June 1 , 2002
Vertical Integration: Necessity or Distraction?
the prevalence of combined gas and power positions in the trading and retail markets, vertical integration is still relatively low in the industry. By our estimate, well over 80 percent of gas production is in firms with no presence in gas midstream or power generation, and more than 80 percent of gas fired generation is owned by firms that have no upstream assets. Instead, the thrust of strategic activity has been horizontal consolidation. Interstate gas transmission is concentrated among a small handful of firms, and the upstream-while still fragmented-has seen an avalanche of M&A activity. The downstream power industry has been slower to consolidate, in part because the size of the merchant industry has expanded as utilities divest assets, and because capacity shortages have encouraged substantial greenfield development activity.
Lacking vertical integration, the industry increasingly depends on markets to coordinate supplies across the chain. In our view, the gas market has approached efficiency, as evidenced by stable basis differentials (apart from the impact of a pipeline explosion in California). Fuel substitutes, voluntary curtailments and storage combine to clear the market. However, the 2000-2001 price spikes and bullish demand forecasts raise some concern as to whether the gas market will change. Conventional gas supply has proven stubbornly unresponsive to wellhead prices, suggesting that sustained demand growth will likely be met only with non-conventional sources (e.g., Arctic, LNG). And as power generation fills in the summer "trough" in gas demand, transmission and storage infrastructure will become strained.
Electricity markets are currently far less efficient. The squeeze between fixed retail prices and a volatile wholesale price faced by marketers in California and other regions is well known. The lack of real price signals to end-users and the impracticality of significant power storage make demand unresponsive to price changes in the short run, creating risky exposure for power retailers. And in tight power markets, even modest changes in demand or supply can result in massive price swings. Physical transmission constraints and faulty price signals for transmission capacity allocation further compound the difficulties of hedging positions downstream of the gas markets, creating even more thinly traded and volatile micro-markets within regions. The result could be the wildly volatile markets of the past couple of years (). Consequently, marketers or generators can capture extraordinary profits, at the expense of retailers and customers.
Many of the industry's leading players are already beginning to place their bets on strategies that assume either or will be critical for success in the coming years. One lesson we would offer from other industries that have undergone the type of fundamental change witnessed by gas and power over the past few years is that the greatest risk of all often is failing to make a strategic choice-based on a clear-eyed understanding of the underlying economic preconditions for its success-rather than making the "wrong" one.
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