Too Much Power?Harlan S. Byrne
Barron's, August 6, 2001
The utility industry's in a building boom. Why skeptics fear a bust.
Hardly a day went by last year without an announcement that a new electric power plant had been planned or put under construction somewhere in the U.S. And who could blame the utility industry for its zealous building binge? Politicians were wringing their hands about an energy crisis in full view of the television cameras. The price of electricity was surging from Montauk to Malibu. Meanwhile, all across California the seething citizenry was sitting in the dark.
In recent months, however, the blackouts have abated and the lights have come on again. Electric bills are falling and the politicians have moved on. But the utility industry's troubles are only just beginning, say several consulting firms and some candid, and canny, insiders. The industry, they fear, is in the midst of a building boom that could result in a widespread financial bust.
By some counts the power industry plans to add as much as 290,000 megawatts of generating capacity over the next six years, which would represent an increase of almost 40% to current capacity of 760,000 megawatts of power. At the same time, the forward price curve for electric power, which tracks bid and asked prices for power delivered at specified future points, has been trending down. This has led some industry observers to predict a power glut, with potentially ugly consequences for firms that are forced to carry unused generating capacity.
William McCormick Jr., chief executive of CMS Energy, a large electric power producer in Dearborn, Michigan, doesn't mince his words. "Just in Michigan, there are 9,000 megawatts of new power that are planned but probably won't be needed anytime soon," he says.
Most of this power will be generated by new plants built by so-called merchant power producers, which sell their output in unregulated markets. If activated, they would increase the margin for capacity reserved for emergencies to an unnecessarily high 35%, from a current 15%.
McCormick and others believe that Michigan may well be a microcosm of the nation as a whole. Says E. Linn Draper Jr., chief executive of American Electric Power, the largest U.S. power producer, "The question is how low the forward price curve will go, and whether future power prices will allow investors in power plants to recover their outlays for new generation."
It is impossible to measure at this early date the aggregate financial damage that the industry might incur if its best-laid plans, and plants, ultimately do not provide adequate returns. Some consultants have suggested that 20%-30% of the plans announced for new facilities eventually will be shelved, and Electricity Daily, a well-regarded industry publication, already has reported scattered cancellations and deferrals around the country. A typical baseload plant generating 1,000 megawatts costs an average $500 million to build, although prices can vary widely by location and specifications.
Wall Street, too, has begun to realize that too much of a good thing may be just that -- too much. Last year the Standard & Poor's electric utility index rang up gains of more than 40%, as many investors fleeing technology shares sought refuge in the group. This year, however, the utility index is down 10.4, compared with the S&P 500's 8% decline, and a drop of 2.5% in the Dow Jones industrial average.
Utility stocks traditionally have lured investors with their fat dividend yields. But even that attraction may be dimming, as companies turn their attention to plowing cash into expansion.
Among the industry's biggest players, Duke Energy has fallen 16%, to 40, and Southern1.2%, to 23.60, from their respective 52-week peaks. The leading independent power producers have suffered even more. Shares of AES have skidded 46.6%, to 38.90, from last fall's high of 72.81, while Calpine has dropped 36.6%, to 36.80, since hitting a high of 58 in April.
Table: Power Players
One New York money manager who has foreseen a capacity glut for some time, and who asked not to be quoted by name, says he's "aggressively shorting" General Electric. The stock, now 42.20 a share, has fallen 12% this year. GE's power systems unit, the leading manufacturer of gas turbines for power generation, has been a big beneficiary of the power-plant building boom, along with Siemens and some smaller equipment makers. "We'll probably be at our order and sales peak for domestic turbine deliveries this year and next," says Delbert A. Williamson, president of global sales for the power systems division.
Williamson says its possible GE will sell out for 2003, as well, but it's not nailed down yet. The company has received some orders for delivery of gas turbines in 2004, but he doesn't yet view this order-flow as an indicator of a trend. On the other hand, Williamson sees signs of a pick-up in orders from Europe and the Middle East that could partially offset what looks like a slowdown in domestic sales two or three years from now.
After struggling for business in the mid-1990s, GE's power systems unit has become a major contributor to the company's earnings growth. Segment profits more than doubled since 1998, reaching $2.8 billion last year. Profits nearly doubled again in the first half of this year, to $2.2 billion from $1.2 billion a year ago. But the aforementioned short-seller says "a lot of investors will start waking up late next year and belatedly discover that a power glut isn't far off." Williamson says he's unaware of any order cancellations, and probably wouldn't expect any for another 24 months, in accordance with the terms of most sales.
Given the rosy long-term outlook for electricity demand, supply constraints eventually are bound to reappear. But near-term concerns about excessive generating capacity aren't all that surprising, either. Boom and bust cycles are endemic to commodities businesses, from steel to paper to power. Whenever there is a need, and the price is right, supply will rush in to meet demand.
By way of illustration, John W. Rowe, co-chief executive of Exelon, a Chicago-based energy holding company, recently testified at Senate hearings on President Bush's proposals to boost energy supplies. Rowe observed that in the five years through 1999, electric demand increased by 9.5% while additions to generating capacity rose only 1.6%. He cited the dramatic rise in electricity prices, until recently anyway, as "proof positive" of what happens when capacity doesn't keep pace with demand.
