Energy Merchant Turmoil by Chris Trayhorn, Publisher of mThink Blue Book, March 11, 2004 In less than a decade, US energy merchant companies have gone from the cradle to the graveside, if not the grave itself. In just two years, well over $100 billion of energy merchant market capitalization has disappeared as almost everything that could have gone wrong with the nascent energy merchant industry did. In the last year, three companies have filed for bankruptcy. Bond spreads suggest that investors expect more of the same. Credit ratings for a dozen companies owning over 200,000 MW of generation worldwide have fallen from investment grade (in most cases) to low, noninvestment grade levels. Many believe that it is too early to dismiss the energy merchants, arguing that matters have improved from a year earlier when these 12 companies were struggling with almost $25 billion of debt maturing in 2003. By the beginning of December 2003, that sum had fallen to about $800 million maturing by year-end as the energy merchants, with the reluctant assistance of their banks, pushed many maturities out several years (see Figure 1). Were the well-publicized 2003 debt reschedulings wise decisions? Who can tell? What seems apparent, at least at this juncture, is that significant economic and business factors indicate that through the remainder of the decade, energy merchants could well have to struggle to remain in business. Energy merchants face nearly $65 billion of loans coming due by the end of 2010 out of a total debt burden of $125 billion – as indicated by ratings in the single B category or lower. Based on current data, it is unlikely that unsecured lenders to bankrupt energy merchants will see anything near par recovery, though secured lenders may, on the basis of recent bank loan ratings forecasting recovery, fare better. Why the gloomy forecast? In short, almost every worst-case scenario that these companies and their lenders considered possible, but remote, has become its base-case scenario. Business positions, always risky, have deteriorated, and financial profiles are generally much worse than two years ago. The independent power industry built more generation, most of it gas-fired, than the market could possibly use. Natural gas prices, low for many years during the gas bubbles of the 1980s and 1990s, have now moved to levels that potentially threaten natural gas’ status as “fuel of choice.” Contrary to the assumptions of many market and feasibility studies, the retirements of older coal plants and nuclear plants did not occur. Indeed, many older plants have displaced their new gas-fired combined cycle competitors. Energy marketing and trading proved to be expensive to pursue and marginally profitable, at best. And the economy appears to need much less electricity than many expected, due in part to a shrinking manufacturing sector. Finally, the short but tumultuous history of competitive power suggests that the industry must intrinsically contend with low and risky margins, much as petroleum refining does. Based on current data, both the energy merchant sector and the credit prospects for the debt that financed the sector’s growth will be subject to further downward pressure. Indeed, it is difficult at this point to construct a credible optimistic forecast. The Longevity of Plants An interpretation of Michael Porter’s competitive industry analysis model suggests that competitive power generation faces inherent obstacles to realizing the substantial profits whose allure drew so many companies into the sector. The structure of the competitive power, or merchant energy, model indicates a fiercely competitive and fragmented environment in which profit margins are painfully narrow. Unless something changes, such as an unlikely public policy shift back to vertically integrated utility structures, the competitive power industry will have to contend with low and uncertain returns. That so many investments in unregulated power generation have fared so poorly reinforces the point. In particular, two inherent qualities of merchant energy, which include the activities of merchant generation and energy marketing and trading, suggest that the industry may be doomed to long-term mediocre performance. First, while the construction costs and the often protracted difficulties of siting and permitting of new power plants would seem to be viewed as obstacles to their wholesale development and construction, some 200,000 MW of new capacity built since 1999 indicates that these obstacles may not have been as formidable as originally believed. The lesson to be drawn is that the sector knows how to overcome these problems and regularly does so. Hence, the barriers to entry are low for new power generation. The second quality of merchant energy keeping industry returns low is the near permanence of power plants. Most facilities built during the last 50 years or even longer still operate. Generating companies may disappear, either through bankruptcy or through consolidation, but their power plants remain. While plants may be mothballed, they can easily return to service if market conditions improve. Prior to the sector’s capacity expansion, most market studies and the developers and lenders who relied upon them assumed that older coal plants and nuclear power plants would be retired. They weren’t. Indeed, the opposite happened. New owners acquired the older plants, invested in upgrades and retrofits and dramatically increased plant efficiencies and availabilities. In addition to the economic forces that have kept older plants in service, some regulated utilities that still own generation have persuaded regulators to allow unused power plants to stay in their rate base to provide reliability and backup in the future. Consequently, merchant power competes in a world where new entrants can easily clear entry obstacles, and their power plants rarely disappear. Such is the foundation for a fragmented industry. One of the Many Poor Competing in the fragmented merchant power industry largely condemns its participants to thin and risky margins. The primary reason for this is that public policy in the United States prevents merchant power plant owners from owning significant or controlling market share. Hence, the market structure forces merchant power into a “price taking” position. In practice, the ability to transport electricity is limited. Unlike other