Being without electricity for almost 12 hours, and without Internet service for 4 days (both are back now) encourages contemplation of the multiple networks on which we are dependent for our well-being and even our survival, and of the interdependencies that exist across these networks…
Energy & Power Generation
Natural Gas – We Got it Half Right
Our energy situation broadly cleaves into two main functions – natural gas, and electricity. Natural gas is used for industry, heating homes and powering stoves, and is taking a greater portion of the electrical generation load. Electricity also overlaps with gas when it comes to home heating and cooling, and is obviously a large component for industrial uses. However, the natural gas and electricity energy industries in the United States have moved in profoundly different directions over the last few decades. The purpose of this post is to describe where we are, as a country, with regards to natural gas. In short – we got it half right.
Natural gas has three main components, broadly speaking – 1) exploration / extraction 2) transportation 3) distribution. In general, natural gas is lightly regulated for exploration / extraction, has general principles for transportation (open access) and is pretty heavily regulated for distribution (local monopolies).
One critical difference between electricity and natural gas is that natural gas can be stored while electricity must be available at the specific time it is needed. Thus users and utilities can store natural gas and have it available for peak times, while the only way to meet peak load demand for electric utilities is to have units on line generating electricity during the hottest parts of the day or to “shed load” by pushing customers off-line to reduce demand.
Both electricity and natural gas are mostly consumed using North American (including Canadian) resources. While OPEC maintains an oil cartel, the fuel used to generate electricity (coal, nuclear fuel, gas) mostly comes from North America. While these resources can be transported across the ocean (for instance Japan imports virtually all of what it needs to fuel electricity) in the USA (and Canada) we have most of what we need for these industries. Until recently there wasn’t a practical way to bring in natural gas from regions that weren’t connected by pipeline, so we were bound to use North American resources.
Exploration & Extraction
The exploration and extraction of natural gas is a mostly unregulated industry (compared to electrical utilities, at least). The biggest constraint was that vast swathes of the US were placed off-limits for natural gas drilling due to environmental concerns. In the 1970’s, a moratorium was placed on new natural gas connections because it appeared that the US would run out of natural gas. However, improvements in extraction capabilities resolved that situation and wildcatters responded to higher prices by finding additional supplies.
Recently it looked as if we were going to run out of natural gas again. Futures prices on natural gas, which were around $2 / unit in the 1990’s, spiked to as high as $14 / unit in the winters of 2006-8 (prices are seasonal and typically move with the weather) but now are below $4 / unit due to the fact that massive supplies of natural gas have been located in shale formations as drillers redoubled their efforts in light of these high prices.
The natural gas industry, as we can see above, is able to use market forces to respond to price signals. Drillers used innovation and new technology to find new supplies which in turn brought down the high prices. If the extraction / exploration industries were heavily regulated and monopolized (like power generation), it is likely that they would just have utilized the high prices as an opportunity to reap large profits rather than to expand supply.
Powering Down
Here’s the great French scientist Sadi Carnot, writing in 1824:
To take away England’s steam engines to-day would amount to robbing her of her iron and coal, to drying up her sources of wealth, to ruining her means of prosperity and destroying her great power. The destruction of her shipping, commonly regarded as her source of strength, would perhaps be less disastrous for her.
For England in 1824, substitute the United States in 2009. And for “steam engines,” substitute those power sources which use carbon-based fuels: whether generating stations burning natural gas, blast furnaces burning coke, or trucks/trains/planes/automobiles using oil derivatives. With these substitutions, Carnot’s paragraph describes the prospective impact of this administration’s energy policies: conducting a war on fossil fuels, without leveling with people about the true limitations of “alternative” energy technologies and without seriously pursuing civilian nuclear power.
Texas Energy Buyout
One of the long-time major public utilities was known as TXU and was based out of Dallas, Texas. TXU was a large utility and expanded to include overseas assets; after the energy bust in the early 2000s TXU shed their overseas assets and participated in the deregulation schemes for the state of Texas.
A bit of background is that utilities are pretty much regulated on a state-by-state basis. In addition, Texas (with the exception of El Paso, which is really almost more a part of New Mexico; I used to consult there) is on their own transmission grid known as ERCOT, that has its own voltage different from the rest of the country, meaning that power in Texas can’t generally cross state lines. This means that you can’t bring power into Texas that isn’t generated in Texas and you can’t sell Texas power outside of state lines. The subtle side effect is that, for power at least, Texas is like a “whole separate country” – if there is a surplus of generation in the state, rates stay low – but if they are short on generating capacity – prices will soar. Surplus or deficit power in neighboring states can’t help or harm Texas.
