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Merchant Power: When Hedging and Profits Collide

Does too much risk management mean leaving money on the table?

Fortnightly Magazine - June 2006

Effectively, these contracts reduce the upside potential of a firm’s profits simply to improve the predictability of year-end and quarterly results. Equity investors would want a company to retain this exposure because it is the defining reason why they will realize any excess returns.

Case Study: Calpine Corp.

To illustrate this point, look at Calpine Corp., a typical merchant generation company that recently filed for bankruptcy protection. Calpine produces gas and geothermal electricity across North America. Disclosure remains at a premium because of its recent bankruptcy filing. Yet this information, along with some Monte Carlo simulation models, will help to illustrate the impact of contracting out this power generation on the upside financial opportunities that exist in this business.

Figure 1 (see p. 32) shows that the majority of Calpine’s generation is located in the western United States and in Texas. It has more than 70 operating gas plants, 19 geothermal plants, and another 8 plants under construction. In total, it has more than 21,000 MW of base-load capacity and another 5,000 MW in peaking capacity. Historically, this portfolio has generated annual operating margins in the $1 billion range (see Table 1). Unfortunately, interest charges on some $18 billion in debt have consumed these profits.

During bankruptcy proceedings such as Calpine’s, the creditor’s influence arguably is predominant, whereas the equity investor, being last in line, must settle for whatever outcome results from the strategies used by the debt holders. With respect to Calpine, the above argument likely will run true. Most of Calpine’s expansion has been driven by debt, due to an industrywide energy slump that has not allowed the company to use equity to fund its growth over the last five years.

Two Scenarios

Let’s look at what the company could do from an earning before interest, taxes, depreciation, and amortization (EBITDA) perspective over the next five years under two different risk-management strategies.

Figure 2 compares Calpine’s monthly EBITDA distributions from 2006 through 2010 to the company’s interest expense, assuming no bankruptcy protection or restructuring. 1 This figure provides insight into the degree of financial distress the company is incurring. Four lines are presented in this figure. The top line (pink in color) represents the 95 percent best scenario for each month; the yellow, or middle jagged line, represents the average or expected EBITDA; the blue line (bottom) represents the 5 percent worst performance each month; and the red line represents the average monthly interest expense. The distance between the two top jagged lines represents the upside potential of this business. The distance between the two bottom jagged lines shows the ongoing risk of the business. These lines and the area in between them illustrate the different risk/reward nature of Calpine’s profits.

Additionally, Figure 2 illustrates the seasonal nature of an energy merchant’s profitability. Each summer, price spikes and profitability increase. Long-term trends increase as well, given current market forecasts. EBITDA levels at the beginning of the forecast period are below zero. They eventually increase enough nearly to cover annual interest costs. Furthermore, the simulation results indicate that the upside potential