Duke, Analysts Debate Electricity Shortage or Surplus
Due to the rapid growth of new generating capacity across the nation, Salomon Smith Barney analyst Raymond C. Niles said the country is currently "crossing the mountaintop" when it comes to electricity prices peaking. He warned that the third quarter 2001 will become the first full quarter of negative commodity comparisons.
In SSB's "Power Curve No. 6" report, Niles said June provided the first hard evidence that the industry had reached the peak of the electricity cycle. Despite previous expectations that negative commodity comparisons in the electricity industry would not occur until the first quarter of 2002, Niles said forward power and gas markets advise that the third quarter 2001 will prove to be the first negative quarter.
On the contrary, Rick Priory, Duke Energy's chairman, president and CEO, said recent reports that the electric growth surge in North America is over, due in part to falling power prices, are "much more knee-jerk reaction than well-researched forecasting."
There has been a tendency in recent weeks to make "sweeping characterizations" regarding North American markets, Priory said during a conference call late last week, adding that such generalizations paint a "false picture." He said Duke prefers to view North America as an "assemblage of distinct, individual and regional" markets. While his market outlook "might seem a little out of kilter" when compared to other recent predictions from people in the industry, he said he is comfortable with Duke's position. "From our perspective, the prediction that spark spread compression and planned capacity at this point in time signals the end of the North American electric expansion" has little basis in fact.
"Our market intelligence indicates at this point that electricity demand growth will probably continue to occur at about 2.4% per year or so on average, even in light of the slower economy," Priory said. "Given reserve margins across the country and where they stand today, we continue to forecast that the industry will need to invest over $120 billion, and roughly [add] 220,000 MW of generating capacity by the end of this decade," representing a 25% increase over currently installed capacity.
"Natural gas supply will most certainly have to increase by over 5,000 Bcf to be able to accommodate both the normal growth of gas consumption as well as consumption necessary to drive these power conversion machines," he added.
SSB's report argued that the price of power and the spark spread both decreased over the last year. In June 2000, power prices averaged around $83.25/MWh, while the spark spread (the difference between power and gas prices) was $56.93. For June 2001, the power price fell to $50.21/MWh, while the spark spread decreased to $23.77.
"What has surprised us is the swiftness and breadth of the decline in the power-pricing environment," Niles said in the report. "Unlike the second quarter of 2001, which had two good months -- April and May -- to buoy earnings, forward markets suggest year-over-year declines in power prices and the spark spread for all of the third quarter of 2001 and continuing into the fourth quarter of 2001."
Priory said even with the mild summer, Duke's research gives him no reason to be concerned that the growth period is over yet. "Spreads in the East and West are quite healthy today as we sit here," the chairman said. "While they are down from their peaks...they are still above where they were, going into last year." At the same time spark spreads came down, intra-day volatility "shot through the roof."
In addition to a "slowing economy and the absence of last summer's hotter-than-normal weather," SSB said the prices are also decreasing because additions to capacity are exceeding increases in demand for power by "a wide margin in most regions." Niles said he believes 2000 was the first year in which incremental capacity exceeded incremental demand.
Priory, while agreeing that the country's economy is faltering, had a different view on the supply/demand situation. He said the high energy prices experienced over the last year are partially responsible for the country's recent economic downturn and can be explained "in some pretty darn simple economics -- demand has clearly outpaced supply" due to the lack of investment over the past decade.
"We still have an underlying power shortage, which has lasted well into 2001," Niles said. "However, the market is adding capacity in a manner that should relentlessly lessen its severity and even potentially create overcapacity in the next several years."
The SSB report showed that 27,000 MW of capacity were added in 2000, up from 11,000 MW in 1999 and less than 10,000 MW during most of the 1990s. SSB said it expect approximately 45,000 MW of capacity to be added in 2001, with a similar amount added in 2002. "Since this amount exceeds the amount required to meet growth in demand, we project a rising reserve margin," Niles stated.
Weighing in with another viewpoint, Friedman, Billings, Ramsey & Co. (FBR) said they are not so sure about the prediction that the country is headed towards a surplus of capacity. It said that the future demand for new power plant capacity is "grossly underestimated," while the forecasts of new supply are "exaggerated."
