How have rising gas prices impacted some merchants?

S&P: How have rising gas prices impacted some merchants?

POWER - 12/08/2004

Saying "It is no secret that rising natural gas prices have been a boon to merchant power generators, especially those that own baseload generation," credit rating agency Standard & Poor's on Nov. 8 released a six-page "examination" of three merchant players from which it was concluded that there are "wide swings" in profitability that are determined by the structure of the markets in which the three firms operate, their respective hedging strategies, and by their level of indebtedness.

The report, by credit analyst Scott Taylor, argues that as gas prices rise and fall, electricity prices move with them when gas-fired capacity is on the margin. S&P, like Platts and Power Magazine, is one of The McGraw-Hill Companies.

"Baseload plants in regions where gas is on the margin more frequently, such as the ERCOT [Electric Reliability Council of Texas] and the Western Electricity Coordinating council [WECC] benefit more from rising gas prices, and suffer more from falling gas prices," Taylor wrote. "Coal is very frequently on the margin in the SERC [Southeastern Electric Reliability Council], the MAPP [Mid-Continent Area Power Pool], the MAIN [Mid-America Interconnected Network], the [ECAR] East Central Area Reliability Coordination Agrement and the SPP [Southwest Power Pool]. These regions still benefit from the rising gas prices, but not to the extent of ERCOT and the West."

Taylor argues that if a horizontal line is drawn across the price duration curve at the variable cost of a given plant, "the area above that line represents the gross margin that the plant would earn if it could operate all of the time that price is higher than variable cost." He said that if such a horizontal line were drawn for a baseload generator with variable costs of $15/MWh, margins would be seen to be very thin when coal is on the margin, but would widen during periods when gas is on the margin.

"The degree to which those margins widen is driven by the price of natural gas, because as the price of natural gas increases, it gets more expensive to run gas-fired generation. Therefore, the price of electricity increases." Taylor writes that for a baseload generator with $15/MWh of variable costs in his "hypothetical market" where gas prices move from $3.75/MMbtu to $5.50/MMbtu, the increase in operating margins of that plant" is close to 70%." A key driver of baseload margins is the market heat rate, which is calculated by dividing the electricity price in a market by the gas price, which "yields a proxy for the least-efficient plant to operate at any given time." He asks, "How overbuilt is the market and, therefore, how efficient is the marginal unit during times when gas sets the price of electricity?" In overbuilt markets, which, he notes is fairly common in the U.S. market, heat rate falls. "If a 7,100 Btu per kilowatt-hour (kWh) plant is on the margin compared with a 12,000 Btu per kWh plant, margins will be much thinner for baseload generation." He said that baseload facilities in regions with higher market heat rates, for example, NP-15 and SP-15 in California, benefit more from rising gas prices than those with lower market heat rates like MAIN and ECAR, and suffer more as gas prices fall.

To see how "theory translates to reality," Taylor said that S&P looked at the EBITDA of AES Eastern Energy L.P., which has four merchant coal-fired units in western New York; Edison Mission Energy's Homer City Funding LLC, which operates a coal-fired facility in western Pennsylvania that sells into PJM Interconnection and NYISO; and Texas Genco Holdings, whose baseload capacity uses a mix of gas coal, lignite and nuclear fuel.

What the three have in common is that they each "earn the predominance of their gross margin from baseload assets operating in a merchant environment without the benefit of long-term contracts." Looking to determine the "magnitude" of the variability in baseload EBITDA as natural gas prices changed, S&P said it found Texas Genco had the more pronounced variability in EBITDA on a per baseload kW basis, and AES the least.

"Texas Genco demonstrates substantially more variability, due primarily to higher operating leverage related to a fleet of gas-fired assets. That gas is on the margin more often in the ERCOT market also affects this variability," Taylor wrote.

He argues Texas Genco's greater variability is largely due to "substantially higher non-fuel operating expenses." "This is not surprising, as there are operating expenses associated with the gas assets, but the capacity associated with them is not counted in the calculation, because we are looking at dollar per base load kW." He argues that the fixed operating expenses associated with the gas-fired capacity "creates substantially higher operating leverage at Texas Genco compared with AES Eastern and Homer City, and thus more volatility in EBITDA." "As gas prices have risen, the gas capacity generates more EBITDA (although baseload EBITDA still dominates), which also contributes to the steeper run-up in EBITDA as gas prices have risen."

Taylor noted that gas is on the margin more often in ERCOT than in NYISO or PJM, "which adds to the benefit," and Texas Genco's coal-fired facilities burn Powder River Basin coal and lignite, "whose prices have been more stable than eastern coal. Market heat rate in is similar in the three markets, so this is not influencing the results, " Taylor wrote.

In the report, Taylor wrote that EBITDA follows a trend similar to natural gas prices, and he said that AES Eastern and Homer City "are very close to the natural gas price trend, although AES Eastern appears to generate more EBITDA on a per kW basis, which, Taylor argues, is likely due "stronger availability." He also writes that AES Eastern appears "lightly less variable, possibly as a result of its hedging strategy." The S&P report argues that gross margins at AES Eastern are "consistently higher," and that this is likely due to stronger availability at AES Eastern, especially in 2002, "when availability was 96% compared with Homer City's 77%."

Availability in 2003 was 89% at Homer City compared with 93% at AES Eastern, and, according to the S&P report, the EBITDA of the two firms were "substantially closer." Also, the percent swing from peak to trough was less for AES Eastern. "This could result from AES Eastern's hedging strategy, which is to maintain about 75% of capacity sold forward at least one year, which could serve to dampen some volatility." Homer City hedges a bit less of its capacity, "with a strategy to keep about two-thirds-two of its three units-sold forward about 18 months."

Taylor's report concludes that, as gas prices have "risen dramatically, so have operating margins for baseload facilities." He further concludes that the magnitude of the variability in baseload EBITDA as gas prices change "depends on how often gas is on the margin, the supply-demand balance in the market, for example, the market heat rate when gas is on the margin, the hedging strategy of the plant owner, and the operating leverage-the magnitude of non-fuel operating costs-of the baseload assets."