Bend over. Deregulation about to screw us a second time.
Oh, and did we all enjoy the perp walk of the arrested El Paso VP for fraud this week ?
fortune.com
ENERGY TRADING
Power Failure
The current scandals pale in comparison to the
energy industry's biggest problem: massive debt it
can't repay.
FORTUNE
Wednesday, December 4, 2002
By Julie Creswell
You'd think that by now--in this annus horribilis for
the once highflying energy-trading sector--all the
bad news would have come out. The sham trades
that boosted revenues have been exposed. The
stocks have been crushed, with companies such
as Mirant, Dynegy, Calpine, and AES down about
90% over the past year. The rating agencies have
downgraded much of the industry's debt to junk
status. The SEC and the Federal Energy
Regulatory Commission (FERC) are investigating
several companies. In November the New York
Stock Exchange notified Dynegy, which ranked No.
30 on last year's FORTUNE 500, that its shares
may be delisted. In fact, many of the largest energy
traders, including Dynegy and El Paso, have
publicly announced that they will abandon trading
altogether--which is where they made most of their
money. Instead the plan is to revert to the
old-fashioned model--generating power,
transporting natural gas, and exploring for
hydrocarbons. It may not be as sexy as the old
"asset lite" strategy popularized by Enron--and
copied by the rest of the industry--but the hope is
that at least it will allow the companies to survive.
Guess what: It might not work. The reason? Debt. During the boom times--and
anticipating a glorious new era of deregulation--power companies borrowed a
stunning $600 billion. They used that money in part to bulk up their speculative
trading operations. But mostly they used it to buy entire power companies or
construct natural-gas-fired power plants.
That bill is coming due. Starting next year and continuing through 2006, a
whopping $90 billion of debt has to be either repaid or renegotiated, according
to Standard & Poor's. Few of the companies appear able to repay it; the
collapse of energy trading has put them in a severe cash crunch, and several
are close to bankruptcy. Speculative trading is no longer profitable, of course,
but far worse is the fact that power plants aren't generating much cash flow
either. The overbuilding has helped lower the cost of energy--and the economic
downturn has meant that the country simply isn't using as much power. Power
prices are severely depressed.
Welcome to the next great debt disaster. "The debt bubble in this industry is
massive," says Karl Miller, a former energy executive who is now a senior
partner at Miller McConville & Co., a private firm that is buying distressed
assets. Starting next year many energy firms teetering on the edge of Chapter
11 are going to fall into it. Once again the brunt of the losses could land on
some of the nation's largest banks. For instance, J.P. Morgan Chase, which
has acknowledged lots of bad telecom and cable loans, says it has another
$2.2 billion in exposure to merchant energy companies. "People have been
focused on the bankruptcies of Enron, Global Crossing, and WorldCom," says
Miller, "but this sector is the sleeping giant."
What set the wheels in motion for the energy meltdown? The same thing that
got the telecom disaster going--botched deregulation. The federal government
had already deregulated oil and natural gas when it turned its attention to
electricity in the 1990s. For decades local utilities were essentially regulated
monopolies. The utilities owned the power plants and the lines they used to
provide service to corporations and consumers. To hold the monopoly in check,
state or local boards set caps on what the utilities could charge customers.
With deregulation, local utilities had to compete to provide power to their
area--and customers could shop around for the cheapest power. Still, it was left
to each state to decide how--and when--to deregulate its retail electricity market.
Enter the big energy-trading companies. Most of them were already operating in
the deregulated oil and natural gas markets--and had seen how open markets
created profit opportunities for them. Now they believed they could do the same
with electricity. The wind, they believed, was at their backs--not only was
electricity about to be deregulated, but thanks to the booming economy there
was also growing demand for power. Furthermore many utilities operated
outdated coal-fired and nuclear power plants that needed to be phased out. And
the big banks--not just J.P. Morgan but also Citigroup, Bank of America, and
Bank One--were eager to lend. It wasn't long before Calpine and Duke Energy
(among others) began constructing power plants.
In theory, once a power plant was up and running, the company that had built it
would sign long-term contracts for up to 80% of the plant's output, guaranteeing
electricity to its customers at a fixed price. And how would the energy firm
ensure that it could supply the electricity at that price? That's where trading
came in: The firm could sell its excess power in the marketplace--and it could
apply hedging techniques to lock in a price for its biggest expense, natural gas,
which would also protect against volatility. Indeed, hedging was the original
impetus behind energy trading. Hedging, however, is not a high-margin
business.
Speculative trading--that is, making leveraged bets on both the demand and the
price movements of electricity--can be hugely profitable, assuming you're on the
right side of the trade. Of course, that kind of trading has nothing whatsoever to
do with guaranteeing the delivery of electricity, but by the late 1990s nobody was
too worried about that. Speculative trading was generating such big profits for
the merchant energy firms that it became, in effect, the tail that wagged the dog.
From the Dec. 9, 2002 Issue
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