Five years ago, electricity prices were climbing fast, and with them power companies’ profits. But already there was a sense that the high times might not last forever.
Financial trading desks at companies like NRG Energy and Energy Future Holdings Corp. were designing elaborate bets to protect themselves when prices came back to earth. Natural gas prices largely set the price of electricity in the United States.
So they bet on the price of natural gas falling, what traders refer to as shorting. And when it did, executives had a new revenue stream worth billions of dollars a year to make up for the shortfall in electricity sales.
In recent years, hedging programs have aided the power industry through a period of sustained cheap electricity prices brought on by the boom in natural gas drilling. But those hedges are now expiring, leaving power companies exposed to power prices half what they were in 2008.
“It’s a big drop in revenue,” said Mauricio Gutierrez, chief operating officer of NRG. “We need to look at the profitability of our plants, our maintenance and operations and capital expenses. We need to make sure our plans are consistent with the new reality of the market.”
Exactly how big a hit power companies are going to take remains to be seen.
A hedge is an investment through which traders try to reduce the risk of financial loss. In the case of power companies, that means protecting against big drops in the price of electricity. Their traders will sell power into the future at a set price or bet on a related commodity like natural gas to insulate the companies.
If power prices go down, the value of the hedge rises to make up some of the financial losses incurred by the company. And if power prices go up, the company loses some money on the hedge but not so much they’re not still making a healthy profit – at least if done correctly.
Last year when power prices were at their low, Energy Future reported its natural gas hedging program generated $1.8 billion. That represented a third of the company’s revenue. NRG reported hedge earnings of $2.2 billion in 2012, more than a quarter of its revenue.
Exelon, one of the nation’s largest power companies with plants and wind farms across Texas, reported a hedging program that brought in $3.2 billion in 2012. Most of that return came from power sales made years ago when prices were higher, the company said.
As the hedging programs shrink, the companies will be exposed by increasing degrees to current power prices, said Travis Miller, a utilities analyst with financial research firm Morningstar.
“We still haven’t seen the bottom of earnings for most power producers, given the hedges they put on even two to three years ago are well above where the market is now,” he said.
The expiration of the hedges and the downturn in the electricity market are already having ramifications.
Energy Future, which has long credited its hedging program with keeping the company going despite $42 billion in outstanding debt, is expected to file for bankruptcy early next year.
Last month, investment bank Morgan Stanley slashed its projections on Exelon’s stock by almost half on lowered expectations on where natural gas prices are headed.
In a recent conference call with analysts, Exelon CEO Christopher M. Crane said while he expected “up-lift” in the power market next year and into 2015, if prices stayed low, the company would have to take action.
Most observers expect the power companies to find ways to weather the storm.
“It’s all factored in. The analysts like that issue, but the market is liquid enough (the power companies) can ride this out,” said Pat Wood III, the former chairman of the Texas Public Utility Commission and a consultant to Hunt Transmission Services.
“The generators knew this was coming since 2009. Hedging gives you time. As the forward curve (on electricity prices) started to decline they started deleveraging,” said Aneesh Prabhu, a senior director with the financial services company Standard and Poor’s.