surpassingly            profits – a situation that few energy merchant companies, their financial
weak credit fundamentals. Given the sector’s poor fundamental credit             advisors, or their investors anticipated almost a decade ago.
characteristics, its degree of fragmentation, and their $125 billion debt             And therein lies the message for the energy merchant business: while
overhang, the group will struggle to improve their credit measures.              competitive power fundamentals may never point to great businesses,
   Thus, consolidated leverage is at least 60 percent for each of                some firms in other industries can survive under similar circumstances
the merchants. Such leverage, combined with about 100,000 MW of                  and may even do well, but they do so under much more conservatively
merchant capacity in the US – much of it natural gas – will very likely          financed structures than many energy merchants first envisioned. ■

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                                                                            Positioning for Growth                                              49

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