Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Running a listed merchant electricity company must often feel like an exercise in corporate masochism.

These companies -- Calpine, NRG Energy, Dynegy and (until its buyout closes) Talen Energy -- are often lumped in with utilities but are nothing like them. They don't get a regulated return. Instead, they take their chances in the wholesale electricity market, hoping their plants can supply that critical, and highly-priced, megawatt-hour of power when demand is high.

On one side, they are exposed to swings in demand and competition from rival generators. On the other, they're exposed to movements in the prices of fuel for their plants, especially natural gas, which tends to set the power price in regional U.S. electricity markets.

In general, higher gas prices are good, lower not so good. And, as you might know, gas prices have been low for a long time.

Vaporized
Booming shale supply has squashed U.S. natural gas prices
Source: Bloomberg

Until recently, that is. A hot summer and the threat of winter have fueled a rally in gas. Apparently, though, no one told merchant power investors:

Disconnected
Merchant power stocks have dropped since July even as gas prices have pushed higher
Source: Bloomberg
Note: Performance indexed to 100.

You'll notice Dynegy and NRG both rallied hard when gas prices first got going at the end of May. They have a much higher proportion of coal-fired plants in their generation portfolio -- although, in Dynegy's case, the recently announced acquisition of gas-fired plants from Engie will shift that dramatically. Burning cheaper coal when higher gas prices set the price of electricity makes for bigger profits, all else being equal. Calpine, on the other hand, generates virtually all of its power from from burning gas, so its profits are less leveraged to swings in the price and generally more stable.

One explanation for why the generators are so unmoved by this apparent windfall is that it looks so fleeting. Here's how futures prices for gas look today and how they looked at the end of May and the start of the year:

Immediate Gratification
The gas price rally is concentrated in 2017, but futures prices fall away fast after that
Source: Bloomberg
Note: Average annual futures prices.

The message from the gas futures market is that a good 2017 will only encourage U.S. E&P companies to resume drilling, in a repeat of what happened in 2013 and 2014. Gas-focused E&P stocks rallied earlier in the summer, and the number of gas-focused rigs has ticked up this month, according to data from Baker Hughes.

This week's deal involving Rice Energy also speaks to the resilience of some companies in the face of very low prices. And in a report released Wednesday by Sanford C. Bernstein, analysts forecast a big increase in pipeline capacity coming out of the giant Marcellus shale basin in late 2017 and early 2018, which would release another slug of gas production onto the market.

This being the merchant power sector, though, it isn't just the possibly short-lived gas rally they have to contend with. Flat electricity demand and the rising penetration of renewable energy is a challenge for utilities and merchant generators alike, but the latter are at the sharper end of it.

Solar and wind-power projects cost a lot to build, but their running costs are minimal (the fuel is free). So when the sun shines or the wind blows, they generally offer the lowest-cost power to fill demand -- displacing higher-cost plants burning stuff like gas from the market. All else equal, this cuts the power price, and available profits, for everyone operating a power plant that isn't part of a utility's regulated asset base.

Greg Gordon of ISI Evercore highlights a recent example in the country's biggest state electricity market: Texas. Despite a torrid August necessitating amped up air-conditioning across the state, prices never got anywhere near the levels seen in the same month five years ago.

Back in August 2011, wholesale power prices in Texas hit the regulatory cap of $3,000 per megawatt-hour at least 10 times, according to Gordon. This year, they hardly ever broke $500. Apart from low gas prices, the amount of wind power available to met peak demand was three times what it was back in 2011. And Texas also has a lot of potential for distributed solar power.

The merchant generation stocks may well be reinforcing the message that the gas rally's lifespan will be brief. Beneath that, though, they are also being slowly squeezed in a vise of shale gas, renewable energy, and energy efficiency.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net