Merchant Power: When Hedging and Profits Collide


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

Fortnightly Magazine - June 2006

Why do energy merchants or those utilities with merchant power divisions obsess over “selling” their upside? These companies feel compelled to show steady, predictable profit streams to both the street and their stakeholders, despite the fact that they operate within one of the most volatile markets in the world. Typically, their method of achieving earnings consistency centers on the execution of complicated purchase and sales agreements that effectively lock in the price of fuel and electricity.

Don’t these contracts really just eliminate the potential positive return an energy merchant strives to achieve in the first place?

The business practice of limiting market risk runs counter to most other resource industries where investors strive to buy and sell the market risk of the underlying commodities around which the entity operates. For example, the typical gold-company investor buys equity in the company to achieve a market exposure to the price of gold as a hedge against inflation, or possibly as a speculative move to take advantage of the expected increase in gold prices. This investor would be unhappy to discover that the investment locked in the sales price of gold over the next few years, effectively nullifying the investment objectives. Gold companies that have tried this “lock-in” strategy in the past have scrambled to exit their hedges ever since gold prices started trending upward.

The Gold Standard

The bottom line is that investors in gold companies want gold exposure. The objective of taking advantage of an efficient, cost-effective gold production process runs a distant second.

Oil companies present another parallel. These global giants cannot possibly hedge the size of their market risk exposure even if they wanted to. But given their hefty profits, why would they? Just as investors in gold want to reap the benefit of increased gold prices, investors in oil companies want to realize the benefit of increased oil prices. Forget about mitigating exposure through hedging; this simply confuses the situation.

Now, consider the typical electricity generating company or energy merchant. This commodity-based business operates quite similarly to those mentioned above. These firms produce natural resources that trade within markets that are becoming more and more liquid. Yet for some reason, energy merchants eliminate as much market risk as possible through the use of both short- and long-term purchase and sale contracts. These agreements often take the form of extremely complex derivative financial instruments.

The typical equity analyst struggles to understand the underlying value drivers of such a business model given the information available to the public. Disclosures are plentiful when it comes to a company’s portfolio of generation units, retail load, or any other native energy exposure. However, information remains opaque, at best, when it comes to any long- or short-term purchase and sales contracts executed around these positions. 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 could generate profits far exceeding the current cost-of-capital requirements.

The key to intelligent financial analysis of an energy merchant is evaluating the impact of these three variables: expected EBITDA, upside, and risk.

The Impact of Risk Management

Within the energy industry, Calpine is not considered an aggressive energy trader. Many other energy merchants possess large trading floors with hundreds of traders and thousands of positions. Yet Calpine’s contract portfolio is made up of 145 positions intended to reduce the risk of its portfolio of plants by locking in a stream of cash flows regardless of the market prices of power and gas. These contracts are long-term in nature (a weighted average of 7 years) and can be quite complicated in structure. Recent disclosures indicate that Calpine has contractually “sold” 31 percent of its future base-load generation and 63 percent of its peakers over the coming five years for $6.3 billion. Table 2 provides a summary of the generation percentages sold over the next five years.

Naturally, this activity reduces the EBITDA distribution native to the business. In other words, Calpine has traded a set of uncertain cash flows for $6.3 billion in contractual cash flows. These “locked-in” positions thus have increased Calpine’s expected net revenue and reduced the market risk of the corresponding distributions.

On the other hand, these positions also have reduced the potential financial upside of the business. Because Calpine has locked in guaranteed returns today, it will not be able to reap the benefits of any extreme power price spikes that could occur in the future on the generation covered by these contracts. Figure 3 demonstrates the monthly financial impact of these contracts.

The primary question Calpine’s stakeholders (investors and management) will need to answer is whether or not the company’s increase in expected EBITDA plus its reduction in risk will be worth more than the foregone amount of above-market return opportunities given away.

Unfortunately, the answer to this question differs depending on what kind of stakeholder one is, and this creates a conflict of interests that must be considered during the bankruptcy reorganization process. Typically, management will pursue as much upside as possible, as long as it avoids financial distress (management failed in this case). One might argue that a better strategy would have been to pursue merchant generation without long-term contracting in order to benefit from any and all market spikes.

On the other hand, unsecured debt holders typically want to contract out as much as possible to increase the probability that their debt interest is paid. Secured debt holders, however, may be less concerned given their more advantageous place in line. They will be indifferent to the upside opportunity (as above-market returns will benefit mainly equity stakeholders), but there also exists a high probability that their investment will be covered in all cases.

Equity holders also will want to insist on eliminating all contracts to maximize their upside opportunities.

Comparing the cumulative distribution function (CDF) of the business both with and without the contracts in relation to interest costs better illuminates the decision management should make. Consider the 2006 portion of the forecast: Figure 4 (see p. 34) illustrates the CDF for EBITDA without the contracts (bottom line) and the EBITDA with the contracts (middle line). In almost all of the scenarios, EBITDA falls well short of the interest expense. In addition, the business plan that includes the contracts generates superior EBITDA in all but the most positive market conditions. The key message here is that business is bad no matter what contracts are in place, but the contracts do help in a significant way.

A similar examination of 2007 through 2010 begins to paint a different picture. There exists a clear tradeoff between the probability of Calpine falling short of the interest requirements versus the amount of upside Calpine has traded away through risk management.

These concepts can be broken down into a tabular comparison to improve the clarity of a stakeholder’s choice. Table 3 lists the probability of EBITDA falling short of interest costs and the 95 percent best-case EBITDA (representing the potential above-market return opportunities) for both the uncontracted business and the business with contracts.

Using 2008 as an example, there is a 63 percent chance that the business without the contracts will fall short of interest costs. This probability drops to 46 percent (17 percent lower) with the contracts in place. One can balance that against a forecasted upside of $4.5 billion from an uncontracted business to an EBITDA of $4 billion when the contracts are in place. In other words, all stakeholders, whether they own equity or debt, should be asking themselves, “Is the 17 percent improvement in the probability of meeting interest payments worth a $504 million reduction in upside earnings?”

The answer differs depending on whether one is management or an investor in equity, secured debt, second lien debt, or unsecured debt. How will the bankruptcy process address this balance?

This article raises some interesting inconsistencies in investing in electricity merchants compared with other resource industries. It attempts to show that risk-management activities can have a material impact on the native business model currently in place. Deregulation continues to move forward in fits and starts. Over time, energy merchants should become less constrained from existing regulation and oversight. When this happens, both investors and company managers will need to understand the risk management choices available to them. Most likely, the key will be aligning the company’s chosen strategy with the predominant stakeholders, whether those stakeholders are management, debt holders, or equity holders.

Regardless of these trends, avoidance of financial distress always will be an important baseline requirement. The above analysis should provide some insight into avoiding such disasters in the future.



1. Figure 2 is generated using a Monte Carlo simulation engine that simulates market prices for power and gas at an hourly level of granularity. These prices then are input into a generation dispatch model that considers the plant’s heat rate, capacity, start-up and shut-down constraints, probability of forced outage, and various operation costs. This model generates a large number of operating scenarios based on the simulated market prices and the plant’s operations. The output includes operating margins and EBITDA. For example, 1,000 market scenarios generate 1,000 different EBITDA amounts for any given month.