2013-12-02

Deflation in Energy and Electricity

Deflation is very fast acting in the financial, but it works slowly in the real economy.

Power companies face grim reality as commodity bets expire
Financial trading desks at companies like NRG Energy and Energy Future Holdings Corp. were designing elaborate bets to protect themselves when prices came back to earth. Natural gas prices largely set the price of electricity in the United States.

So they bet on the price of natural gas falling, what traders refer to as shorting. And when it did, executives had a new revenue stream worth billions of dollars a year to make up for the shortfall in electricity sales.

In recent years, hedging programs have aided the power industry through a period of sustained cheap electricity prices brought on by the boom in natural gas drilling. But those hedges are now expiring, leaving power companies exposed to power prices half what they were in 2008.
Power companies haven't suffered too much in recent years because they shorted natural gas prices, which delivered big profits to offset falling prices and weak demand for electricity. Now as those roll off, their profits will sink.
Last year when power prices were at their low, Energy Future reported its natural gas hedging program generated $1.8 billion. That represented a third of the company’s revenue. NRG reported hedge earnings of $2.2 billion in 2012, more than a quarter of its revenue.

Exelon, one of the nation’s largest power companies with plants and wind farms across Texas, reported a hedging program that brought in $3.2 billion in 2012. Most of that return came from power sales made years ago when prices were higher, the company said.

As the hedging programs shrink, the companies will be exposed by increasing degrees to current power prices, said Travis Miller, a utilities analyst with the financial research firm Morningstar.
Even though the market situation changed greatly, the effect was delayed due to the structural make up of the market, in this case a large amount of hedging. This is why the housing market peaked in 2006, but the collapse came in 2008 when many homeowners started seeing their mortgages reset. There won't be a similar crisis from power companies seeing their earnings drop, but if interest rates keep rising, utilities could really feel the pinch in 2014. This will really hurt firms invested in very expensive to produce alternative energy.
The expiration of the hedges and the downturn in the electricity market are already having ramifications.

Energy Future, which has long credited its hedging program with keeping the company going despite $42 billion in outstanding debt, is expected to file for bankruptcy early next year.

Last month, investment bank Morgan Stanley slashed its projections on Exelon’s stock by almost half on lowered expectations on where natural gas prices are headed.

In a recent conference call with analysts, Exelon CEO Christopher M. Crane said while he expected “up-lift” in the power market next year and into 2015 if prices stayed low, the company would have to take action.

“If we have it wrong, then there are some assets that we’ll have to look at for the long-term profitability. That would be around the time frame that I think it would be a very serious conversation taking place,” he said.

Most observers expect the power companies to find ways to weather the storm.

“It’s all factored in. The analysts like that issue, but the market is liquid enough [the power companies] can ride this out,” said Pat Wood III, the former chairman of the Texas Public Utility Commission and a consultant to Hunt Transmission Services.
I'm going to guess that the interest rate assumptions by these firms and analysts are optimistic. If rates jump in 2014, there is going to be a run on some utility stocks.

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