Energy's future in a new market

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Energy's future in a new market

Deregulation: Consumers are buffeted by prices of electricity and natural gas that are increasingly subject to the power of the profit motive.

-------------------------------------------------------------------------------- By Marego Athans Sun National Staff

NEW YORK - With 10 minutes to go before the closing bell, the traders in the ring were shouting, waving hands, making hand signals, throwing paper and glancing nervously up at the neon-lighted boards, where the price of natural gas has been at record high levels for months - pingponging at rates up to five times those of a year ago.

Historically, the trading floor of the New York Mercantile Exchange has been where the price is set for commodities such as grain and pork bellies, but over the past few years, this chaotic weekday scrum has also become a sophisticated marketplace for energy due to the transformation of the gas and power industry over the past decade.

Once, state public service commissions set electricity prices, but because of market deregulation in key states, a free market increasingly rules. An entire new industry has sprung up of marketers, who link buyers with sellers and arrange pipeline transportation for natural gas to power plants or the transmission of electricity through interstate grids.

If they're prudent, they come to "the Merc" or other such exchanges to buy futures contracts ensuring them against price swings. This is where exotic instruments such as California/Oregon Border electricity options are swapped by the megawatt hour. Or natural gas futures are traded in millions of British thermal units.

Today, the energy marketers are getting particular attention because of a power crisis in California that threatens to bankrupt two giant power utilities and involve Wall Street, the federal government - and potentially U.S. taxpayers - in a massive bailout.

On Monday, California Gov. Gray Davis, calling deregulation a "colossal and dangerous failure," threatened to seize some California power plants if the state couldn't get some sort of price relief. The next day, as well as yesterday, he was in Washington pleading his case.

The headlong plunge toward near-bankruptcy of the California utilities - Pacific Gas and Electric and Southern California Edison, which rank 73rd and 178th respectively on the Fortune 500- has resulted from what energy analysts have dubbed the "perfect storm."

Warm winters over the past several years had kept prices for natural gas low, and drilling activity slowed because low prices gave companies little incentive to explore.

Meanwhile, the federal government was encouraging the use of natural gas as a cleaner, more efficient alternative to oil and coal. Most of the new power plants being built were fueled by natural gas, though none was built in California during the past decade because of opposition by environmentalists and strict regulations governing potential plant sites.

When California deregulated on March 31, 1998, the state capped the price customers could be charged through the year 2002 at 5.4 cents per kilowatt hour, enough to make a hefty profit since utilities' costs at the time amounted to a little more than 3 cents. That formula worked, however, only if gas stayed cheap and demand stayed relatively stable.

But demand grew throughout California - one reason was the enormous requirement of the Silicon Valley computer industry - and the Pacific Northwest, where the population boomed.

In addition, the state provided no consumer incentive to conserve, said Rebecca Followill, a gas and power analyst at Howard Weil in Houston.

Then, this year, the country was hit with a cold winter, adding to the demand, and natural gas prices increased to unprecedented levels. In January 2000, gas prices were barely $2 per million BTUs. On Monday, the price closed at $10.29 at the mercantile exchange and yesterday at $8.94.

A year ago, the two California power companies could have locked in the price of power they acquired from generating plants by entering into long-term contracts for as little as $38 per megawatt hour.

Instead, they chose to speculate that prices would stay at that level or drift even lower, and that they could find all the power they wanted in the spot market.

But prices exploded, reaching as much as $450 per megawatt hour. In recent days, the price has been around $300 per megawatt hour.

The result: the two utilities lost more than $11 billion last year. As 2001 began, they were paying about 40 cents per kilowatt hour for electricity for which they were forced, by law, to charge consumers just 5.4 cents.

As a consequence of the huge losses by the two utilities, their stock was battered on Wall Street and their bond ratings lowered. The bankers who extended them credit trembled.

But there were huge winners, as well.

Companies that trade energy as a commodity are enjoying huge gains in earnings and stock prices.

For the group that Followill calls the "energy convergence" group - those companies that market both gas and power, have trading operations and, in many cases, have pipeline assets and power-generating facilities - stock prices on average jumped 104 percent in 2000.

Dynegy Inc., a Houston-based energy marketer, reported that its energy trading and marketing profits rose 80 percent in the third quarter. Its stock price rose 218 percent last year, from $16 to $56.06, ranking it among the year's top gainers on the New York Stock Exchange.

Another Houston company, Enron Corp., whose chairman, Kenneth Lay, is one of President-elect George W. Bush's chief contributors and energy advisers, saw its stock price rise 87 percent last year, from $44.38 to $83.13.

"For them as a group, it had to be the best year ever," Followill said. "In a market like the one we had last year, that's tremendous."

