Eyes Peeled for a Texas Energy Shake-Up

Two huge events may suddenly transpire in Texas, and either one could shake up the state's power market and boost margins at NRG Energy (NRG), Calpine (CPN) and Exelon (EXC).

The first event may be a spectacular bankruptcy: Bloomberg reports that Energy Future Holdings may file a Chapter 11 within weeks. The firm -- Texas' largest electricity provider -- has struggled since 2007, when KKR (KKR), Goldman Sachs (GS) and TPG Capital took it over in one of the nation's biggest leveraged buyouts. The deal left Energy Future with more than $43 billion in debt, of which $32 billion is held by Energy Future's competitive power unit, Luminant -- and this is where any bankruptcy would likely focus.

Luminant is Texas' largest generator of electricity, with power plants capable of generating 15,427 megawatts of power. Most of its revenue relies on the Electric Reliability Council of Texas (ERCOT), the state's largest Regional Transmission Organization (RTO). Luminant's fleet includes Comanche Peak Nuclear Power Plant, one of the nation's newest and most costly nuclear power plants. It also owns approximately 4,000 megawatts' worth of gas turbines and gas boilers and some 8,000 megawatts of coal-fired power plants, the latter of which rely mostly on lignite for their fuel.

Luminant is also the state's largest miners of lignite coal -- one of the lowest-ranked coals, with high-ash and high-moisture content, as well as a low energy value per ton. Most of Luminant's coal-fired power plants are located near their nine lignite mines. 

The unit's power plants may have a low mark to market valuation if this is based on projected earnings. As a result of this, it appears equity owners and debt holders could face a haircut. In addition, some of Luminant's generating assets are targets of the Environmental Protection Agency and the Justice Department. Last August, EPA and DOJ sued Luminant over air-pollution standards for their Big Brown and Martin Lake power plants.

Energy Future unit TXU Energy -- the state's largest energy service provider for competitive electricity -- likely has a financial relationship with some of Luminant's assets. But a third Energy Future unit, state-regulated wire utility Oncor, appears to be protected from any bankruptcy-related restructuring.

In any case, a bankruptcy could mean that some of Luminant's power plants will exit ERCOT's energy market, dependent upon economics and ERCOT's market conditions. Inefficient plants operating in a low-priced market would find their plants earning low to zero market values, and Luminant's creditors may conclude it is difficult to sell marginal units. Consequently, they might shutter some units rather than sell them.

If that happens, it will benefit incumbents Calpine, NRG and Exelon. ERCOT is already critically short on capacity -- so if even small amounts of its capacity suddenly evaporate, the lower supply and growing demand should bump up energy prices and margins at those firms.

Away from this potential bankruptcy, another even that could transpire is a possible structural change in ERCOT's power markets. Currently, ERCOT is one of the few RTOs that offer generators no payments for capacity. Again, ERCOT is critically short capacity, so state policy officials are looking at all options -- including the potential of offering generators capacity payments.

At the same time, if Energy Future's Luminant unit does declares bankruptcy, this could focus policymakers' attention on generators and their investors. They may conclude that the introduction of capacity payments could retain and attract capacity by converting previously uneconomic generators to profitability.

Capacity payments would likewise benefit Calpine, NRG and Exelon. Calpine in particular owns over 8,000 megawatts in Texas -- so, at an estimated $50 per megawatt-day, the firm could earn an additional $150 million per year. NRG has over 10,000 megawatts that could earn an additional $180 million per year. Exelon, for its part, owns almost 4,200 megawatts, which could earn an additional $75 million per year.

So if either of the two events transpires, ERCOT's incumbents will benefit. Most market participants should expect higher revenue from energy production or capacity. If both events materialize, Calpine, NRG, Exelon and other market participants should see significant climbs in energy and capacity revenue.  

Nobody wants to see a large nuclear, coal and gas utility file for bankruptcy. However, it appears the leveraged owners of Energy Future Holdings may have been seeking alpha in all the wrong places.

At the time of publication, Williams had no positions in the stocks mentioned.