A marriage made in heaven
As deregulation in the power and natural gas markets takes hold, convergence of these two industries is becoming a reality. A perceived advantage for players embracing this trend is reduced risk, but what does it mean for competition and the consumer?
Prospex Research Ltd.,
For those that are tired of the plain old power business, bored with the highly regulated gas business, and looking for exciting new energy solutions, look no further than Europe. Here, gas-power convergence is no longer an abstract idea, but a basic fact, a common strategy, and perhaps the chief criterion of long term success in competitive energy. Even if Europe is behind the USA, it could catch up soon enough even with formidable US convergence pioneers such as Duke and Enron.
It is easy to understand why. As in the USA, there are so many arguments for convergence strategy that one wonders how any player can resist, although some do. Key drivers include the following:
• The dash for gas: Now that they are exposed to competition, several European power markets will surely be transformed by the rise of gas-fired power. Dutch gas major Gasunie is forecasting that European Union (EU) power sector gas demand will more than double from 81 billion cubic metres (bcm) in 2000 to 170 bcm in 2020. True, power industries like Germany`s may have more than enough generation capacity to meet current and even medium term requirements. But many existing coal and oil-fired plants simply cannot compete with a high efficiency combined cycle plant, and are targeted by greens for environmental policy punishment. So power players armed with gas reserves and gas players active in power are in an enviable strategic position today, and certain to look even stronger tomorrow.
• Reform pressures: Power is not the only industry under deregulation pressure. EU member states have also agreed a gas directive that is modelled on the EU electricity directive. The gas reform pace is slower, but the pro-market spirit is the same. Moreover, all power generators are eligible to switch gas suppliers under the directive, and minimal reform targets have already been exceeded in some member states. The momentum behind radical change looks unstoppable, as it is in power. Yet too many European gas companies are accustomed to tight regulation and de facto or even de jure monopoly protection. This means new commercial approaches are vital, including mergers with battle-hardened power players.
• One plus one can equal three: It is no coincidence that several top US power traders are prominent in US gas trading rankings too (see Table 2). Market share success depends increasingly on size and depth when wholesale customers demand comprehensive energy solutions. A position in both markets can also be highly profitable. Under a `tolling` arrangement with a fuel supplier, a player can decide when to burn gas in a power plant and when to sell it on the gas market. This is an important option: wholesale market volatility can be extreme in both power and gas, while price trends for the two commodities can diverge. Arbitrage, in other words, should be lots of fun, and a straightforward gas or power strategy too simplistic in both Europe and the USA.
• Long term security: Some European gas supplies come from models of commercial and political stability, such as the Netherlands, Norway and the UK. But unless exploration yields new reserves, these supplies will run out soon. BP Amoco puts European proved reserves at just 5.21 trillion cubic metres (tcm) at the end of 1998. If 1998 European gas production levels are sustained (and if anything they should rise), the region`s reserves to annual production ratio (R/P ratio) would give us just 18 years (see Figure 2).
But the big suppliers of selected countries today, and perhaps most of Europe tomorrow, such as Algeria and Russia, are not regarded as stable. Algeria boasts reserves of 3.68 tcm and an R/P ratio of 50.7 years. Russia has an incredible 48.14 tcm to tap and an R/P ratio of 82.7 years. Securing Western reserves before they run out or before a crisis rocks one of these big external suppliers might be the best long-term move a power player can make.
Multi-utility money: If one plus one can equal three in trading, then perhaps the sum in retail business should be four. Bringing natural gas and power together hedges fuel supply risk in fixed price retail business, increases the convenience offering to customers and also allows dual fuel discounts that others might struggle to match in a low margin supply business.
Multi-utility strategy can also create excellent cost-cutting opportunities. Two sets of customers can be served by one billing centre using one technology platform. Add in a high growth telecoms offering and cable television subscriber services, and the economics can look irresistible.
One market, more risks
But visionary convergence talks sound too good to be true, even when backed up by strategic deals worth billions of dollars. UK generator PowerGen is one player that has had enough of the gas story. It bought North Sea reserves and jumped at the chance to build CCGT plants in the early 1990s. But it paid a heavy price for quick commitment. Long term supply contract prices for its Connah`s Quay CCGT plant were set well above today`s gas prices. PowerGen did renegotiate the contract in late 1998, securing a 37 per cent price cut, but at the cost of a hefty £535 million ($861 million) one-off payment to BHP Petroleum, Lasmo and Monument Oil and Gas. The North Sea reserves were sold to Centrica (British Gas), the UK`s convergence giant.
PowerGen is by no means a convergence cynic. Getting out of legacy upstream business made sense, it said last year, since growth would require more capital and the upstream sector is highly competitive. This situation should last – the group does not fear it will find itself trapped some day by its natural `short` gas position. But in downstream trading and retail business, gas is still a central element of an ambitious strategy. Wholesale market power, supply efficiencies and marketing prowess can all be exploited in gas as they are in power.
Nevertheless, prudent Continental players are likely to look at PowerGen`s experience and wonder whether they should make their own long term, all-in commitments when their markets are just opening to competition. Perhaps a wait-and-see attitude would be safer, especially when spot trading could take off in the years ahead, stranding the business plans of those saddled with today`s long term, inflexible and untradable supply contracts. Existing gas supply contracts are already the subject of stranded cost pleading across Europe as utilities realise the blows they might suffer under competition.
