During the last several months, major disruptions have been swirling about the electric power markets. Politicians and special interests claim these disruptions are caused by excessive federal regulation, but the main culprit is low natural gas prices.
These disruptions have changed the outlook for some of the nation's largest independent power producers. Three companies that could see new challenges are Exelon (EXC), First Energy (FE) and GenOn Energy (GEN). One company that may benefit is Calpine (CPN), but more on that later.
The issue is market-clearing prices for electricity; they frequently drift below production costs. Normally, when production costs exceed revenues, operators shut their plants down. However, nuclear and large coal plants are designed to serve a base load and cannot turn on and off on a dime. Typically, these units will continue to produce when market prices are below production costs, and expect to make up the difference during peak periods.
This strategy works if unproductive hours are not too punishing and peak hours are bountiful. However, in recent times, unproductive hours have been brutal and peak-hour prices have been underwhelming. As a result, most independent energy producers are experiencing declining revenues and tighter margins.
Power prices are not really the problem; they are the symptom. The root cause is incredibly low natural gas prices and the gradual introduction of newly efficient gas turbines.
Companies such as General Electric (GE) and Siemens (SI) offer utilities incredibly efficient combined-cycle gas turbines. While most utilities are pleased to produce power with 35% thermal efficiency, GE and Siemens have units reaching 60% efficiency.
Efficient gas turbines and low natural gas prices are a powerful combination; they raise havoc for the established nuclear and coal power market segments. For the first time in decades, nuclear power and coal see a new competitor emerge for their baseload customers.
The math tells the story. On its website, the Nuclear Energy Institute (NEI) tells readers: "Nuclear plants are the lowest-cost producer of baseload electricity." The NEI goes on to say that nuclear power's average production cost is approximately $21.40 per megawatt-hour. Therefore, nuclear power and $21.40 per megawatt-hour should represent a benchmark. When natural gas is compared to that benchmark, interesting issues emerge in the deregulated markets.
Now let's look at the arithmetic. Natural gas is currently priced at approximately $2.50 per Dekatherm. Using that price, an efficient combined cycle gas turbine can produce power for $15.00 per megawatt-hour (heat rate of 6,000). A moderately efficient gas turbine can produce power for $20.00 per megawatt-hour (heat rate of 8,000). A gas clunker can produce power for $25.00 (heat rate of 10,000).
Compare those production costs to energy markets' clearing prices. Last Thursday night and Friday morning, the market-clearing prices for hubs within Midwest Independent Transmission System's region were trading around $18.00 per megawatt-hour. By noon, some regions reached $35.00 and others remained below $18.00.
For investors, these numbers reveal important issues. First, the reason many independent power producers decided to retire old, fully depreciated and inefficient coal plants is largely tied to their inability to compete in the free power markets. New Environmental Protection Agency (EPA) regulations were simply the last straw in the decision process.
Second, nuclear power is no longer the financial leader within the nation's fleet of power plants. With natural gas prices at current levels, General Electric and Siemens' combined cycle gas turbines are the nation's new cost leaders.
Third, domestic coal is facing new challenges. At current prices, spare gas turbines will likely be dispatched ahead of many older coal plants. With more than expected coal plants idled or sidelined, domestic coal consumption should decline more than currently forecasted.
Fourth, some independent power producers might go under. According to Bloomberg, a large privately owned power producer in Texas needs natural gas prices to be over $6.00 per Dekatherm to cover its operating expenses and its interest payments to Berkshire Hathaway (BRK.A). As a distraction, this same producer is fighting EPA's new emission regulations.
Fifth, regulated utilities are largely immune from these disruptions. Companies such as Southern (SO), Scana (SCG) and Duke Energy (DUK) have little risk because most of their generating assets are financially hedged in state-sanctioned rate bases.
Last, looking at Calpine's generating assets it appears this company emerged as a potential winner. Most of Calpine's assets are combined cycle gas turbines - now the best in breed. In addition, Calpine is emerging as a pure play on low natural gas prices.
As long as natural gas prices remain low, Calpine's production costs should beat Exelon's fleet of nuclear power plants and First Energy's coal and nuclear facilities. Cost leadership delivers maximum margins.