The New Energy Landscape, Part 3

 | Mar 12, 2013 | 5:00 PM EDT
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After the successful merger of several large utilities last year, a new energy landscape formed. Today, the nation has three major independent power producers, NRG Energy (NRG), Exelon (EXC) and Calpine (CPN), and they have very different strategies.

Part 1 of this series described how each company has its own fuel strategy. Most of NRG's capacity is tied to a blend of natural gas, coal and oil, most of Exelon's capacity is nuclear, and Calpine's capacity depends on natural gas.

Part 2 described each company's geographical strategy. The wrong fuel in the right location can be profitable. But inefficient use of fuel at any location can cost producers.

So the third critical success factor is fuel efficiency. Wasting fuel in inefficient power plants increases production costs and reduces margins.

Mechanical efficiency is a simple measurement. Measure the energy going into the plant in the form of fuel. Measure the energy produced by the power plant in the form of electric power. The difference between the two indicates the plant's efficiency.

Most power plants are only 30% efficient. About 70% of a power plant's fuel is completely wasted. The waste is tolerable when the price of fuel is low. But as the price increases, waste becomes an economic issue.

What matters more than mechanical efficiency is economic efficiency. Economic efficiency is the plant's mechanical efficiency times the cost of fuel. While the math may be an oversimplification, economic efficiency is critical for profitability.

As fuel prices change, so do competitive advantages. Right now, natural gas prices are low. If prices migrate upwards, as many commodity traders hope, the competitive landscape in the power industry will change.

Nat Gas vs. Nukes and Coal

The graph shows six different gas-fueled power plants. The mechanical efficiencies range from 55% to 25%. The six gas plants are benchmarked against an average coal plant and an average nuclear plant; both fleets are about 30% efficient.

The least efficient gas-fueled plant shown requires 13,660 British thermal units (Btu) of fuel to produce one kilowatt-hour of electricity (25% efficient). On the other end of the scale is a gas turbine, which needs only 6,200 Btu of fuel to produce the same amount of electricity (55% efficient). In the power markets, a 55%-efficient gas turbine will always beat the average coal plant, which is only 32% efficient, as long as the price of delivered natural gas is $4.20 per million Btus or lower.

Looking at it another way, when the market-clearing price for power is $26 per megawatt-hour or less, all gas turbines, except the least efficient, can economically outperform the average coal plant. At prices below $22, most gas turbines can outperform an average nuclear plant. However, if the price of natural gas is high (above $3.75 per thousand cubic feet) and market-clearing prices for power fall below $20, no gas plant, no nuclear unit and no coal plant can be profitable on energy production alone.

From the graph, we can see that high power prices and low natural gas prices create windfalls for the gas turbine, the average nuclear plant and the average coal plant. Several times a year, this happy windfall actually appears.

But low power prices and low natural gas prices have been the rule. When low natural gas prices meet lower power prices, Calpine wins. Calpine owns the nation's most efficient gas turbines, many of which are in the 45%-to-55% efficiency range.

As natural gas prices migrate upward, Calpine begins to lose margin and its relative competitive advantage. When delivered natural gas prices exceed $3.00, nuclear units become cost leaders. At $3.40 per million Btu, only the most efficient combined-cycle gas turbine can beat a nuclear plant.

Exelon owns many of the nation's most efficient nuclear plants. In fact, most of Exelon's nuclear units can beat the industry average of $22 per megawatt-hour. So as natural gas prices migrate upward, Exelon wins.

Not far behind are the nation's efficient coal burners. The average coal plant is 32% efficient and uses coal, which averages only $2.47 per million Btu to produce power at about $26 per megawatt-hour. A coal plant's mechanical inefficiency is partially offset by the low cost of coal.

NRG Energy owns many of the nation's most economic coal plants. Because it has scale and buying power, NRG can lower its production costs. Further, as weaker competitors retire inefficient coal units, NRG's competitive position improves.

Calpine, Exelon and NRG are really gambles on energy prices. To win, investors need a specific combination of power prices and natural gas prices. Each company needs a different combination.

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