commodities, electricity does not typically transport far from its source. Therefore, because power generation cannot always reach the most desirable markets, it tends to compete regionally instead of nationally. A negative reinforcement to this regional focus has been the lack of investment in transmission facilities in the United States for the last 20 years, as well as a governance structure that has on occasion restricted access to transmission and customers. Another problem is that many developers have built new generation away from load centers and out of sight of potential public opposition. While bulk capacity transmission lines may be available, the older and much smaller lines around population load centers create bottlenecks preventing potentially cheaper power from reaching markets. The broad absence of market-based transmission operations constrains merchant power sales opportunities, a problem that FERC has attempted to address with its Standardized Market Design. Finally, merchant generation, in some parts of the country competes against generation held in rate base by vertically integrated utilities. The resulting competitive advantage in favor of rate base supported generation makes it difficult for merchant power to recover its capital costs, especially in the overbuilt generation market that dominates much of the United States. Consequently, in a market characterized by the absence of long-term contracts, energy merchants find it difficult to earn the stable returns that regulated industries earn or the high profits that industries with high entry barriers enjoy. Poor Industry Fundamentals A destructive consequence of operating in a fragmented industry with low barriers to entry is a susceptibility to “boom-bust” cycles, not unlike the mining and chemical industries. Moreover, the lumpiness with which new generation enters the market and its longevity may threaten extended time frames at the bottom of the merchant business cycle. Now at what appears to be the end of a build-out period, energy merchants may have to confront surplus reserve margins for years. Should that happen, energy merchants will continue to find that poor industry fundamentals and depressed operating margins will frustrate capital recovery. And without the liquidity on the balance sheet necessary to sustain these companies through the bottom of the cycle, some may be forced to leave the business. Declining Manufacturing It is unlikely that the US economy will provide much help to the energy merchants. Over the years, the historical correlation between GDP and electricity demand has been weakening. Electricity demand in megawatt-hours since 1990 has grown at an annualized rate of 1.8 percent per year while GDP in real 1996 dollars has grown more rapidly at about 3 percent per year (4.9 percent in nominal dollars). Peak demand has grown faster at about 2.2 percent per year, but still at a rate slower than GDP. Electricity demand has grown more slowly than GDP in part because the US economy has become more efficient over the last decade. But the more influential demand driver probably lies with the economy becoming more service-oriented as manufacturing moves offshore. Electricity demand per dollar of GDP has been steadily declining since 1990 at the latest. Poor Credit Fundamentals By almost every measure, the 12 energy merchants exhibit surpassingly weak credit fundamentals. Given the sector’s poor fundamental credit characteristics, its degree of fragmentation, and their $125 billion debt overhang, the group will struggle to improve their credit measures. Thus, consolidated leverage is at least 60 percent for each of the merchants. Such leverage, combined with about 100,000 MW of merchant capacity in the US – much of it natural gas – will very likely retard recovery prospects because of the inherent volatility of merchant power revenues. The second credit measure that points to distress is the “funds from operations to interest” ratios (FFO/interest). Most coverage levels for the 12 trailing months prior to mid-2003 are below 1.6×1 and well below the sector median of just over 3×1. The most telling measure is the “funds from operations after interest expense to debt” ratio (FFO/debt). Weak and declining FFO/debt ratios are empirically among the clearest indicators of financial distress as cash flow is declining or debt is rising, or both. Eight of the 12 companies have FFO/debt ratios of 6 percent or less and all are below 17 percent. By comparison a solid investment grade electric utility traditionally enjoys a FFO/debt ratio of at least 25 percent. Outlook for Debt As matters now stand, the energy merchant business model is under siege. The shared strategy of rapid and debt-funded growth premised upon rapid deregulation of the US electricity industry and open competition has not played out. Against this backdrop the energy merchants must find a way to reduce their crushing debt burdens and do so fairly quickly if they are to survive. But the task promises to be formidable, even for those with “nonmerchant” power. Lenders may look at upcoming maturities in light of the possibility of excess reserve margins through the decade and decide to retreat from the energy sector, especially if their overall lending portfolios improve with a strengthening economy. Hence, energy merchants will likely have to either slowly grow their way out of their debt problems through an improving economy or, failing that, look to reorganization strategies in bankruptcy to improve their financial positions. Structurally, the nascent competitive power industry resembles other capital-intensive industries in which assets tend to remain in service for a long time and where barriers to entry are not difficult to overcome. These factors are the traditional basis for fundamentally low and uncertain returns occasionally punctuated by a brief surge of great profits – a situation that few energy merchant companies, their financial advisors, or their investors anticipated almost a decade ago. And therein lies the message for the energy merchant business: while competitive power fundamentals may never point to great businesses, some firms in other industries can survive under similar circumstances and may even do well, but they do so under much more conservatively financed structures than many energy merchants first envisioned. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.