Gas Producers Entering the Power World
A question was asked “could you blog about the strategy for a gas producer to participate in the power market as an independent power producer (IPP)?” Given my background in both Oil & Gas and Power it puts me in the perfect position to discuss this.
Let me first start simple and then build up to be a large scale IPP. The question posed was black and white in terms of participating in the power markets as an IPP. However, it really isn’t that black and white. There is potential strategy for the gas producer to unite with the power markets without actually operating a facility. This can be as simple as acting as the hedging agent for the utility. We see many people try to emulate the coal markets with their long-term contract arrangements. The difference for gas is the product is fungible – a molecule at Y is essentially the same as the molecule at X. This cannot be said for coal. Coal products are non-fungible with unique characteristics. Therefore building a coal plant with a boiler specified to operate with certain characteristics puts the power generator at fuel risk without a long-term contract. Beyond the equipment flexibility, fungible nature of natural gas has allowed the forward gas markets to be active and representative to the actual market in the near term. This cannot be said for coal as the coal forward market does not represent a significant portion of the physical market. Therefore, utilities, who would like a fixed price on natural gas price, can obtain a fix price by participating in the forward gas markets. There are several utility executives who would like to deal with gas like coal, but by doing so, all they are doing is shifting the burden of the hedge to the producer. There is still value for them to do this, as long as the premium of the hedge is understood. Shifting the hedge to the producer will allow the utility who is typically lean on the balance sheet not to be concerned about the fluctuations to the market. In theory, the producer should be able to hedge the gas better than the utility since it is their business therefore economy of scale should play into it. The premiums of the hedge will certainly be passed onto the power generator with a little return for the added risk. I suspect a small producer could not fill this role for the utility, since the counter party risk could be too great relative to the value of the producer. In a de-regulated environment, it is essentially betting on a position, which is no different than fixed coal pricing if the price is low enough. Clearly a bad deal will result in both parties losing in the end. Teaming up with a regulated entity to supply a fixed gas and volume has many significant advantages once the public utility commission has approved the deal. There is less risk of not being paid as the market risk is essentially being socialized.
The large scale alternative for the gas producer to act as an IPP offers many competitive advantages along with the associated challenges. This strategy still is not black and white. There is a potential to take small enough volumes from various fields and qualify as a distributive generator. The technology has progressed in the micro-turbine world to make it economical. This volume will not be large, but could work well for areas having to flare gas. In essence, most of the generation will be used to supply internal energy use, and on occasion be used to support the grid. Once again, depending on the market dynamics the challenges will differ. ERCOT related markets, where most of the market and several actors are de-regulated; more upside value can be captured. Markets with significant regulated actors could compress margins as their returns are less a result of optimal decision making, but more on the approvals of the public utility. In today’s market of essentially zero yields for cash, it becomes a very compelling reason to put your money to work. The power sector can bring a relative consistent return with a conservative outlook. Building or acquiring a combined cycle can offer decent returns with upside potential. Examining the cost of production of some shale plays, it makes sense to have part of the portfolio of production sold with upside potential. By operating a combined cycle a producer can essentially sell their production with an upside potential. There are locational issues which must be examined, but I suspect given the various transmission initiative for renewables, gas units can piggy back on that infrastructure build out.
There are several other key points to consider and local market analysis needed before producers jump into the power market, but I am sure there are several markets/situations it will make sense for producers to be more active in the power sector. Actual implementation will require back office support. The positive note most producers already have some form of risk group and a trade floor. If you are a producer, please do call or email me as I can help guide/assess/re-affirm your decisions [email protected] 614-356-0484.
