Generator profits likely to peak in 2002

Dana Bacciocco, Associate Editor

It’s a great time to own stock in the electric generation sector-but the end may be nearer than the beginning, according to Deutsche Banc Alex. Brown analyst Jay Dobson. With proposed capacity additions, the United States could reach adequate electricity supply by 2004. In the report “Electricity Supply & Demand in the U.S.: The March to a Commodity Drum!” Dobson said, “We continue to be confident that the question of excess generating capacity in the United States is a question of ‘when’ and not ‘if.’ Like many other asset-intensive, commodity businesses, we expect developers to add too much capacity to the U.S. generation market. Gross profit margins for U.S. generation companies are likely to peak in 2002. The decline from the peak will be determined by how fast additional generating capacity is added.”

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According to Dobson, “The summer of 2001 and thus, the second and third quarters of 2001, still look very promising from an earnings growth perspective.” His study indicates that every region of the country will likely be short generating capacity in 2001, which should drive margins and fuel profits for the U.S. generators.

However, Dobson expects the supply and demand environment to reach equilibrium in 2004 and move to excess capacity by 2005. In fact, he notes that large amounts of capacity are expected to come online in 2002 and 2003, which should lead to more moderate power prices and, therefore, profit margins.

The report says the United States will move from a short capacity position to a long capacity position over the next several years; 350 GW of capacity additions have been announced and it is estimated that about 200 GW are necessary to adequately meet the anticipated three percent demand growth (percent of GDP) comfortably by 2005. The report assumes 218 GW of capacity additions by year-end 2005. This compares with a base of installed generating capacity of approximately 750 GW.

Generators are adding around 50,000 MW of capacity a year. U.S. demand is about 700,000 MW a year. Dobson maintains the United States needs to add about 21,000 MW a year just to break even; adding net 30,000 MW a year will level out the supply and demand curve over time.

A region where prices are very high will attract a lot of players, said Dobson. Deregulating generation breeds new players coming in to build new generation-Calpine, AES, El Paso, Williams, Enron are all new entrants into the business. Companies are adding new capacity, with Calpine in the lead with the largest backlog in the industry-just under 31,000 MW announced. The table shows the 20 largest U.S. developers along with announced development plans for each company.

Put into perspective, California is not so much a victim of deregulation, as a victim of short supply. Re-regulating, stopping deregulation, or municipalizing will not change the supply shortage. It simply shifts the burden from the private sector to the public sector, said Dobson.

Nearly 100 percent of the United States has electric supply. In this mature industry, with consumptions growing slowly, generation is competitive. However, in the electricity sector the regional capacity outlook is more significant than the national outlook. According to Dobson, although the electrical grid is interconnected, control regions-11 NERC regions-are limited in transmission capacity. The regions closest to adequate capacity include Texas and New England. The regions shortest in generation capacity include California, the upper Midwest (MAPP), the Midwest (MAIN), the Southeast (SERC), Florida and New York. The most interesting region is Texas, which appears to reach adequate or possible oversupply by 2002. Although profit margins are rising on every level now, said Dobson, the generation opportunity is a finite one.

Dobson is managing director at Deutsche Banc Alex. Brown, the investment banking and securities arm of Deutsche Bank AG in the United States. Dobson can be reached at jay.dobson@db.com

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