The electric utility market has wrestled with overcapacity in the past, but never in the memory of industry veterans has the problem loomed as large as today. That's because almost no new plants were constructed in recent years, as the industry coped with the fallout from deregulation. The wholesale market was deregulated six years ago by federal decree, and the industry has been further liberated on a state-by-state basis since. But the process was marked by political wrangling between consumer and other special-interest groups, and the outlook remained uncertain in many parts of the country until fairly recently.
The upshot was a general reluctance industrywide to commit to large capacity expansions. As a result, the regulated utilities erected only a few power plants over a five-year span. This paved the way for several independent generators of power to thrive, and in the past two years catapulted the leaders in that market, AES and Calpine, into the growth-stock leagues.
Calpine, in particular, achieved star status, and its shares quadrupled as the San Jose company's earnings soared. Last year Calpine posted earnings of $325 million, or $1.11 a share, on revenues of $2.3 billion, compared with net of $96.2 million, or 43 cents a share, on $848 million in revenues in 1999. In the latest quarter earnings more than doubled to $132 million, or 32 cents a share, while revenues more than tripled, to $1.6 billion.
Yet, investors no longer seem quite as dazzled by the company's plans to build or acquire up to 70,000 megawatts of capacity by 2005, which would represent a 10-fold increase over current capacity of 7,000 megawatts of power. Calpine, too, must recognize that its ambitious plans could face some roadblocks ahead. Recently the company has turned much of its attention to expanding outside this country, in places such as the United Kingdom and Canada.
If Calpine manages to realize its goals, however, the company could become one of the largest, if not the largest, U.S. power generator. It would be the leader of a spunky pack of merchant power producers, although it currently lacks the extensive power-marketing operations of some others in the field.
Many regulated utilities also have been captivated by the potential for profits from wholesale and trading activities. Some frankly trumpet the wholesale trading of power as their main growth initiative, and a few have spun off or otherwise separated for operating purposes their unregulated operations. Mirant, a former subsidiary of Southern, came public last September, and after a rough start its shares spiked up to 47 from 20-21. The stock now trades around 33. Other prominent independents include Reliant Resources , spun out of Reliant Energy in May 2001; NRG Energy , an offshoot of Xcel Energy , and Aquila , which was recently taken public by parent UtiliCorp .
Other power providers, including industry giants Duke Energy and American Electric Power, have been contemplating similar spinoffs. In part, the independents are hoping to emulate Enron , one of the largest traders of wholesale power.
While brokerage analysts generally have applauded the utilities' drive to exploit wholesale trading, some are now growing wary about the possible financial consequences of an energy glut. That's because a recent and unexpectedly sharp decline in power prices has raised red flags about the industry's future earnings from the sale of wholesale power. According to statistics compiled for Barron's by McGraw Hill-Platts, a prominent trade publisher, wholesale electric prices nationwide have dropped to less than $50 per megawatt hour, and in some areas to $40, from about $125 in May. Late last year power in California fetched a stunning $1,000 per megawatt hour, while the national average soared above $200 in December. In part it was this sort of price action that spurred orders for new plants, as merchant power producers and others envisioned printing money.
The forward price curve, which peaked in early April, tells a similarly sobering tale. According to Platts, the cost of power bought in the mid-Atlantic region for delivery in 2002 then sold for about $51 per megawatt hour. The price since has fallen to $38. Power for 2003 would have cost $44 per megawatt hour, and now it's $36. In the main hub in California, meanwhile, power for 2003 has fallen to $41 from an April high of $73.
Two weeks ago Raymond Niles, a utility analyst at Salomon Smith Barney, issued a cautionary note about power prices, noting that June was the first month this year to show a year-to-year decline in electric prices, and a violent one at that. Niles sees worsening comparisons ahead, which prompted him to cut his earnings estimates and price targets for several utilities, including Entergy, Xcel and UtiliCorp.
Steve Fleishman, of Merrill Lynch, long considered one of the top utility analysts, also has begun to acknowledge a potential power glut. But he's quick to give the weather and economy their due in guiding supply and demand. By Fleishman's reckoning 45,000 megawatts of new capacity will be added to the market next year. But demand has been dampened by a weak economy, lower power prices stemming, in part, from federally imposed price caps in California, and cooler summer weather throughout the U.S., which has led to cutbacks in air-conditioning loads. Fleishman maintains power prices may get weaker still before rebounding.
Lowell Miller, a money manager specializing in utility shares, thinks the stocks are still vulnerable precisely because they were accorded glamour status by some fans on the Street. Once considered the province of risk-averse investors, they migrated last year into the hands of the growth-oriented crowd.
Ruth Ann Gillis, the chief financial officer of Exelon, concurs. The company's stock recently dropped more than five points in two days, even after the company, which was formed by the merger of Philadelphia's PECO Energy and Chicago-based Unicom, posted strong second-quarter earnings, and predicted further gains. "The momentum crowd took over the trading in utility shares after dumping technology stocks," she says. "Now they may be getting out."