In addition, the risks over long-term supply security may not be such an important issue. The countries of the former Soviet Union, excluding Russia, have reserves of 8.6 tcm that have barely been tapped. They may be dangerous places, but they do enjoy potential exit routes that avoid Russia. It is perhaps unrealistic to assume that all these countries, together with Russia and Algeria, could plunge into crisis at any time, disrupting their vital hard currency commerce. Even if they did, there is another army of suppliers ready to deliver LNG from the Middle East and the Americas. Reserves in the home region too may be more ample – and cheaper to extract – than they are thought to be today.
In fact, convergence skeptics now have support from the highest level. Enron, a lonely but visionary convergence prophet at the beginning of the decade, decided in July to separate itself from most of its upstream oil and gas interests. Like PowerGen, it is not leaving the gas game, but it simply does not need platforms and reserves to play. If Enron was right about convergence at the beginning of the decade, it could be right now about divergence.
Convergence and competition
Time will tell who has made the best call on long term gas market trends. Today, though, there is an even more pressing issue: competition. European power utilities are courting fuel majors with great eagerness. But some of these blossoming `corporate romances` could be shattered straight away by regulators.
There is already an important precedent for keeping romance in its place. When the Finnish government decided to merge its two energy nationals, oil and gas major Neste and power group IVO, the European Commission was not impressed. However, it approved the deal in June 1998 on the condition that the merged group – Fortum – sell off 50 per cent of its interest in Gasum, the Neste subsidiary which runs the Finnish gas network. Gasum`s de facto monopoly was not the only problem. The Commission said vertical integration was the big issue: with Gasum under its wing, Fortum could “successfully adopt market strategies that would not have been possible prior to the concentration.”
Fortum complied with the ruling in May 1999 by selling 24 per cent of Gasum to the Finnish state, 20 per cent to German major Ruhrgas and six per cent to Finland`s top three paper groups. Russia`s Gazprom retained its 25 per cent interest in Gasum. Thus Fortum was left with an interest of just 25 per cent in one of its most strategically valuable operations. This was an unwelcome setback for Fortum strategists, but excellent news for consumers and new entrants.
Elsewhere in Europe, `romance` has yet to be properly controlled. In Italy, Enel and ENI are apparently still working on a generation joint venture. How far they have progressed is difficult to ascertain, as neither side is talkative on this point. By securing ENI`s friendship, Enel will neutralise 2500 MW in ENI on-site generation capacity and align its interests with a group that runs virtually all of the Italian gas business. This is hardly likely to be in the public interest, whatever `arm`s length` form the joint venture might take.
Spain is at risk too. In January 1997, the dominant gas player Gas Natural, its 45 per cent holder Repsol, and Spain`s second largest power utility, Iberdrola, announced a strategic gas-power alliance. However, the relationship appears to have deteriorated in 1998 and 1999: differences have arisen not over a purely independent course at Gas Natural, but that group`s developing relationship with Endesa, Spain`s top power utility.
Officially, there is little misbehaviour here for competition enthusiasts to target. Endesa and Gas Natural will build combined cycle plants together, but operate them separately. Gas Natural will supply Endesa`s burgeoning fuel requirements, but only on an arm`s length basis and at market prices. Nevertheless, convergence and multi-utility strategy are sure to be very high on the agenda across the Spanish energy business in the years ahead. These players should be kept under very tight supervision.
The same is true of the Iberdrola-Repsol axis, which is still intact. Any investment banker worth his bonus will look at both Spain and Latin America, where Repsol has pulled off its bid to join the oil big leagues by acquiring YPF of Argentina. It could also acquire Iberdrola too – forget today`s CCGT project cooperation, and go for integrating everything, from Argentine gas field to Brazilian retail supply to Spanish fuel risk. This would form a perfect hedge for both sides at home and abroad, increase strategic power and create opportunities that neither side can fashion alone.
But no-one in Spain is dropping hints, publicly anyway, about convergence mergers. Spain`s web of cross-holdings between players and banks is already the subject of a determined government campaign to reduce conflicts of interest, such as a bank director sitting on the boards of two nominally competing groups that the bank has large stakes in. Furthermore, market power is the biggest issue in the electricity market. A merger could therefore spark concern in Madrid and Brussels that could only be alleviated by a action similar to that imposed on Finland`s Fortum.
The situation in Italy and Spain is especially unfortunate when one considers how important convergence is to competition elsewhere in Europe. Over-regulated European gas groups may have a lot to learn about operating in open markets, but they do bring important firepower. Norway`s Statoil and Shell`s 50 per cent held IPP unit InterGen, to name but two fuel-power players, are serious contenders and likely to stay the course.
In fact, the UK power market has been transformed by gas-power convergence, and Ireland may be about to go the same way. In time, parts of the Continent and the Nordic region could follow. Unless convergence leaders become part of the competition problem rather than a key to the solution, market enthusiasts should cheer them on.
Figure 1. The entrance of advanced gas turbine combined cycle technology into the market has been driver behind the convergence of the power and gas markets
Figure 2. Reserve-production ratios, 1998.
Source: BP Amoco
Statistical Review 1999