In the company's report, "The Overbuild Scenario Debunked: Supply and Demand Balance More Likely," analyst Maurice May said that numerous factors have been overlooked regarding the power supply/demand picture. He said the technological displacement of inefficient power plants, the critical need to rebuild reserves and the growing need for electricity are demand drivers that "have not been widely recognized."
FBR said its study of 439 gas-fired power plants in operation revealed 112,000 MW of inefficient capacity, which is a target for displacement. In addition to that decline, FBR said its research shows that more than 200,000 MW can be constructed without creating a power surplus.
"On the supply side, it is unreasonable to presume that all announced generation will be built," May said. "Based on regional and state analysis, we estimate that no more than 60% of all announced generation for the next five years will be built, which amounts to about 175,000 megawatts. Compared to our demand projections, excess capacity is absent, and supply and demand are more or less in balance."
From its calculations and research, FBR believes that 225,691 MW could be built over the next five years without throwing off the supply/demand balance. The company said demand growth will account for 67,706 MW, displacement of inefficient generation for 112,613 MW and reserve margin rebuilding for 45,372 MW.
The Duke executive also cited the replacement of older, less-efficient generating units in North America. "If you stop and count you will see there is about 100,000 MW or so of thermal generation capacity that is over 40 years old in this country," he said. "Some of that capacity will need to be retired in the next decade, and some of it is undergoing considerable pressure for environmental purposes, but I think the reality is that there is going to be an opportunity to replace some fraction of that generation with new supply that's 30-40% more efficient."
He also said that just because new generating plants are announced, it does not mean all of them are going to be built. A shortage of skilled construction labor is just one of the constraints that new projects face, Priory added.
SSB's Niles said with the declining power pricing environment, investors should take a "more cautious" approach to companies that are "long" the commodity. SSB said it currently recommends companies that have small exposure to power, whether by strong trading and risk management skills or a lack of generating capacity. The analyst said the company still recommends "a more cautious stance" toward power producers than energy merchants.
FBR's May said in his study that he believes "economic forces in play will favor big power producers with efficient and low-cost generation, sophisticated energy merchant marketing, and trading operations, as well as scale and critical mass in targeted markets."
Priory during the conference call also took time to weigh in on other current industry events. Regarding the appointment of Commissioner Pat Wood III as the next chairman of the Federal Energy Regulatory Commission (FERC), Priory said although he does not know Wood well, he has studied his background and is cautiously optimistic about him heading up FERC. "He says a lot of the right things, [but] he also says a few things to get you nervous," Priory said. "I wasn't particularly impressed with the price control efforts that took place under that political environment, but that is one of the realities of the Federal Energy Regulatory Commission, it is a highly political environment.
"I tend to measure these commissioners by the actions that they take," said Priory. "Unfortunately, Commissioner Wood has not been in this role very long, and a number of his fellow commissioners have not either, but I can assure you that within a few months and some significant decisions we will have a much better fix on Commissioner Wood and whether we think he is headed in the right direction or not. I want to reserve judgment on him. He sounds like a very talented, very capable, young, aggressive individual who wants to make these markets work. Boy, I think that is great. That would be certainly consistent with what our company would like to have happen."
Moving on to Duke Energy's structure, the chairman said that the company completed six gas-fired power plants for summer 2001's peak, and expects to build an additional 10 facilities for summer 2002, and approximately 20 facilities for 2003-2004. He added that Duke does not plan to own all of the facilities.
Priory said that because Duke has such a diverse and integrated portfolio, providing a natural hedge against many of the market cycles and weather factors that affect the industry on a regular basis, he continues to feel that 10-15% earnings growth for the year from a base of $2.10 per share earned in 2000 is "quite sustainable." He said the company sees "considerable opportunity" for expansion in the Southeast, Mid-Atlantic, Midcontinent, Northwest and Southwest regions.
Duke's diversity covers much of the energy industry, Priory said. Its businesses build one-third of the plants in the country, while its gas gathering and processing arm touches 20% of the natural gas molecules that come out of the ground in the country. He said the trading and marketing business is one of the top three marketers of natural gas and power, while its pipeline network transports approximately 8% of the gas consumed in the country.
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