Dan Watikiss, contributing editor
A recent Forbes article, Energy Bull Has Room to Run, noted that energy stocks were the leading investment in 2004 and will likely remain so because “demand-driven energy bull markets tend to have staying power.” But, what demand is that? Which energy products and services are likely to drive investments in the energy sector in 2005 and beyond? Who will be making the investments? And, what could fence in the bull’s running space?
New energy technologies and renewable energy are likely to continue to attract investor dollars, as will liquefied natural gas (LNG) delivery systems. Even formerly unlikely beneficiaries of investor dollars, such as developers and operators of power transmission systems and competitive retail energy service providers, appear positioned to catch the eyes of investors. Demand for LNG and alternative energy sources is strong and will likely grow stronger, particularly if oil prices remain high and demand for natural gas continues to outpace domestic production.
Energy technologies are inclusively defined as technologies that harness new or alternative energy sources (fuel cells, solar panels, submarine watermills), enhance the efficient or non-polluting use of energy, or improve the reliable delivery of energy, such as enhancements to the high-voltage power grid. The potential value of these energy technologies is pumped up by the prevailing and projected high cost of traditional fossil fuels and of power disruptions, such as the August 14, 2003, collapse of much of the northern half of the Eastern power grid. Disruptions cost the U.S. economy more than $120 billion per year. For these reasons, according to one analyst with EnerTech Capital, “it has never been a better time to invest in energy technology.”
Improved economics, backed by legislated incentives and guaranteed demand, will induce investment in power generation from an array of renewable technologies, with wind poised to capture the greatest number of dollars. According to the American Wind Energy Association, the production cost of today’s most efficient wind turbines is 5-7 cents per kWh. The recently re-enacted federal production tax credit of 1.8 cents per kWh (in effect for a facility’s first 10 years of operations) further improves the economics of wind and other renewables. Moreover, for power generated from wind and other renewables, demand is guaranteed currently in 19 states by renewable portfolio standards that require a minimum amount of a retailer’s delivered power to come from a portfolio of wind, solar, hydro and, in some instances, geothermal, biomass and waste coal.
The same declining supplies and high prevailing prices of domestic natural gas that improve the comparative economics of wind generation also drive demand for LNG facilities. Approximately 50 LNG terminal and degasification projects (including expansions) currently are under development in the U.S., Canada, Mexico and the Bahamas. In each of the past five years, oil companies and LNG importers have spent $4 billion to build LNG delivery systems, including liquefaction, tanker, terminal and degasification. Demand for natural gas in electric generation and other applications will see another $3.1 trillion invested in LNG over 30 years, according to the International Energy Agency.
So long as natural gas prices remain high, unabated by proposed LNG delivery systems, demand for king coal will be robust, as evidenced by the surging stock prices of industry leaders Peabody, Arch, Consol and Alliance. Over 90 new coal-fired power plants are slated for construction in the U.S. Nevertheless, coal’s seemingly bright future could darken quickly were the U.S. to join with other countries in a second stage of the Kyoto protocol on global warming.
Transmission systems also appear poised to attract private investment dollars well into the future, possibly in tandem with federal and state appropriations. The confluence of expanded wholesale power markets dependent on transmission and regulatory insistence that traditional utilities surrender operation of transmission systems to independent, regional operators has exposed bottlenecks and other weak links in the three North American interconnections. Recognition of the lost opportunity costs associated with these “holes” in the grid has driven public-private collaborative grid investments, such as the Trans-Elect upgrade to California’s notorious Path 15 bottleneck, and also strictly private investment plays such as the Cross Sound cable linking Connecticut with New York. As investors and the power industry and its regulators gain experience with independent transmission projects-privately or publicly financed-there are sure to be more, such as Montana’s announced plan to bankroll a transmission corridor that will tie its coal and wind resources to major West Coast load centers.
From what wellsprings will these energy investment dollars flow? Of course, much of it will come from traditional sources. LNG delivery systems predictably will be financed by the oil and natural gas industry majors and producing states. Traditional coal majors, and new coal entrants such as International and Foundation, can be expected to carry water for that industry. But investments in new energy technologies, renewable generation, wholesale energy trading, transmission systems and even competitive power retailers can be expected to come increasingly from non-traditional sources, such as investment banks, private equity and hedge funds.
