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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

the US gas and power market over next few years. ()

Below, we provide a brief overview of the current position of the U.S. gas and power sector, and then go on to suggest a few critical uncertainties that may tilt industry evolution one way or the other. As we'll see, perhaps the most critical question facing the industry is whether stable markets will exist at intermediate points in the value chain, or whether the assets will migrate inexorably toward vertically integrated firms which will coordinate supplies internally.

What We See Today

The $200 billion wholesale gas and electricity industry continues to "unbundle" and "rebundle" in novel ways, driven by regulatory mandate as well as economics. And convergence of the gas and power value chains is one of the most obvious patterns emerging.

  • The principal growth market for natural gas is electric power generation.
  • Essentially all planned incremental generation capacity is gas-fired.
  • The share of gas-fired generation produced by competitive merchants (as opposed to franchised utilities) rose from 30 percent in 1990 to 53 percent in 2000, while utilities still produced 88 percent of power from all other fuel sources.
  • Power generation accounts for more than 50 percent of summer gas demand.
  • In many regions, natural gas prices set power prices.
  • Given the informational benefits enjoyed by playing in both gas and power markets, as well as economies in sharing systems and talent, there is a 70 percent overlap between the largest wholesale marketers of gas and electricity.
  • Nearly all energy retailers also are leveraging economies of scope between power and gas in marketing, billing, and some field operations.

Industry leaders have positioned their firms for success in this market in part by engineering a series of strategic transactions. Most notable are deals where a big midstream gas player joined a large power generator (e.g., Duke/Pan Energy; Houston Industries/NorAm; Dynegy/ Destec/Illinova). In general, the objective of these deals was to transfer the merchant capabilities developed in the natural gas sector to the much larger but still deregulating electric sector.

Tipping the Balance:
Issues Affecting Industry Structure and Value

As players ponder their next move, they find relatively little vertical integration between the gas and power sectors in place, but the future efficiency of the critical wholesale markets that link the value chain segments is in some doubt. Which way will the market evolve from here? We believe the next several months will be critical, and would suggest staying focused on a few key factors.

Indicator 1

Will large merchants weather the storm? Important signs of their prospects will be whether merchants retain investment grade credits and resume execution of basic strategies (e.g., whether Reliant Resources can close its Orion acquisition and complete its separation from its utility parent).

 

Impact

Favors rise of "Seven Sisters" scenario. If the merchants are substantially weakened, their assets and businesses may well be purchased by oil and gas majors or by European mega-utilities, already trolling for bargains. Furthermore, as important market makers and traders, their diminution will reduce the liquidity and thus effectiveness of the wholesale