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.

January 11, 2001|By Marego Athans | 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.

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