generation asset valuation: are we at the nadir for gas-fired power plants?

Shanthi Muthiah, ICF Consulting

New natural gas-fired power plants-those operational in the post-2000 period-will start to show significant recovery in valuations over the next two to three years in most U.S. markets. This recovery will be one of several examples of energy markets returning to more sustainable levels after a period of tremendous turbulence.

Merchant transactions of new natural gas power plants in 2003/2004 were completed at low prices. The recent Duke Southeast 5,300 MW gas-fired portfolio sale, for instance, transacted at an average price of $89/kW, possibly reflecting the local minimum in the market. (The portfolio included approximately 55 percent simple cycle combustion turbine capacity and 45 percent combined cycle capacity.)

This compares to an original investment cost of roughly between $300 and $600/kW just three to four years prior. While there are other gas-fired plants that have fetched higher values, almost all (except those with long-term power purchase agreements , or PPAs) have included a substantial discount to original investment costs.

The loss in value of natural gas power plants has been the result of three principle developments (i) excess capacity in the generation sector, (ii) high oil and gas prices, and (iii) structural problems affecting the wholesale power market. However, in most markets this situation should reverse in the next few years and indicative signs of this should be apparent within 24 to 36 months.

First, construction of new power plants in the U.S. has essentially ceased. In contrast to 27 GW in 2004, 51 GW in 2003, and 64 GW in 2002, only approximately 6 GW of new plants are projected to come on-line in 2006. Only plants with PPAs (with a regulated utility) or other limited opportunities such as wind with a renewal of the production tax credit are likely near-term constructions. In this context, demand growth will easily outstrip capacity growth reverting to a situation of tighter capacity. Demand growth has averaged roughly 2.5 percent over the last two decades, on a long-term average basis. At this rate, peak demand will increase by approximately 18 GW per year and an additional 3 GW will be required to meet reserves for this incremental demand. Even 2004, a year with one of the mildest summers recorded over the past 115 years that records are kept, still evidenced 1.7 percent year to date growth.

Second, oil prices at $50-55/bbl (or approximately $8-9/MMBtu) are simply unsustainable on a long-term basis, as are natural gas prices at $6/MMBtu. A number of supply and demand responses are inevitable. One point worth highlighting on the oil side is that consumption of oil for heating and cooling (and even potentially in transportation) could largely be replaced by the use of natural gas at these high prices-and certainly transportation fuel efficiency could improve, leading to lesser demand for oil.

High gas prices will create more supply and reduce demand for gas. Natural gas prices above the $5/MMBtu threshold (Henry Hub) would justify replacing most existing U.S. gas power plants with new coal power plants. Above the price of $4/MMBtu would make coal the dominant resource expansion option for incremental electric power generation. This would be in addition to a large loss of gas demand in the industrial chemical feedstock sector which is vulnerable at these prices to lower cost imports.

The potential for increased liquefied natural gas (LNG), and secondarily supply expansion within North America, will play an important role in the supply response. At prices above $4-5/MMBtu, LNG will find a way of overcoming any siting or other obstacles and could flood the market. An unprecedented total of more than forty proposals for new terminals including in the U.S. Gulf Coast, Bahamas, New England, eastern Canada, the west coast including southern California and the Pacific Northwest, and Baja Mexico have been announced. Indeed, new North American LNG terminal construction is already underway at two gulf sites and one Nova Scotia site. Additionally, of the four existing facilities, all are planning expansions. These terminals can be fed by several countries that have natural gas resources estimated at hundreds of years of U.S. consumption: Russia, Trinidad and Tobago, Nigeria, Qatar, Algeria, Indonesia, Australia and others. Furthermore, the recent enactment of legislation supporting an Alaska natural gas pipeline is a harbinger of additional government action to increase natural gas supply.

Thus, we believe that oil and gas prices at current levels cannot be sustained. This timing of market turnaround in gas prices is important because the one remaining threat to gas plant valuation recovery is a massive build up of new coal power plants. While a mix of new plants can be expected, massive build out of new coal plants, given the necessary construction lead time, will be unlikely in the face of gathering strong evidence of lower oil and gas prices.

Third, we believe the wholesale power market is taking some largely unnoticed but substantial steps towards structural improvements. As of October 1, 2004, 18 states have in whole or in part adopted FERC’s Standard Market Design (SMD). By 2005, 25 states and roughly 40 percent of U.S. electricity consumption will very likely be under an umbrella of SMD and locational market pricing (LMP). And, with California and Texas, a significant majority of consumption will be under this regime by the end of 2006. These structural adjustments will allow for supply/demand fundamentals to better influence value in a much more unfettered manner. This will also allow FERC to concentrate its efforts on two key remaining areas: (i) the few remaining areas without SMD and (ii) marketizing the treatment of scarcity in a sustainable and socially acceptable manner.

In summary, low transaction values will remain only if you believe that markets will never restore the supply/demand balance. As electricity demand growth has proven resilient over a multi-year period, the pessimists must be convinced that utilities will be building rate base units sufficient to offset demand and/or that there will be a massive construction of coal plants. Indeed, we see the need for new power plant construction even under moderate demand growth rates, and very modest retirement scenarios, on the order of 30 to 40 GW by 2010. While we do believe that some will be rate based, and possibly too much, the odds do not favor large scale (i.e. more than 20 GW) construction of coal plants for a number of reasons, namely lead time, government policy on CO2, the lack of clear regulatory structures in many states, likely evidence of significantly decreasing oil and natural gas prices within the next couple of years, etc.

We believe that what now may be perceived as a contrarian view, i.e. the expectation of market turnaround vis-àƒ¡-vis stronger gas plant valuations in most markets (although still not at original investment cost), will become more main stream within the next two to three years with observable evidence. Unsustainably high fuel prices and unjustifiably low valuations for natural gas plant, will be replaced by more balanced prices. This will result in lower fuel industry margins and higher power plant sector margins.

Muthiah is a vice president in ICF Consulting’s wholesale power practice.

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