Jim Hendrickson is a Partner in Accentur’s Utilities Industry Group
The deregulated power industry in North America is seeing its first down cycle. This is not a lasting trend, but part of a cycle witnessed in virtually every asset intensive commodity market. Though the cycles may have diff e rent characteristics, we have seen the same behavior in the metals, crude, and the petrochemicals markets for years. What can we learn from these industries? If we are, indeed, in a cycle where is the bottom? Are we there yet?
Since the birth of a robust crude industry and its petrochemical derivatives we have seen boom and bust cycles on the price of commodities. They are almost always a function of supply demand imbalances. Huge amounts of capital are required to search for, process, and distribute these commodities. The players read the same price signals, build at the same time, overbuild and then lay low during the down cycles. Of course there are other influencing factors such as economic down-turns and OPEC, but by and large what we’ve seen historically is a herd mentality. In petrochemicals we have typically seen 5-7 year boom-bust cycles.
How is this relevant to power? Electricity is a pure commodity (in fact, the most volatile commodity), it’s asset intensive, and participants certainly exhibit herd behavior.
What’s different? Competitive power markets are immature and exhibit low liquidity. Power is largely a local game. Power is subject to local demand and supply imbalances rather than global phenomena. This applies to both the power and its fuel. And the characteristics of each market, both natural and man-made, are somewhat unique -and overlaid by local, often parochial, regulation .
Unlike other industries we can’t blame the cheap labor in Asia, or global cartels like OPEC. We created our own situation in our own local market. The good news is we have more control and insight into what drives this business than those that operate on a global scale.
Most importantly, opportunities exist for those with vision and the ability to judicially act. As we see so many companies retreat - is the time to be entering, or re-positioning upon us?
SO WHAT DO WE KNOW AND WHAT IS IT TELLING US?
1) We overbuilt and over- weighted gas generation. Power usage has historically grown at 2-3% annually in North America. In a year 2000 scenario, even in the best case of a manic demand for computers and systems in the Internet era and a robust economy, we were looking at 5% growth. A recent study by Cambridge Energy Research Associates (CERA) shows the new capacity built or planned in the U.S. from 2000 - 2005 would increase installed capacity by over 300 Gigawatts, a 37% increase from a 1999 base level of 800 Gigawatts. In addition, the added capacity was almost exclusively gas shifting the mix and increasing the linkage between electric and gas prices.
2) Prices will remain low - but... With the current economic climate, we can expect to be in an oversupply situation for at least the next three-to-four years. There may be some exceptions in certain load pockets, where regulations and local opposition caused development delays. El Nino is forecasted to decrease precipitation in the Northwest, but the reservoirs are at healthy levels and can endure a season of low water. However, the increased usage of natural gas, and what appears to be a permanent step increase in gas prices, creates exposures. We can expect the spread between base and intermediate/peak prices to increase.
3) Credit crisis has mitigated but is not over. Many merchant generators and integrated utilities are taking steps to alleviate their immediate balance sheet problems - and significant improvement is evident. Problematic, though, is that the lack of liquidity in the markets is reducing trading profits, and the entities in the worst situation are selling off their cash cows. And many others are taking on additional debt at extremely high relative rates to cover obligations. Once the ‘good’ assets are shed - the valuation collapse will be most acutely felt.
4) New entrants are emerging. In particular, we are seeing the emergence of large financial institutions into the market, such as Citigroup and Goldman Sachs, and private equity groups. The long term intent of these entrants remains to be seen but it is safe to assume that some will stay and all will help redefine, and reinvigorate the market. Most importantly, they will bring new skills and a commercial savvy that most in the market lack.
ARE WE THERE YET?
Have we reached the bottom of the cycle? No.
Will the market come back and will opportunities exist to create value? Yes
So what should we be doing today?
1) Rethink our generation port folios. In many markets, there is an abundance of new gas fired peaking units. Though less expensive to build, it is unlikely gas peakers will be economical to run until the supply/demand balance is level again. For baseload plants, the situation is a bit more complex. While newer units may be more economic to run, the added cost of financing may make them overall more expensive than the older units they are intended to displace. It may not make sense to take on additional debt, even if the plants look like they are “in the money”. In some cases, we will likely see distressed assets on the market below their replacement cost.
2) Disclosure. While many are, and will continue, to have financial troubles there has to be a regained trust with Wall Street and the credit agencies. The Committee of CRO’s published recommended disclosure reports. These are a good start to standardize the reporting of energy commodity positions and risks. They will allow for easier comparison across companies with common line items, measures, and levels of granularity. Those players suffering from “guilt by association” should see more favorable treatment from the credit agencies.
3) Mitigate Credit Exposure . The credit crisis is real and will continue if steps aren’t taken to correct some of the current practices. The Committee of CRO’s again suggests a couple of important actions. One, adopt the EEI’s Master Netting Agreement. This will establish a standard contract that incorporates netting into the margining agreement. Two, adopt a central clearinghouse. The practice has been in place in the financial industry for many years; it has proven to reduce a counterparty’s overall credit exposure by up to 75%. Though some of the stronger players may balk at what they perceive as taking on the burden, it should in fact reduce their overall risk by improving liquidity.
4) Systems Operation Design. Each FERC region has its unique market and systems operation design. This, in turn has increased the cost and efficiency of operating in multiple regions. FERC has moved from the concept of four “super regions” to a single national systems operation design. The industry should consider this option and support the design of a single model that incorporates the best ideas from our existing models. Though the upfront cost is significant, it pales in comparison to years of future inefficiency interfacing to multiple regional models for transacting spot power, scheduling, and settling transactions.
5) Build Commercial Capabilities. One major contributor to the problems in the wholesale power markets was the fail-u re of most participants to truly understand the components of a commercial operating model. Models ranged from regulated-like to asset-lite trading models - with little emphasis on integrating production, trading and origination effectively. Going forward, effective participants will need to put significant emphasis on defining and managing these interfaces consistent with how value is created in the market. This will require, in particular, moving the ‘brains’ of the organization to an asset optimization function distinct from both production and trading.
Boom and bust cycles will be a natural occurrence in the new North American power industry. The good news is that power is not a global market; we have more control of the outcome than many global commodities.
In the movie “Being There” Chancey Gardner, is a simple naive gardener thrown upon chance into the country’s elite establishment. Mr. Gardner is mistaken for a wise businessman attune to natural cycles. The U.S. President is pondering what to do with the struggling economy and seeks Mr. Gardner’s counsel. His advice to the President is that in the winter there is work to be done. In the winter, the roots need tending, then spring and summer will follow. This is a time to tend the roots, there is work to be done.
The Accenture Industry Group also includes Jack Azagury, Partner, Steve Crawford and Kirk Weichsel, Senior Managers