The profitability of merchant power generators is largely linked to natural gas prices and industrial gas demand destruction as well, as domestic exploration and production success could yield long-term benefits for the sector, according to Standard & Poor's Ratings Services (S&P).

Credit quality for U.S. energy merchants, power developers and trading and marketing firms has improved due to better business fundamentals, S&P said. In a recent report S&P said it views the short- to medium-term environment in the power markets as supportive of merchant generation companies. Ratings for most companies are considered stable, though a few demonstrate upward momentum.

"In the longer term, a lower demand for electricity caused by economic factors or a sustained decline in natural gas prices could affect these companies' cash flow generation ability," said S&P credit analyst Aneesh Prabhu.

"Consequently, what the companies do with their free cash flow is an important consideration for us," S&P said. "Any improvement in the credit quality of the merchant sector is predicated more on the financial policies the companies adopt. If these companies deploy their strong anticipated cash from operations in a credit-supportive manner, improved financial measures could lead to ratings improvement."

S&P rates 30 merchant companies in the sector. The ratings of these companies mainly fall in the "BB" and "BBB" categories. "Although the geographical base of each company is different and diverse, exposure to natural gas prices as the marginal fuel creates more similarities among these companies from a credit perspective than differing asset portfolios might suggest," the analyst said.

S&P outlined several major trends in the merchant sector.

For one, coal prices are expected to rise over the medium term along with the cost of processing uranium for use as nuclear power generation fuel. Additionally, "natural gas prices have continually increased over the past five years, have been very volatile, and are likely to react sharply to a cold snap or weather event that affects production.

"Longer term, profitability for the merchants will be dictated by natural gas prices, which could revert to lower levels owing to demand destruction or if additional supply becomes available."

Additionally, shrinking generation reserve margins in many regions across the country mean higher market heat rates and rising power prices. Nuclear plant uprates and improve fossil fuel plant capacity factor improvements have been realized. "Any growth in demand now generally has to be met with new capacity and energy efficiency," S&P said. "Add in the desire for increased reserve margins and for fuel diversity, and it is no wonder that we are witnessing a building spurt with markets in many regions such as the PJM and NEPOOL that are now pricing in capacity over the short to medium term."

And S&P noted that the average baseload generating plant in the United States is about 35 years old, and plant retirements are inevitable. At the same time, global demand for raw materials, particularly from Asian countries, as well as a shortage of skilled labor have driven up construction costs. "Factoring in the prospects for cost overruns, this means that a 500 MW baseload plant will easily cost more than $1 billion," S&P said.

Future carbon legislation is another factor that will affect merchants and will dictate investment strategies. Coal-fired projects have been canceled recently and companies are showing a renewed interest in nuclear power, S&P noted. "We believe companies with a diversified asset portfolio will be better positioned to take on the likely environmental changes," S&P said.

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