Meanwhile, companies that acquired power plants in California from PG&E and Edison under the deregulation plan - notably Duke Power of North Carolina and another Houston-based firm, Reliant Energy - had the prices they could charge in California capped at $750 per megawatt hour, once an unthinkable figure and still far more than the current market price.

It is these outstate companies that Davis has accused of price gouging, and whose plants he has threatened to seize.

The California governor was not treated sympathetically when he came to Washington by Texas Sen. Phil Gramm, a former Texas A&M economics professor who told the Los Angeles Times that he would resist any bailout that would "take California politicians off the hook.

"As they suffer the consequences of their own feckless policies, political leaders in California blame power companies, deregulation and everyone but themselves, and the inevitable call is now being heard for a federal bailout," he said.

"I intend to do everything in my power to require those who valued environmental extremism and interstate protectionism more than common sense and market freedom to solve their electricity crisis without short-circuiting taxpayers in other states."

Gramm is a conservative Republican and Davis a Democrat who some say entertains presidential ambitions in 2004, so partisan politics might be at play.

But Gramm's view is a popular one among many energy company executives and traders who see the growth of a free market as a boon that will ultimately benefit consumers with lower prices. This group sees California as a stark example of all that can go wrong with deregulation.

Other states, such as Pennsylvania, have successfully made the transition without a disruption, and several states are proceeding with deregulation, including Texas, where Bush signed a bill approving the transition last year.

One big difference is that numerous new power plants have come on line in Texas during the past decade, a situation proponents of the Texas plan say should spur competition.

Eric Thode, a spokesman for Enron, citing this contrast, said, "It doesn't take a rocket scientist to see what the problem is. The problem has nothing to do with deregulation. It has to do with California."

Texas also has a more realistic pricing policy, under which prices can rise twice a year if the costs of producing power increase.

As more states deregulate, traders at the mercantile exchange say the futures market they are developing will become an essential part of the process whereby energy is produced and delivered.

Most of those trading in natural gas on the exchange are not speculators. In fact, most of the trading on the exchange - 85 percent to 90 percent of overnight positions - represents companies trying to hedge, or protect their positions from future price swings.

The other traders are speculators, and they are the ones who inject "liquidity" into the market, allowing prices to rise and fall. These speculators benefit from price volatility, which is driven by uncertainty as well as tight supply and increasing demand.

Albert Anton, a partner and oil and gas analyst at Carl H. Pforzheimer & Co., said that while speculators don't exactly manipulate the energy markets, they can have some impact on prices. In volatile times, "the traders tend to push things a little too far," he said.

For example, when oil spiked to $37 a barrel last fall, he said, "It didn't feel like the market should have been at 37, but the traders were going along with it because they were convinced something was going to happen in the Middle East. The speculators tend to exacerbate problems."

But traders, as well as some analysts, say that energy prices would probably be higher without the open exchange.

"Over the past 10 years, the movement toward marketers has made the system more efficient," said John Arnold, vice president of natural gas trading at Enron. "The competitive system gives price signals to the market.

"If it were not a competitive industry, those signals might not get to the producers. What we've seen in California is that the price signals were hidden, and the market was short power."

While natural gas trading on the exchange is booming, electricity - which became a commodity in 1996 - has not matured at the same pace. Unlike oil and gas, power is difficult to transport and impossible to store, hindering the creation of a national market. And deregulation has been uneven among the states.

As a result, while the other commodities are traded in their own pits on the floor, electricity is still traded by computer.

One of the contracts on the exchange is a power pool that includes Maryland, Pennsylvania and New Jersey. While the Baltimore area's deregulation plan has been held up by court challenges, Maryland in general has moved forward, and the "PJM" pool has several new power plants under way now, scheduled to come online in the next few years, which should temper electricity prices in the area, said Andre Meade, a utilities analyst at Commerzbank Securities.

As the electricity market finds itself, the Mercantile Exchange is developing an e-trading system that will enable people to trade commodities over the Internet, as they do stocks. In this brave new world, people will be able to hedge their own home heating costs by taking positions in futures markets.

And at Enron, which helped pioneer the new energy market, executives are looking for new financial worlds to conquer. The company has already developed financial instruments to trade in weather-risk management, wind-power services, bandwidth and pulp and paper, and a host of other products.

Quipped Anton: "They'd trade bananas if there were money in it."

Originally published Jan 11 2001

http://www.sunspot.net/cgi-bin/editorial/printversion.cgi?storyid=1150540202173&breadcrumb1=News&breadcrumb2=Nation/World

-- Martin Thompson (mthom1927@aol.com), January 14, 2001


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