With energy innovation growing as a percentage of overall venture capital activity, investors are placing bets on which technologies will emerge as the big winners.
The Electric and Gas Industries are Converging: What Does it Mean?
250 million cubic feet per day (MMcfd) of deliveries) face two dominant strategic issues. First, they cannot rely on rising commodity prices to improve the generally disappointing return on capital they have realized in the past 10 years, because competition may keep real prices at the wellhead flat or falling (from the 1994 annual level) for many years. Second, they cannot afford to be excluded from the convergence of gas and electric supply.
Most large-volume gas producers have not made a return on total U.S. E&P capital that averaged 11 to 12 percent per annum over the 10-year period between 1984 to 1994 (since the modern gas market arose). Very large-volume (more than 500 MMcfd of deliveries) producers are unlikely to have averaged even a 10-percent return over the same period. There is little prospect that the large producers as a whole can do better over the next 10 years unless they change their strategy from commodity gas production to gas-electric "manufacturing" (GEM) and gradually become gas-electric manufacturing companies (GEMCOs). Merchant gas-fired generating plants could produce an average return on capital in the low teens, after tax, over the foreseeable investment horizon. Niche plants could produce a return in the middle or even high teens, depending on location. Niche generation is not for large producers but merchant generation is. Integrating forward into merchant generation and wholesale power marketing can boost the mar- ginal return on capital for large producers, including the majors, appreciably. Niche generation can also be desirable for medium-sized producers (at least 75 MMcfd in production).
The economic imperative for medium-sized independents or subsidiaries of diversified energy companies and financial houses to integrate into niche generation, and for large producers to integrate forward into merchant and dedicated power generation (through both grass-roots construction and the acquisition of generating assets from the rate bases of utilities), will drive the gradual development of combined gas and electric supply companies or GEMCOs. In time, GEMCOs will broaden their fuel mix and asset base by acquiring other fossil energy (oil, coal) generating assets from rate bases, or by acquiring independent power (IPP) and cogeneration companies or unregulated utility affiliates now in the IPP/cogeneration business. Reverse transactions are also likely with spun off fossil energy generating companies of electric utilities integrating backward by buying a large IPP or the regional E&P division of a major. GEMCOs, anchored by gas reserves and gas turbines, may well have North American assets of $10 to $25 billion each when the integrated gas/electric supply industry finally evolves.
FOOD FOR THOUGHT
Since this article began as a thought experiment, it should close with questions, not answers:
s Influence. Which companies or regulators will embrace convergence; which will oppose it? Which side can wield enough power to get its way?
s Finance. What will convergence mean for balance sheets, credit quality, and equity formation at energy companies? And how will it affect the pace at which assets are transferred from rate base functions to market activities? What happens to nuclear plants?
s Efficiency. Will companies capture sufficient economies to win big