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Merchant power gaining steam amid debt shuffle, stronger gas and retail outlook

Q2: U.S. Solar and Wind Power by the Numbers

Essential Energy Insights - September 17, 2020

Essential Energy Insights September 2020

Rate case activity slips, COVID-19 proceedings remain at the forefront in August


Merchant power gaining steam amid debt shuffle, stronger gas and retail outlook

Debt restructuring, higher natural gas prices and retail growth are key catalysts helping to improve analyst sentiment around independent power producers entering 2017, marking a nascent reversal on merchant names after a year of tumult.

Assurances by management to prioritize debt reduction and restructuring are conveniently coinciding with expectations of a near-term improvement in natural gas prices in 2017, taken with earnings growth from expanded retail operations, a line of business partially inspired as a tactical response to prolonged weakness in wholesale power prices.

With NRG Energy Inc. and Dynegy Inc. each advancing negotiations with creditors of their respective distressed GenOn Energy Inc. and IPH LLC subsidiaries, analysts are finding clarity to be a welcomed reprieve from the typical uncertainty that long weighed on the stocks, while further acknowledging the prospect of washing their hands of those assets.

"GenOn restructuring is a key near term catalyst we have been looking forward to and not an overhang; likely a positive catalyst, in our view, even if these assets are no longer part of the portfolio in the future," Guggenheim Securities LLC said Dec. 14, adding that it did not expect NRG to necessarily "hand the keys over to the creditors and bankrupt the entity," since it favors GenOn's PJM Interconnection LLC exposure, but stopped short of saying that such a move was out of the question.

Analysts at UBS Securities LLC made a similar observation around Illinois Power HoldingsIPH, which filed Chapter 11 bankruptcy, suggesting that Illinois' newly approved energy policy does not particularly benefit the Dynegy fleet, despite its initial lobbying effort, perhaps challenging the generator's fidelity to hold on to the assets.

"Should the restructuring prove problematic there would be substantially less reason for Dynegy to negotiate with creditors to arrive at an outcome to keep the segment," UBS said Dec. 12.

For its part, Calpine Corp., while not grappling with restructuring pressures of NRG and Dynegy, moved to reprice a pair of term loans due in 2023, according to S&P Global Leveraged Commentary and Data on Dec. 14, knocking the price on both loans down by 25 basis points, in line with the Federal Reserve's move to boost rates by the same measure this week.

While proactive steps around debt management by all three merchant names at the close of 2016 have occurred in earnest, these efforts have been necessitated by historically low power prices, driven by weak spark spreads — the difference between the market price of electricity and its cost of production — eating into energy revenue, thus making debt reduction a heavier lift in the absence of greater free cash flow.

But taken against the backdrop of improving natural gas prices in 2017, particularly in PJM and the Northeast, the prospect for a recovery in energy margin appears more likely, particularly if, at a project-financing level, new build in PJM slows down due to incremental increases in the Fed funds rate throughout 2017.

"We are reiterating our 2017 forecast of $3.45/MMBtu and see the recent price rally as sustainable," Morgan Stanley posited Nov. 15. "As a result of supply challenges, gas demand from power generation needs to fall 10-15% in 2017-18, relative to 2016 levels, to keep the market balanced, driving prices higher."

Morgan Stanley further estimates that for each 100 basis point increase in interest rates, the capacity revenue requirement for new-build gas-fired projects in PJM lifts by roughly $15/MW-day, enough to drain some of the investor fervor around financing those projects in the coming year.

Investors have responded favorably to electric retail platforms, according to UBS analysts, who suggested that a recent debt raise initiated by Vistra Energy Corp. has provided comparables that may indicate retail platforms owned by incumbent merchant names, as well as Exelon Corp., are providing uplift on the stocks.

Still, UBS suggested that the retail sector may be hitting the top of its cycle, but it did suggest certain names, including Calpine, Exelon and Public Service Enterprise Group Inc., that could still be in the market to boost their retail units.

"Amidst the question of what multiple to put on this business, we emphasize we are likely nearing the top of the cycle on this business," UBS said Dec. 14.