Hang On, Exelon

 | Oct 08, 2012 | 5:30 PM EDT  | Comments
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Exelon (EXC) has recently been garnering political and media attention as the company describes new challenges for its nuclear power generating business. As the owners of the nation's largest fleet of nuclear power plants, the company's insights are important and relevant. But an unintended consequence has been to highlight a bleak future for nuclear power plants.

Exelon's form 10-Q filed with the Securities and Exchange Commission (SEC) tells the story. For the quarter ended June 30, Exelon's fleet of nuclear power plants accounted for 56% of the company's revenues. But by losing $98 million, the nuclear fleet damaged the parent company's bottom line.

Of course, Exelon Generation Company LLC's losses could be attributed to seasonality and post-merger factors. Nevertheless, their generating company's loss was a shock. Worse, Exelon's message is that commercial nuclear power has become unprofitable and will remain so for the short term.

Take Exelon at its own evaluation. For the first time in decades, power markets are signaling nuclear power may not always be the most price competitive resource. It turns out that nuclear power's production costs of approximately $22 per megawatt-hour are somewhere in the middle.

To achieve profitability, nuclear power plants depend on inefficient and costly power plants to set market-clearing prices. In the good old days, when oil fired power plants were in wide use, efficient coal and nuclear power plants printed money. The cost difference between oil and nuclear and oil and coal was always substantial, and it would guarantee rich earnings for nuclear and coal.

Today, the Energy Information Administration (EIA) reports that 20% of the nation's power plants use oil as fuel, but less than 1% of the nation's electricity originates from oil-fired power plants. EIA's tables show that every year less oil is used to make electric power, which means oil rarely sets market-clearing prices for electric power.

Today, power prices are more frequently set by the next lowest tier of power plants: inefficient natural gas and inefficient coal-fired power plants. But with natural gas prices at historic lows, even inefficient natural gas power plants can produce power below $30 per megawatt-hour, leaving nukes with a gross margin of around $8.00 per megawatt-hour.

Inefficient coal plants also sit on the margin, and frequently set market-clearing prices. Old coal plants typically have bad efficiencies (in the 14,000 British thermal units per kilowatt-hour range) and can be more costly to operate than inefficient gas plants. Stripping off high production cost gas and coal plants are wind and solar plants. Every time a wind or solar plant produces power, the highest priced coal or gas plant is economically displaced. When the highest cost plant is displaced, market prices fall.

To be profitable, Exelon needs inefficient and high cost power production to remain in the mix. But high cost producers (particularly of coal) are exiting the market because they have become unprofitable for their owners.

The Environmental Protection Agency (EPA) is accelerating the process. By imposing stricter pollution controls, marginal plants are forced to make additional investments or exit. For owners, the decision is easy. Additional capital investment in an old power plant provides insufficient returns, so retiring the plant is the only practical option.

But the EPA's new rules do not affect most of the nation's oil-fired plants. These plants can remain in the fleet and sit idle for months. While they have low standby costs, they can collect alternative revenues from capacity availability and ancillary services.

But now, a new dynamic is appearing:  Wind and solar are on the bottom of the stack. As more wind power and solar power companies enter the power markets, marginal plants will be sidelined and bulk power prices will fall. While consumers win, efficient power producers such as Exelon, Calpine (CPN), GenOn Energy (GEN) and NRG Energy (NRG) lose. On the top of the stack is a different story. Nationwide, there is a culling out of inefficient generating capacity, particularly in the coal sector.

The big surprise appears to be oil. The math suggests that as more coal exits the power markets, there should be a growing reliance on oil. This is because there is limited motivation to build new plants to replace retiring power plants in the nation's deregulated power markets.

Exelon's management and their investors have to maneuver their way through this transition. While their near-term earnings may be less that many hope, in the long-term Exelon should see improved margins. In the meantime, the comapny offers investors a dividend of 5.8%, its payout ratio remains healthy and its cash flows remain strong.

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