The managers of the nation's biggest electric utilities are mixed in their assessments of the threat of a power glut, and in their tactics to combat it. Linn Draper, of AEP, sticks by what he calls a contrarian view about new generation. AEP, he notes, is meeting increased demand through its merger with Central & South West, which was completed in June 2000, and is increasing its operating efficiency by upgrading equipment and procedures. The company has entered into joint ventures with chemical companies for new plants, but Draper emphasizes that AEP has refrained from building new plants on its own.
Initially, he says, the company's Wall Street followers failed to appreciate why the utility didn't follow the trail blazed by more aggressive producers, such as Calpine, Duke and Mirant . But with power prices falling, Draper feels that AEP's stance will be vindicated. The company based its predictions for future supply and demand on both published price curves and its own internal analysis, he notes.
Draper's on the same page as the rest of the industry, however, in viewing the wholesaling and trading of unregulated power as the best avenue to earnings growth. (In addition to being the nation's largest electric power producer, with nearly 40,000 megawatts of capacity, AEP claims it's No. 2, behind Enron, in trading electric power and gas.) The bulk of the 85% growth in the company's second-quarter earnings, which totaled $287 million, or 89 cents a share, came from wholesale electric and gas operations. AEP expects to earn $3.50-$3.60 for the full year, and $3.75-$3.85 in 2002.
Duke Energy, another giant in electric and gas operations, has taken a somewhat more aggressive stance than AEP in capacity additions. Richard B. Priory, the company's chief executive, doesn't seem surprised by the industry's aggressive building plans, given that many utilities, several years back, were too paralyzed by the problems surrounding deregulation to respond to an obvious impending shortage of power. "A lot of executives had their heads in the sand," he says.
Duke is still expansion-minded, with a number of new power plants on its books. Priory seems reassured by the growing contributions of wholesale electric power and gas to the company's earnings stream; wholesaling drove second-quarter earnings up 23%, and contributed to a 43% gain in revenue in the year's first half. The company expects to earn $1.9 billion, or $2.50 a share, for the year, compared with $2.10 a share in 2000.
Still, Priory is keeping an eye on industry supply, and says Duke could curtail construction if necessary. "Over the next three-to-five years we're likely to see an easing of currently tight markets, and that could mean some new plants that have been announced don't get built," he says. The company canceled orders for two small "peaker" plants earlier this year, but still plans to add around 20,000 megawatts of capacity by the end of 2002.
In recent years the utility industry has been partially reconfigured by several big mergers, and further consolidations might radically alter the outlook for power supply and demand. It is hard to handicap the prospects for more deals, however, because proposed mergers often risk substantial regulatory and other delays.
The electric industry has mounted a protracted effort to obtain Congressional repeal of the Public Utility Holding Company Act, a relic of the Great Depression that was designed to halt consolidation. Utility executives have speculated that outright repeal would unleash a tidal wave of mergers among the roughly four-score publicly traded firms. That, in turn, conceivably would lead to plant consolidations and diminished need for additional plant capacity. Completed and pending mergers between electric power producers and natural-gas pipeline companies also might mitigate the need for some new power plants. In the long term, the development of alternative energy sources, such as solar- and wind-based power, also could curb construction of coal- and gas-fired electric power plants.
The supply of natural gas in itself might alter the utility industry's future building plans. Many independent oil and gas producers stepped up drilling last year as energy prices rose. But Christopher R. Ellinghaus, energy analyst with Williams Capital Group, a New York investment bank, recently predicted a third of the new power plants planned in the U.S. won't be completed because of a shortage of gas. Ellinghaus thinks contraints on the supply of electric power will be eased for the next few years, but anticipates a much tighter market thereafter unless an "unprecedented" amount of new gas is produced in three-to-five years.
The Bush Administration, which took office in the midst of California's energy crisis, isn't banking entirely on gas-fired plants, but pushing for the expanded use of coal and nuclear power. In recent years, however, it has been tough to obtain regulatory approval for new coal-powered plants, despite much progress in developing so-called cleaner coal. Industry groups have been pressuring the White House to lower environmental standards in order to speed coal-mine development, and coal executives now seem jubilant about the prospects for success. The industry notes that coal-fired plants generating more than 20,000 megawatts of power are now in the planning or development stages.
Similarly, the nuclear power industry is flexing its muscles again, thanks in part to encouraging words from President Bush. Nuclear plants, which now supply 20% of the nation's electric power, fell into disrepute after accidents at Three Mile Island in Pennsylvania, and Chernobyl, in Russia. But the operating records of most of the 104 nuclear plants in the U.S. since have improved, and the industry is determined to speed up the license renewal process. Building a new nuclear plant would take several years, but some in the industry are looking to newly-designed models that require shorter lead times.
In the meantime, plans continue apace for the industry's build-out of more gas- and coal-fired plants. But unless demand for power increases at a similar clip, their output will go begging. Company earnings will suffer, and investors will find little reason to fall in love with utilities all over again.
learn more on topics covered in the film
see the video
read the script
learn the songs