When It Comes to Nat Gas, Consider the Landscape

 | Oct 19, 2013 | 3:00 PM EDT  | Comments
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Commentators claim coal is exiting, nuclear is dead and natural gas is on the ascent. Combine these trends and it appears that investors should focus on natural gas. They may be right. However, before jumping into gas turbine manufacturers like General Electric (GE), Siemens (SI), Rolls-Royce or Mitsubishi, investors need to consider the landscape. It turns out; most U.S. utilities will not be buying new gas turbines. Instead, a better investment could be a utility like Calpine (CPN).

There are three reasons utilities will not rush to turbine manufacturers. The first is they already bought their turbines.

According to the Energy Information Administration, the party started in 1999. That year the nation had 200,000 megawatts of gas turbines (the equivalent of approximately 250 nuclear power plants). By 2003, EIA reports the turbine inventory doubled to 400,000 megawatts. Today, it is approximately 500,000 megawatts.

Most of this build occurred well before shale gas was exploited. It also occurred well before this administration took office or when the Environmental Protection Agency focused on coal. As the first chart shows, the nation's inventory of gas turbines jumped 250% within a decade.

Source: EIA/Williams

Not all of that huge investment was economic. This might explain the second reason why utilities will not be rushing to build more gas turbines. It turns out the nation is not using the natural gas facilities it just built.

The industry calls it the "capacity factor." It represents the amount of time the asset is producing energy. In a perfect world, capacity factors should be 100%. However, nuclear plants need to shut down for refueling, coal plants need time maintenance and gas turbines need overhauls.

A more realistic capacity factor is between 60% and 85%. As the chart illustrates, the upper number the nuclear power industry regularly achieves. The coal industry ranges between 60% and 70%.

Source:Williams

The chart should be a surprise. The capacity factor for natural gas has been horrible. The average gas plant is idle more than 75% of the time. Of course, some of these plants are used for peaking and intermediate loads. Nevertheless, if you owned a factory that was useful less than 25% of the time, it is unlikely you would be rushing to buy more factories.

The third reason why most utilities will not be buying new gas turbines is market economics. Since 1999, many states deregulated and restructured their utilities. Utilities serving most of the nation's population centers sold their power plants to independent power producers like Exelon (EXC), Calpine and NRG Energy (NRG).

Independent power producers depend on the deregulated power markets for revenue and margins. In order to invest private money into new power plants, producers need to be assured there will be a return on their investment.

Consider for a moment what it takes to build a new power plant. From studies to licensing to permitting to construction to operations, a new nuclear plant can take 10 years. A new coal plant can take six years. A new combined cycle gas turbine can take five years. During the entire project development period, shareholders' funds are committed but they are earning no returns.

The math is the deal breaker. Assume an alternative investment offers shareholders an 11.2% return on equity (this is what Southern Company (SO) expects from its utility assets in Georgia). To earn a similar internal rate of return on an investment that delays revenue by five, six or 10 years, means when operating the gross margins must be huge and sustainable.

The problem is nobody knows what energy prices will be in five, six or 10 years from now. Investors cannot know if they can earn a return in the deregulated markets. Without a reasonable probability of a return, most boards will not invest in multibillion-dollar power projects. Consequently, very few combined cycle gas turbines will be built.

As long as policies remain intact, the barrier to entry is high for new gas turbines. Utilities already owning assets in those markets could win big. Calpine could be the biggest winner of all.

As fuel shifts from coal to natural gas, do not expect to see many new gas turbines built. Instead, look to see whose capacity factors improve. Higher capacity factors mean more revenue, higher margins and minimal capital expenditures.

First in line is Calpine. They are the sector's cost leader. With 50,000 to 70,000 megawatts of coal and 5,000 to 7,000 megawatts of nuclear exiting the market, Calpine is in a solid position to improve capacity factors. Better, there is minimal threat that a competitor could emerge with similar technologies.

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