Here is an instant tip for you – any deal done in 2007, at the height of the bubble, is generally in trouble. The 2007 mortgage “vintage” is the stinkiest year, and the same type of damage spilled over to the deal arena. Generally if you are looking at a 2007 deal, when equity values were at their highest and “easy money” for debt was readily available (meaning that you could “leverage up” higher), those are the deals with the characteristics likeliest to make them go South.
So now that we have gone through a bit of background on the unique nature of the Texas electricity market, and gone through the general background of deals that were executed in 2007, now we move on to the current status of TXU, which became “Energy Futures Holdings” when a leveraged buy out of equity owners occurred during that year for $45 billion, led by KKR, Texas Pacific Group, and Goldman Sachs (see brief wikipedia article).
Energy Futures Holdings incurred a large debt taking a utility public. Historically utilities have had substantial and steady free cash flow. Thus the plan typically is to leverage up with debt (which is cheaper than equity, because you can deduct interest on debt), cut expenses, and keep the cash flow. For a utility with large capital expenditures (investments), another obvious way to increase your cash flows is to pare back on new investments of items like power plants, transmission lines, and distribution networks.
The debt of Energy Future Holdings is trading at a substantial discount to “face” value, which is 100 cents on the dollar. For this bond issue (each one is valued differently, because they have different terms, maturities and rights, although they generally move in sync along with the overall enterprise’s health) the bonds were trading at 70 cents on the dollar for the 2017 maturity.
One item that is eye-popping is that this bond returns a coupon of 10.875%, almost 11% a year! The current treasury (risk free) rate today for bonds with a 7 year maturity (to be in synh with the 2017 bonds) is 2.74%, per this government bond yield table. Thus these bonds pay (10.875 – 2.74) = 8.131% HIGHER than the “risk free” rate, for a period of 7 years. Thus if risk was equivalent (which it clearly is NOT), then this bond would be trading for far above 100 cents on the dollar, maybe something like 150 (I will leave it up to Andrew from Aurora, the new guy on the blog, to figure it out if he feels like it).
So for a bond to be trading at 70 cents on the dollar with a high coupon rate basically means that investors are bracing for a serious fall. A quick look at their financials shows why (even though they are private and have no equity investors, they have debt investors with publicly traded debt so they still file SEC filings and have quarterly conference calls). EFH has huge amounts of debt coming due in 2014, and it currently doesn’t appear that they are generating enough cash to pay down this debt. To be fair, when deals like this were done at the height of the “easy money” boom, you not only had models showing growing cash flows, but you also figured that you could easily re-finance and push out the maturity of debt as it comes due. In general, those days are mostly over unless you have a heavy equity component (a lot of your own money at stake) or a sterling balance sheet.
Another Blow Against Nuclear Power in the US – History
For the last couple of years there has been talk of a “renaissance” in nuclear power in the United States. The government has issued some loan guarantees to various parties and the greens are starting to come around to nuclear power because of greenhouse emissions. While I am a supporter of nuclear power and of investing in generating capacity in general, from the moment that this false hope started I have been steadfast in maintaining that virtually no new nuclear plants will be built in the US in the near term, meaning the next 5 or so years.
One other block against any sort of nuclear power investment is HISTORY. This article in today’s Wall Street Journal titled “Costs Cloud Texas Nuclear Plan” discusses the South Texas Project, a nuclear site in Texas that is owned today by municipal utilities in Austin and San Antonio, Texas and NRG, a public company that owns various generating assets around the USA.
The South Texas Project (STP) has 2 nuclear units today. NRG applied for federal financing to build 2 additional nuclear units at the site, as part of this “renaissance” of nuclear power.
The original STP project was subject to massive cost overruns. Per the article:
“skittishness about the cost of nuclear energy is understandable. The first two units at STP were supposed to cost less than $1 billion but ended up costing more than $5 billion. With that memory seared into its memory, San Antonio officials have been sensitive to anything suggesting that they could, again, get blindsided by escalating costs”
Note that the costs escalated by a FACTOR OF FIVE from the original estimate – $4B cost overrun in 1982 dollars translates into over $8B based on this “inflation calculator” I found on the web.