Exelon Hedges About the Future

 | Feb 08, 2013 | 3:00 PM EST
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Once again, energy distributor Exelon (EXC) has struggled to achieve earnings. The culprit seems to be its power generating business, and management's solution seems to be to grin, bear it and hope for the best.

For the fourth quarter, Exelon posted $6.28 billion in revenue and $384 million in earnings. Exelon Generating posted revenue of $3.93 billion and $137 million in earnings. But those results may not fully represent the financial performance of its generating assets.

It turns out that generating profits came from hedging activities, not power production. Of the $137 million in earnings, $145 million came from "mark-to-market impact of economic hedging activities." Take that $145 million away and Exelon's generating subsidiary is upside down.

Of course, achieving margins in energy production on hedging activities is a prudent undertaking. But the issue is the viability of Exelon's generating assets as a core business. In addition, as forward prices sink, achieving success solely from hedging activities could prove increasingly difficult.

Hedging was not the only activity bolstering Exelon Generating's earnings. Exelon, like many other utilities, created a subsidiary that collects shared expenses. In its consolidated statement of earnings, Exelon reports revenue and expenses for its Generation, ComEd, PECO and BGE subsidiaries. Generation is its independent power production subsidiary. ComEd is the local distribution utility serving the Chicago area, PECO serves the Philadelphia area and BGE serves the Baltimore area.

In addition to Generation, ComEd, PECO and BGE, Exelon lists another subsidiary. It's called "Other," and management offers very little about Other's financial performance. But in the fourth-quarter consolidated statement, this odd "subsidiary" posted top-line revenue of -$426 million (yes, that is a minus). Clearly, this subsidiary is financing other corporate activities. The costs should be allocated to each operating subsidiary to get a complete understanding of each unit's performance. When costs are allocated, Exelon Generating's full earnings are something less than the reported $137 million in all likelihood.

Clearly, owning a huge fleet of nuclear power plants is not working for Exelon -- at least not at the present time. But the conference call addressed the future, and management is betting that the future will be better than it is today.

It's not a simple bet. Management is betting on a strong national economy and elevated commodity prices for natural gas and bulk power. They are betting on market spreads between natural gas and bulk power (the so-called spark spread). They are betting they can operate their nuclear plants at unusually high levels (93%). They are betting tens of thousands of megawatts worth of coal will exit the market. They are betting only a limited amount of wind and solar will enter the market. They are betting demand-response and energy efficiency will have minimal impact on the market.

Exelon is betting that all these events will happen. Should one or two fail to materialize, Exelon may find more challenges ahead.

Predicting commodity prices months and years in advance is impossible. Exelon is not trying to nail future prices. Rather, it is attempting to predict pricing trends by analyzing market fundamentals. There is no doubt its appreciation of market trends for the power industry is largely correct. If and when the nation's power markets run out of baseload generating capacity, Exelon will be sitting pretty. Its challenge is to nail the timing.

So it is not surprising to hear a subtle message in Exelon's conference call that management is worried about the financial challenges ahead. The message is found in plans for capital expenditures. If shareholders look at Exelon's fourth-quarter exhibits, they can see management is maintaining capex for the regulated subsidiaries and lowering capex for the generating fleet (they plan to decrease capital investments by 23% in 2013 and decrease it again in 2014). It appears internally that management is betting that additional capex in generating cannot achieve competitive returns.

Clearly, if management thought power generation would become profitable in the months and years ahead, they would be investing to capture higher returns. They would be uprating existing plants and adding more generation to the fleet. They would have bought Dominion Resources' (D) Kewaunee plant for pennies on the dollar. They might even attempt to buy NextEra Energy's (NEE) Point Beach plant. Both nuclear facilities are in Exelon's back yard.

Investing in Exelon is speculation. To be clear, it's not simple speculation. It is a complex and interdependent bet on the U.S. Congress, the economy and the future prices of commodities.

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