Emblematic of this infusion of private equity is Berkshire Hathaway, Inc., and Kohlberg Kravis Roberts & Co., LP (KKR). In 2000, Berkshire’s investment in MidAmerican Energy Holdings took the utility from investor-owned to privately held. MidAmerican has since proceeded to acquire and invest in two major interstate natural gas pipelines, the Kern River Gas Transmission Company and Northern Natural Gas. Also in 2000, KKR helped to finance the spin-off of Detroit Edison’s transmission system to the International Transmission Company and more recently co-financed the acquisition of Texas Genco, LLC.
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Particularly noteworthy are the number of hedge funds that have entered energy markets after the collapse of the first generation of energy merchants, such as NRG, and speculative traders, such as Enron, Dynegy and the resulting tightening of credit requirements. Hedge funds are broadly understood as investment pools with fewer than 100 investors that invest in assets and derivative securities, using long and short positions, including leverage. Generally, the investment horizon of a hedge fund is shorter than that of investment banks and private equity investors. Until recently, hedge funds have not been regulated under the securities laws; due to a recently adopted rule under the Investment Advisers Act of 1940, however, managers of hedge funds having more than 15 customers must register with the Securities and Exchange Commission beginning in February 2006.
Hedge funds perceive in volatile energy markets opportunities for uniquely high returns. By some estimates, over 90 hedge funds have entered or are poised to enter U.S. energy markets, and over 200 hedge funds in the energy sector worldwide. These funds, together with investment banks such as Goldman Sachs and Morgan Stanley have invested and will continue to invest. They come from risk-management cultures, enjoy deep pockets and have access to the veteran physical and financial traders who once populated the trading floors of Enron, et al.
With a few notable exceptions, traditional, vertically integrated utilities seem to have lost (at least for now) their appetite for investments outside of the traditionally regulated sphere. Since revenues in that sphere have stabilized, the more aggressive players will pursue growth not through diversification but through mergers and acquisitions, such as Exelon’s recently announced acquisition of PSEG. An interesting dynamic will arise from these consolidations: Concerns over market power will force the merging and acquiring utilities to divest generation and possibly other assets to satisfy regulators, thereby creating additional investment opportunities for investment banks, private equity and hedge funds. To assuage market-power concerns, Exelon and PSEG have announced that they will divest 5,500 MW of generating capacity. There is also evidence of a reverse dynamic in which traditional utilities, with local regulatory approval, are buying independent (and often distressed) projects in various stages of development and adding them to their rate base.
The enthusiasm of private equity, hedge funds and other energy bulls will surely add welcome liquidity to financial energy markets that the 2002 credit collapse desiccated. That enthusiasm, however, will remain cabined in physical markets by the procrustean ownership restrictions of the Public Utility Holding Company Act of 1935 (PUHCA). While a growing number of traditional utilities-accustomed as they are to economic regulation-have found in recent years that they can accommodate and even prosper under regulation as a holding company (even as a registered holding company), investment banks, private equity and hedge funds cannot be expected to be so accommodating and will limit their ownership within the power and natural gas distribution sectors so as to give PUHCA a wide berth. Efforts in several recent Congresses to repeal PUHCA have failed, and the prospects for repeal are at best uncertain. So long as PUHCA survives, private equity investors, like Berkshire and KKR, will be largely fenced off from further power or gas distribution investments.
One other constraint on the new investors’ participation in domestic wholesale power markets is the briar patch of pending litigations that grew out of the 2000-2001 Western energy crises. Central to many of these is the demand of unhappy buyers that the market-based (rather than traditional cost-based) prices that they paid in bilateral transactions for wholesale power during the crisis be denied traditional filed-rate protections and instead be retroactively undone and refunded. Were the regulators at FERC or the courts to rule in favor of these claims, private investors would surely beat a hasty retreat from U.S. wholesale power markets.