Dominion, Duke Have Left the Building

 | Mar 08, 2014 | 10:30 AM EST
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In the energy sector, risk money has always been on ends of the value chain. On the front end are energy exploration and production companies like Chevron (CVX), Exxon Mobil (XOM) and ConocoPhillips (COP). On the back end are the nation's consumers. In between, there is a huge investment in privately owned infrastructure. Except for each end, all participants across the value chain expect guaranteed returns knowing that in the end, consumers will be forced by government regulators to pay.

There are two exceptions. One is liquefied natural gas (LNG) terminals. The other is power plants.

LNG and power plants serve similar functions. Neither one produces energy. Their only function is to convert energy. LNG terminals convert natural gas from a gas to a liquid and back to a gas. Power plants convert energy from a fuel to electric power. In both cases, the energy conversion requires significant capital expenditures. In both cases, the energy leaving the facility needs transportation infrastructure in the form of dedicated ships or dedicated wires.

Today, the U.S. has 10 LNG import facilities and one LNG export facility. Most of these facilities, including the nation's only export facility are in mothballs. Occasionally, an import facility is needed. Other than that, most LNG facilities have become stranded assets.

The stranded asset issue is the motivating factor for companies like Cheniere Energy (LNG) and Dominion Resources (D) to convert their old LNG import facilities to export terminals. This time, owners are insisting on protecting their investments. Since the government will not guarantee any return, prospective LNG exporters seek guarantees through long-term offtake contracts. Consequently, most new LNG production is hedged, and the risk money is again on consumers. However, this time the risk is not on the American consumer.

Unlike LNG facilities, power plants sit in the middle of the nation's value chain. Historically, these assets were regulated.

In an incredible act of inconsistent policymaking, many state governments decided power plants should be an exception. After these facilities were built, these states changed their mind and decided the consumer should not be the risk money. Instead, they forced utilities to back out of state-sponsored arbitrage agreements. They forced power plant investors to assume all economic risks.

Power plant owners immediately sought long-term power purchase agreements with any bankable offtaker. Unlike LNG exporters, few power offtakers are willing to assume the risk. Today, it is virtually impossible to find a counterparty willing to assume the risk for 20 years of power production. More and more power plants are finding themselves at the mercy of the power markets, which are about energy commodities.

The sticking point has become capital expenditures. By "deregulating," the state no longer provides a return on capital. Federal regulators also ignore returns on capital. With no ability to hedge, few power plant operators are willing to invest more capital with no assurances of a return.

This is why companies like Exelon (EXC), Entergy (ETR), Duke Energy (DUK), AES Corp (AES) and others have been considering selling or retiring fleets of perfectly good power plants. With these assets in play, there appear to be far more sellers than buyers. These assets appear to be impaired.

Consequently, investors should expect adjustments to balance sheets. Write-downs could be significant. Some, like Dominion and Entergy already started the process by writing down some of their nuclear assets. Exelon is warning they may write down several of their nuclear units in Illinois. More write-downs are on the way.

It is not about fuel. Duke is warning they may write down natural gas. This is in addition to their fuel oil and massive numbers of coal-fired power plants.

Behind the scenes, utilities are fighting back. They are trying to engage the Federal Energy Regulatory Commission (FERC). Federal regulators are concerned about reserve margins and reliability. Utilities want to earn a fair return on their capital. The code word stakeholders use is, "capacity payments."

States from New England to Texas are unwilling to fully pay compensation for capacity. They are willing to take capacity for free, but they unwilling to pay for reliability. Strangely, these same policymakers are willing to provide returns for pipeline assets to feed power plants and other consumers. They are willing to provide returns for transmission line assets to accept production from power plants. They will even pay returns to distribute power production to consumers. But, a power plant's capital cost is considered a free economic good.

If utilities win the battle with federal regulators, there could be a huge turnaround within the power industry. If they lose, there could be massive impairments and write-downs over the next 24 months to 36 months. Either way, volatility is in the market for those willing to stay. The others, like Dominion and Duke, already left the building.

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