INTERNATIONAL: Crisis raises costs for energy projects

Analysis

The energy sector has seen a reduction in liquidity across a range of markets in which US investment banks were active, as banks either have collapsed or had their commodity trading operations taken over. Moreover, the counter-party risk of trading with financial institutions as a whole has risen and traders have curbed their exposure ahead of potential default. This has been most marked in US wholesale power and gas markets.

The retrenchment in trading strategies to reduce risk contributes to two trends, both of which tend to increase further the risk of market participation. They are:

• greater price volatility; and
• less effective price discovery.

Ripple effects. The result of bank failures and takeovers is consolidation and contraction, which also means reduced trading activity. In addition, counter-parties have become wary of trading with companies supported by credit lines to insecure banks. Commodity trading operations have had to convince counter parties that they have sufficient credit to sustain them at a time when credit is in short supply. The crisis is having a ripple effect throughout the energy sector, exposing weaknesses, but also creating opportunities:

• Electricite de France has signed a memorandum of understanding to buy Eagle Energy Partners, Lehman Brothers' physical power and gas trading operation, and is vying with MidAmerican Energy Holdings to gain control of US utility Constellation Energy. The catalyst to Constellation Energy's downfall was concerns that it would not be able to secure sufficient credit to back up its trading operations. Its stock plummeted, turning it into a vulnerable takeover target.
• Lehman Brothers' other energy trading concern, Lehman Brothers Commodity Services (LBCS), has fared less well, having been suspended from power exchanges in New England and California. LBCS has also defaulted on gas deliveries to municipal gas purchaser Main Street Natural Gas, which in turn has had the ratings on its revenue-raising bonds reduced as it is unlikely to receive any compensation from LBCS for the lack of gas delivery.
• Power generator Bosque Power has also seen its ratings downgraded, owing to its links with Lehman Brothers. Bosque has a hedging arrangement with LBCS regarding the output of a 245 megawatt (MW) gas-fired generation plant in Laguna, Texas. Ratings agency Moody's questioned whether this facility would be honoured and Bosque Power would be able to secure the same terms from another institution in the current environment.

Increased debt servicing costs could well see exposed energy companies collapse or be turned into takeover targets. It will also reduce the ability to raise new capital for investment, and may affect existing capital investment programmes:

• Nevertheless, a report issued by ratings agency Standard and Poor's on September 22 said most US merchant generators had sufficient liquidity and were benefiting from recent falls in commodity prices (see INTERNATIONAL: OPEC resolve is uncertain - September 18, 2008). Lower commodity prices mean less collateral is needed to fund hedging agreements. S&P said higher commodity prices would be a 'material' risk because companies would be unable to enlarge revolving credit facilities under current market conditions. The collapse of either Morgan Stanley or Goldman Sachs would have much more profound implications, owing to their much larger positions in energy trading
• In the oil and gas sector, firms that have borrowed to finance asset development are also cutting back, while those that retained cash rather than fund new investment are now in a strong position to pick up assets. In the United States, the financial crisis looks likely to reduce oil and gas demand at a time when domestic gas supply has increased sharply, reducing domestic prices and the likelihood of increased liquefied natural gas (LNG) imports. Companies that have based expansion plans on debt are now looking to sell assets to improve their cash position, which is improving opportunities for buyers.
• Companies that have borrowed to invest in LNG import facilities look particularly vulnerable as they hold debt, and are still calling on it, but have little prospect of being able to generate early cash flow. Upstream, the increase in domestic gas supply is already causing some companies to reduce capital expenditure as neither domestic price returns nor the cost of borrowing justify expansion.

Future borrowing. Banks and other financial institutions are making their borrowing requirements more stringent, and there are likely to be both beneficiaries and losers in the energy sector. While concern has been expressed that renewable energy companies will find it harder to raise funds, they may not suffer significantly. Renewable energy targets remain in place as a matter of government policy and subsidy regimes -- where they exist -- provide guarantees of future profitability:

• While rising oil prices make the economics of renewables more attractive, they also threaten continuation of subsidies, as they are seen as no longer necessary. Falling energy commodity prices in fact may ensure subsidy regimes pursue government mandated climate change mitigation goals over the longer term. Nevertheless, financiers are likely to back tried and tested technologies, such as wind, rather than those still at the more experimental stage, such as wave power (see INTERNATIONAL: Marine power holds great potential - May 27, 2008; and see INTERNATIONAL: Solar PV set to grow - May 9, 2008).
• However, highly capital-intensive energy projects will suffer disproportionately from higher borrowing costs, which may end in further calls on public finances. New nuclear already is struggling to find financial backing, owing to the difficulties involved in determining fixed cost estimates for construction. Where the cost of capital is such an important part of the total project, higher borrowing costs will have a major impact on economic viability. Calls for increased public support are likely.
• In addition, clean coal technologies -- particularly involving carbon capture and sequestration -- are significantly more capital intensive than standard coal-fired or gas-fired plants. If compensation to incentivise these schemes is to come through an Emissions Trading Scheme, the cost of carbon will have to be higher to make the initial investment worthwhile as financing costs rise.

Outlook. The future pattern of energy demand growth (or contraction) has become much more uncertain as a result of the financial crisis, owing to its impact on the general macroeconomic outlook. A serious recession in the United States now looks more likely (see UNITED STATES: Failures worsen de-leveraging spiral - September 18, 2008). A pause in energy demand growth may prove a welcome respite to regional grids facing a looming demand gap, but also will tend to extend the life of the existing generation fleet rather than encourage its renewal with lower carbon alternatives.

Higher borrowing costs and more stringent borrowing requirements also will push energy companies to rely on financing projects from their own balance sheets. In a low commodity price environment, this is likely to prove harder for upstream oil and gas projects, though much depends on how far a less positive price outlook impacts financiers' views on energy investments; they may still benefit from the 'search for quality' relative to other options. In the power sector, lower feedstock prices would help utilities, though again this would weaken nuclear energy's attractiveness relative to coal and gas.