ENERGY: Is the Merchant Power Industry Out of the Woods?

October 13, 2004

Investors and industry pundits who believe the merchant energy sector is poised to emerge from the distress of the past few years may be well advised to examine recent changes in the industry's fundamentals.   More precisely, the lack of change in fundamentals should serve as a warning that much of the sector is likely to experience several more difficult years before turning the corner towards long term financial health.

How Did We Get Here?

The merchant power industry has experienced a very turbulent period during the past few years.   The industry has witnessed three major bankruptcies and the keys to approximately 20GW of generation capacity have been, or are in the process of being, turned over to lenders.   The crisis has been caused by the confluence of several factors, including poor decisions leading to overcapacity, rising natural gas prices, and excessive debt levels. The partial deregulation of the energy markets in the 1990s unleashed a construction boom fueled by freely available financing from the capital markets.   Most of the new capacity was gas-fired, which was justified by expectations of low gas prices and gas plants' environmental advantages versus nuclear and coal-fired plants. At the time, natural gas prices were in the range of $2 - $3 per MMBtu (one million British thermal units).

As traditional power companies shed their utility images in favor of revenue growth and higher price earnings ratios, their debt levels ballooned.   Similarly, many independents put massive merchant exposure on their balance sheets.   Meanwhile, the volume of new construction resulted in significant overcapacity throughout the US.   In each of the North American Energy Reliability Council (NERC) regions, reserve margins are well above the 15% - 20% necessary to ensure system reliability.

More troubling still was a fundamental error in the forecast for natural gas prices, upon which the construction boom was predicated.   Specifically, participants in the gas-fired generation boom ignored the impact all the new demand for gas from these very same plants would have on prices.   Rather than staying within the expected range of $2 - $3 per MMBtu, the price of natural gas rose to $4.50 per MMBtu in mid-2000 and is above $6 per MMBtu today.   For many gas plants, these price levels are too high to cover the fixed costs of operation and debt service.

Positive Indicators?

In response to the above factors, the merchant power industry has undergone several years of extensive restructuring efforts designed to cut costs, shed non-core or risky assets and reduce leverage.   Debt maturities have been pushed out via refinancings and exchange offers, thereby reducing the likelihood of near-term liquidity crises and additional bankruptcies.   Those companies that could not weather the storm thus far have reorganized via the bankruptcy process, rejecting onerous contracts and cleaning up their balance sheets.  

Optimists point to several other developments as indications of a recovery in the sector. First, while gas prices remain high, coal's cost advantage has been partially eroded due to a significant increase in coal prices this year.   Secondly, the volume of asset sales has been on the rise.

But Have the Fundamentals Really Changed?

Despite these positive indicators, the industry's fundamentals have not changed substantially enough to proclaim an end to the crisis.  

First, gas prices are expected to remain high for several years.   Reserves in North America have not increased and are not forecast to.   Imported liquefied natural gas may become available later this decade, but in what quantity, at what price, and in which regions is still very much unclear, as is the geopolitical nature of importing more of our energy needs.   This means that even while coal's cost advantage has been reduced, production costs for distressed gas plants will remain uncomfortably high for the foreseeable future.

In addition, demand growth will not absorb existing excess capacity for some time.   In several of the most overbuilt regions, the supply/demand imbalance is expected to persist throughout the decade.   This implies that power prices will not rise sufficiently to offset the high gas costs, at least until regional power markets return to supply/demand equilibrium.

Asset sales necessitated by debt repayment obligations do not in themselves indicate improving fundamentals.   In fact, many of the recent transactions have included long-term contracts that eliminate much of the commodity price risk inherent in the merchant power industry.   Asset sales do not therefore indicate a recovery for the remaining un-contracted merchant power plants.  

And while asset sale proceeds and refinancings have enabled companies to extend maturities and reduced leverage, overall debt levels for merchant power companies are still uncomfortably high.   Of the 23 companies with merchant power exposure, Standard & Poor's has negative outlooks on 15. *Merchant power companies have simply put off their problems for another day and must continue to rely on the capital markets to provide liquidity.

Perhaps a more telling indicator than asset sales is the trend of large power companies turning over deeply distressed merchant plants to their project lenders.   Until the fundamentals of supply and demand come into equilibrium and leverage is reduced to sustainable levels, the pace of projects being turned over to lenders is likely to accelerate rather than decelerate.

In conclusion, the principle of caveat emptor (buyer beware) applies strongly to the merchant power industry.   Buyers of gas-fired merchant generation had better buy at prices that allow them to sustain at least several more difficult years while demand catches up with supply.

Mo Meghji is a Principal of Loughlin Meghji + Co., a financial advisory boutique offering restructuring, distressed mergers & acquisitions and crisis management consulting services.   LM+Co has offices in New York and Cleveland.   Doug Greer is a Director with the Firm.   They can be reached at (212) 340-8420.   www.lmco-ny.com

* As of the second quarter 2004.   Standard and Poor's report "Is the Refinancing Challenge Over for the US Energy Merchant Sector?" June 3, 2004.