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Ken Silverstein
UtiliPoint International - July 14, 2003

By Ken Silverstein Director, Energy Industry Analysis

Utilities are following doctor's orders. They are watching what they spend and burning off fat. And while that may be the start of a healthy future, some of the offshoots of that strategy do hurt. Take power plant construction: With an oversupply of generation on the market, projects are being delayed or canceled. Just last week, Duke Energy and Fluor Corp. said that they will cease building new plants together.

The outcome is a byproduct of an earlier era. But the aggressive expansion plans could not be indefinitely maintained. Eventually, a glut would form and companies would have to rethink their positions. And while it may take another three years before supply and demand reach equilibrium, the long term prognosis for growth is solid. As the economy improves, credit will ease and investor confidence will return. At that point, construction can begin anew, particularly as older plants start to be retired.

“This action is necessary given the state of the market in the United States,” says Alan Boeckmann, president of Fluor Corp., an engineering firm that has combined with Duke to build 43 plants over 14 years.

Constructing power plants, of course, is a much riskier proposition than it used to be. With deregulation, the burden is on power-plant operators to run at maximum efficiency and to find buyers for their electricity, preferably before the first shovel goes into the ground. Without such measures, they couldn't get the financing. Still, there's risk. And that's why investors are demanding at least 10-percent earnings growth—a good bit higher than the 2 percent earned traditionally under regulation.

To maximize productivity, some companies have tried to achieve size and scope and have built state-of-the-art facilities that burn fuel cleanly and efficiently. It's all to win fast approval and to cut the cost of operations. During the late-1990s, companies perceived an energy shortage and worked to acquire or build such plants to meet the expected demand at 2.5-percent annual growth.

Altogether, 122 plants have at least been started in the last decade, driving up debt levels from $23 billion in 1999 to $49 billion in 2001, says Thomson Financial Securities. Wall Street rewarded those companies initially, pushing the values on some independent power producers' stocks such as Calpine and Mirant through the roof; some independent producers traded at price-to- earnings ratios of between 20 and 30—oftentimes double that of traditional utilities.

The sky became the limit. But supply eventually exceeded demand and the Enron mess made lenders and investors skeptical. Some of the highfliers like Calpine and Mirant suddenly tanked. Calpine's stock has ranged from $2.5 a share to $55 a share from April 2001 to the present. Mirant, meanwhile, has traded between $44 a share and $1.5 a share from April 2001 until the present.

Simply put, the value reflected in the forward price of a kilowatt- hour came down. Investors then realized that the return on their capital invested would not be as much and their earnings would not be as great. Stock prices therefore dropped, which then hurt their currency in the market to borrow money.

Economic Cycles

The dynamics have assuredly hit the construction segment. GE Power Systems, for example, has seen its orders drop from $24.5 billion in 2001 to $14.2 billion in 2002. The company says in an interview with Reuters that it rode the construction boom in the United States to its highpoint, with the understanding that the good times would not last forever. Equipment orders set for 2004 and 2005, it says, have been either deferred or canceled because of the oversupply of generation.

The cut backs, however, are only now becoming apparent. That's because more than 54,000 megawatts of new U.S. power generation was completed in 2002, according to Energy Argus. That's a record year, it says, despite the ongoing financial problems at many energy companies. Still, that's about three-quarters of the plants that were expected to come online, indicating that utilities have curtailed capital expenditures, it says.

The 2002 additions are also the culmination of deals already in the pipeline. Cancellations and deferrals, however, started to exceed announced projects in 2001—for the first time in a long time, says the North American Electric Reliability Council.

Now utilities and in particular the unregulated “merchant” operators are trying to shore up their balance sheets. Mirant, for instance, has cut capital spending and is looking to sell what it considers its non-strategic assets to create more liquidity. It further said that it would complete about 5,700 megawatts of power currently under way in North America, but that it would cancel or defer about 8,300 megawatts in projects that it had previously made public.

For the foreseeable future, most of the construction by investor- owned utilities will occur in regions where companies can support their trading and marketing activities and where the economies are robust. It's the impetus behind deals taking place in the Southeast. Tampa Electric, for example, has begun adding two natural gas- powered power plants to its fleet, or about 1,750 MW—all to accommodate Florida's expected growth in electricity demand of 1,000 MW annually.

Economic cycles are a fact of life. And while the nation may have enjoyed growing prosperity in the 1990s, things have changed. It's true in all business segments but especially in the energy industry. Individual utilities are reacting to the slowdown in their own ways, although most are positioning themselves to raise cash. That's meant delayed and canceled power projects.

It's all part of the medicine that the industry must take to regain its strength. In time, a rising demand will serve to wash out the current glut. Utilities should then make a full recovery.

An archive list of previous IssueAlert articles is available at www.utilipoint.com

UtiliPoint International, Inc

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