June 4, 2008
Electricity is in the air now that that NRG Energy had bid $11.3 billion for Calpine Corp. If the deal between the two unregulated power merchants goes through, it would send a positive economic vibe that, despite liquidity concerns, the sector will remain vibrant.
After a severe trough, independent power producers appear poised for takeoff. As individual enterprises, though, they lack the financial wherewithal and the economies of scale to increase productivity and efficiencies. Through consolidation, they can achieve such gains -- all within the context of expected generation shortages combined with projected rises in demand. Risks still exist, however, as uncertain regulations, escalating construction costs and stiffer lending standards dampen the atmosphere.
"It has been evident for some time that consolidation in the industry was likely as some players moved to harness economies of scale and generation fleets," says Standard & Poor's in a report. "The (NRG) offer indicates that sector participants believe that the fundamental improvement in merchant power markets is here for the medium term."
The ratings agency says that the major independent power producers have all perked up. In addition to NRG, it makes note of Dynegy, Mirant and Reliant that have also been performing well in recent times. Stronger balance sheets along with a positive economic outlook could spawn more mergers among those enterprises, it says.
For now, NRG's bid tops the news. The Princeton, N.J.-based provider hopes to add to its current portfolio of 49 plants that produce about 24,000 megawatts, most of which are coal-fired and in Texas and some of which are gas-fired and in New England. For its part, Calpine owns 60 facilities that generate 23,000 megawatts of gas-fired and geothermal electricity mostly in California. If the two merge, it would become the largest free-market electricity supplier in the nation with a capitalization of $22 billion.
Both companies know the pain of bankruptcy. NRG spent seven months in Chapter 11 in 2003 while Calpine emerged after two years from such protection in February. To get on its feet, Calpine cut more than $20 billion in debt while slicing its workforce by 1,000 people. NRG says that the new-found geographic and fuel diversity would help the new enterprise minimize its risks. At the same time, it says that it could trim annual expenses by about $100 million through the elimination of duplicative corporate bureaucracies.
"The combined company would be the culmination of what we in this industry have aspired to become," says David Crane, chief executive of NRG Energy. "We look forward to working with Calpine to demonstrate the full potential of the benefits enumerated in our letter for our respective shareholders. This is, quite simply, the right deal, at the right point in time, between the right partners."
Smarter Producers
In the 1990s, Calpine emerged as a beacon of the American power industry and saw its stock price shoot to about $57 a share in 2001. But its massive build out eventually proved unworkable as the economy recessed and the demand for power nosedived. It subsequently reported losses of about $12.4 billion in 2003 and when it filed for protection against creditors in December 2005 its stock was barely above zero. Since coming out of bankruptcy in February, its shares have risen about 38 percent.
The good news for Calpine is that the business plan it formulated in the 1990s is in vogue today. It mostly owns and operates state-of-the-art natural-gas fired plants that are considered environmentally friendly. And, in an era in which state and federal policies are paying close attention to emissions levels and particularly carbon dioxide that has been tied to global warming, the company may be a hot commodity. Because Calpine does most of its business in California and Texas where the demand for power is escalating and where more generation capacity is needed, it has a positive outlook.
At its peak, Calpine owned 92 power facilities. When those plants were built, the markets anticipated they would be going full blast. As such, most of those unregulated facilities only got commitments for about half of the gas-fired power they were to generate. The rest was supposed to be sold on the open market at a premium. But those predictions fell short. It was not just Calpine that had a tough times making ends meet. Mirant and NRG also struggled. But NRG vastly improved market conditions along with a reliance on coal-fired power has allowed it to re-emerge stronger than ever.
During the tough cycle, bondholders hunkered down. They reasoned it would have been shortsighted to sell heavily capitalized assets at fire sale prices, particularly when they could eventually be expected to operate at full capacity. The patience appears to have paid off. While credit worries persist, the rising demand for electricity in many regions has added gleam to the sector. Moreover, merchant generators are smarter and will no longer build plants on speculation.
"The timing of this offer is excellent for Calpine, as it has not yet settled on a strategic view or chief executive officer," writes Howard Kagan, managing director of Harbinger Capital Partners that owns 24 percent of Calpine. "NRG offers the combined company a fully focused management team and a well articulated strategy already in place."
Unlike the regulated power markets in which utilities can pass through their expenses to customers, the merchant sector receives no such guarantees. But they can earn substantially higher returns -- if their investments are well-considered. Right now, much of the country is short generation and wholesale electricity prices are expected to climb as a result. Independent power producers welcome the news, which is lifting them from their knees and giving them the legs they need to compete.
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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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