The New Energy Landscape, Part 1

 | Mar 01, 2013 | 4:00 PM EST  | Comments
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Stock quotes in this article:

nrg

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exc

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cpn

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enoc

After the successful merger of several large utilities last year, a new energy landscape formed. Today, the nation has three large independent power producers with a combined capacity of approximately 108,000 megawatts (108 billion watts). While electricity is a fungible commodity, the three major producers use their assets to produce power in unique ways.

First, let's look at the landscape. As of 2013, there are three major independent U.S. power producers: NRG Energy (NRG), Exelon (EXC) and Calpine (CPN).

When it comes to power production capacity, NRG is the leader. After completing its merger with GenOn Energy, NRG now owns 45,940 megawatts of production capacity in 17 states. Under construction is another 1,780 megawatts. After completing a merger with Constellation Energy Group, Exelon became the nation's second-largest power producer. It owns 34,731 megawatts of production capacity in 22 states. The third-largest producer by capacity is Calpine. It owns 27,321 megawatts in 20 states.

While these rankings are by generating capacity, total production may be much different. The reason is that not all capacity is alike. Some capacity is too costly to operate and other capacity is not always available. So a critical success factor is not necessarily the accounting of capacity, but production costs and geographical strategies (I'll address geographical strategies in a separate article).

Production costs vary by the type of capacity used. While a company may own a lot of capacity, that does not mean that all their capacity is used or is profitable.

A critical success factor is production costs. From a power market perspective, allocation of gross margins is determined by relative production costs. So cost leadership is critically important.

To provide perspective, energy efficiency is the new cost leader. Marketed as demand-response, megawatts and megawatt-hours, power markets reward wholesale power providers to drop load. One of the nation's leaders in this segment is EnerNOC (ENOC). But Exelon and NRG are also active in this business.

The next cost leader is solar and wind. Production costs for solar and wind approach zero. This is because the power markets are indifferent towards maintenance, capital, interest and other non-production costs.

Next in the competitive lineup is hydroelectric. While the source of energy is almost free, hydroelectric plants need to mobilize staff to operate and monitor facilities.

Following hydroelectric are the traditional sources of power. Natural gas, nuclear, coal and fuel oil provide the bulk of the nation's power. But the competitive positions among these sources vary as fuel prices, regulations and production efficiencies change.

Today, natural gas is a cost leader among this group. A couple of years ago, nuclear power was the cost leader, with coal a close second. Ten years ago, coal was the cost leader with nuclear a close second.

Cost leadership positions will likely change in the future. One driver will be production efficiency as power producers cull out old, inefficient plants from the fleet.

With this in mind, investors should look carefully at NRG, Exelon and Calpine's generating assets. As can be seen in the accompanying graph, each company has a very different strategy.

Most of Calpine's capacity depends on natural gas. This suggests that knowledgeable investors are betting on Calpine's management and the strategic positioning of the company's assets. They are also betting big on natural gas remaining as the cost leading fuel.

Most of NRG's capacity is tied to natural gas, coal and oil. Because the nation's electric grid is essentially oil free, most of NRG's oil assets are idle and they do not produce much electricity. As such, NRG should be seen as a play on coal. NRG's investors are betting big on coal as a cost-leading fuel. Their coal bet is hedged against NRG's strong position with natural gas.

Most of Exelon's capacity is nuclear. While the company owns significant investment in other sources, Exelon's investors are gambling on the future of legacy nuclear power plants.

For Exelon, it may be worth the gamble. It turns out that nuclear production costs may be much lower than many believe.

Until 2015, it will likely be a rough ride for these power producers. In their most recent 10-Ks, each company attempts to help shareholders guess what that change will mean. They don't agree.

Investors should pay close attention to their company's cash flows. Of course, earnings are important, but as fuel prices change, cash flows will also change.

Each company has a different fuel strategy. Therefore, a change in one company's cash flows will not necessarily be correlated to a competitor's fuel costs. Cash will be king.

To see Part 2 of this article, please click here.

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