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Vertical Integration: Necessity or Distraction?

An analysis of the latest wave of unbundling, re-bundling, and convergence plays in the gas-power industries.
Fortnightly Magazine - April 15 2002

An analysis of the latest wave of unbundling, re-bundling, and convergence plays in the gas-power industries.

The New Year brought turmoil to the merchant energy markets. The Enron bankruptcy, coming on the heels of the Sept. 11 tragedy, has sent a chill through the industry. The debt markets are scrutinizing the quality of earnings and mark-to-market accounting, while the equity markets have simply turned and run. Since June 30, 2001, the market capitalization of six large merchants not named Enron has fallen from $85 billion to $45 billion. At these prices, well-capitalized upstream players (e.g., BP, Shell and ExxonMobil), or the acquisitive European mega-players (RWE, E.On, EdF, Endesa, etc.), may be tempted to simply add a business line to their portfolios, via a distress sale.

More fundamentally, in light of the California market meltdown and the Enron debacle, some industry observers are questioning the orthodox view of progressive market liberalization and unbundling. Rather than relying on fragile, opaque, and complex wholesale and financial markets to allocate energy, perhaps the future really belongs to a new breed of vertically integrated energy players. Some argue that only companies with direct access to gas supply and generation assets-as well as rock-solid balance sheets-will be able to weather the coming storms of cyclical and volatile energy markets, while providing the reliability and rate stability the public demands. They also point to integrated players such as AEP and PSEG whose share prices well have withstood the recent flurry of bad news compared to those of the more "pure play" energy merchants.

This issue of the appropriate degree of vertical integration certainly isn't unique to merchant energy. In any industry, companies must choose a portfolio of assets and businesses to own along a value chain. In doing so, they make an implicit trade-off between the benefits of and (providing proprietary access to supply or customers). In the petroleum industry, for example, the emphasis was on the latter until the past few decades, largely due to the need to ensure markets and supplies for very large, irreversible investments in new infrastructure.

Factors such as security of supply, counter-party risk, or simply the inability to fully hedge long or short positions can provide integrated players major advantages relative to their competitors. However, as the physical infrastructure matures, and well-functioning markets emerge and provide the requisite supply or outlet for their projects, companies often substitute paper contracts for hard assets. Winners in this world tailor their business models to the special requirements of a particular value chain segment, out-competing less focused players for customers and capital.

So which will it be in gas and power? Even before the Enron episode, we detected a subtle but important shift in the strategic activity within the industry. In 2001, mergers and other transactions drifted toward deals with an explicit goal of vertical integration. Calpine, Williams, and Dominion each cited security of gas supply and risk reduction as a strategic rationale for the acquisitions of EnCal, Barrett, and Louis Dreyfus. Was this a harbinger of things to come? We see two basic potential scenarios for