Auvila Flash (05/30/2018): FERC/DOJ support IL nuclear subsidies; Favor EXC in overall long IPP strategy

Contrary to what we thought would happen, the FERC and the DOJ filed a (amicus) brief with the 7th Circuit of the US Court of Appeals in support of IL’s Zero Emissions Credits or ZECs
In the brief, attorneys for the FERC and DOJ argued that unlike the MD program that was struck down by courts, the ZECs do not require nuclear plants in IL to participate in MISO and PJM capacity markets
This is in contrast to the MD program …

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2018 Industry Update: Economic growth should favor commodities-driven businesses in 2018

Warmer than normal winter:
Weak gas prices:
However, 4Q2017 and 1Q2018 power gross profit could be better than expectations:
Similarly, we’d expect natural gas infrastructure businesses to perform well for 4Q2017 and 1Q2018:
We expect economic growth to surpass 4% for 2018:
Strong economic performance should lead to strong power sector performance:
Commensurately, we expect natural gas infrastructure businesses to perform well:
Adjusted for seasonality, we expect natural gas prices to creep up throughout 2018 and, given normal weather, we’d expect natural gas prices to average at or just below $3.50 for 2018 with an exit price of some $3.65-$3.75:
Conclusion: Going into 2018, we believe that natural gas prices will stage a moderate recovery, but power margins should do better benefiting from accelerating economic activity. Individually, we continue to like… . However, the real star may be … . Among the utility names, we like … due to their growth prospects. We also look for … to outperform as … .

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GOP Tax Bill is win for utilities, power, infrastructure, and customers

GOP Tax Bill (GOPTB) looks to be positive for industries and companies in our coverage universe
Key aspects of GOPTB that affect our coverage industries and companies include, but not limited to:
21% corporate tax rate would be expected to reduce deferred income tax liability by some 40%
Interest expense deductibility capped at 30% of EBITDA for 2018-2021 and to 30% of EBIT after
100% investment deduction, except for utilities that would continue to deduct 100% interest
Preservation of existing investment tax credits (ITC) and production tax credits (PTC)
Repatriation of profits tax at 15.5% for cash and equivalent and 8% for non-liquid assets
Base-erosion & Anti-abuse Tax (BEAT) not impactful: If payments to foreign affiliates are 3% or more of a large company’s tax deductions then BEAT is imposed. We do not view this as relevant to companies that we cover, given 100% of PTC would be allowed to offset up to 80% of BEAT
AES Corp. faces large disqualification of interest expense deductibility but given its $3.7B in NOLs, we do not believe this to be an immediate issue; AES has time to remedy the situation:
NRG Energy shouldn’t have any issues with interest expense deductibility:
Exelon Corp. isn’t expected to have any problems with interest expense deductibility:
Cheniere Energy, oddly enough, shouldn’t have any problems with interest expense deductibility:
BKH, CNP, DUK, EIX, PCG, PNM, SRE should not have any issues with interest expense deductibility but may be able to use 100% investment deductibility to create win-win:
We note that the inability to deduct interest expense is limited to $0.21/$1 of lost deductibility
Loss of interest expense deduction could lead to some unexpected corporate behavior

Conclusion: Net effect of GOPTB looks to be positive, more so if utility holding companies are permitted to use non-utility subs to take advantage of the 100% capital investment deduction

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Our Expectations for 2H2017 is Better than would be Expected


Soft winter weather (warmer than normal) has not helped natural gas prices currently, nor the prospect for strong natural gas prices in 2H2017
However, due to declining production, storage levels have continued to remain below record levels seen last year


There was an article in the Central Daily News Agency (CDNA) of South Korea that predicted a large shortage of global LNG supply by some 2024 that would have a strong impact on pricing

In a related article, the CDNA is contending that India is set to renegotiate its contract with Cheniere Energy (LNG), also due to high pricing


Given our natural gas outlook, it is natural that investors may think that our view on the power sector is negative; however, it is not, particularly given the developments at NRG Energy
We believe that the power sector is at the cusp of another paradigm shift in which unprofitable assets finally exit stage left (or right, we don’t care which as long as they do)


We believe that the flight to safety is over and a general migration towards a “risk-on” portfolio started in 1Q2017, which we expect to continue into 2018
Also, we expect interest rates to continue rising, which isn’t going to do any favors for the utility and infrastructure sectors in terms funding costs and comparative investment profile relative to fixed income instruments

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Power Company Privatization will Lead to Unintended Consequences

Lately there has been talk about privatizing power companies, including both CPN and NRG, and while we believe that the most rational course for these companies may be to go private – given the lack of “enthusiasm” for these names in the public markets – we are certain that the end result will not be either what the market expects nor what the regulators, politicians and, most of all, what the consumers desire
The assumptions we are making in our analysis are as follows:
Private equity (PE) investors are not unintelligent and will act in their own self-interest
Virtually all of the market (public and private) believe in the theory of “all else being equal”
Market forces move along least resistant path absent paradigm shift, typically externally imposed
As reserve margins dip below 12% market prices become more volatile and margins begin to expand at an accelerated rate
PE investors will be betting on the reduction of debt from internally generated free cash flow and asset sales, supplemented by cost reductions, to increase the equity value of its investments with the option value of changing market dynamics to further boost its rate of return
The first thing that PE investors are likely to do is to make the assumption that the underlying market forces and conditions don’t/can’t/won’t change for the foreseeable future
Based on these underlying assumption, PE investors will be able to figure out which plants they buy will remain profitable, which won’t and which are on the margin

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Supreme Court Stays Implementation of the Clean Power Plan; a New Plan May Already Be in the Works

On February 9, 2016, the Supreme Court of the US (SCOTUS), in a 5-4 verdict, stayed the implementation of the Clean Power Plan (CPP) until the DC Circuit Court could review the plan.

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The Myriad of Changes Are not Challenges, but Rather Opportunities

First time in almost 15 years, the electricity industry is facing rapid changes. Not since the separation of generation from transmission and distribution (T&D) businesses has the industry faced so many changes. Some of these include renewable portfolio standards (RPS), greenhouse gas (GHG) regulations, other regulatory and legislative changes, and the proliferation of distributed generation, energy storage, smart meters and smart grids, electric vehicles, and renewable power. Many view these changes as challenges and hurdles, but we believe that these changes should not be viewed as challenges, but opportunities, particularly for the utility sector and conditionally for the independent power producers (IPP).

Some of the more difficult issues involve RPS, and GHG regulations on the regulatory/legal side and the proliferation of distributed generation, renewable power, energy storage and electric vehicles from a commercial viewpoint. Many of these issues are interrelated and entangled and one change cannot be properly accommodated without integrating another change properly. From a high level, we believe that challenges encompassing these changes are as follows:

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Barring abnormal weather, we expect stronger commodity prices

• As expected, due to mild weather, gas prices dipped below $3/MMBTU and continues to languish
• However, the strange turn in March weather has alleviated the downward pressure on gas prices
• Our forward-looking forecast on commodity prices does not consider the possibility of additional strange weather patterns occurring, i.e., we assume normal weather for the rest of 2017
• We believe that two factors will contribute to higher demand that will drive gas prices up in 2017 and 2018, which would keep gas prices mean-reverting above $3.50/MMBTU levels, in our view:
o Higher economic growth conditioned on reductions in both corporate and personal tax rates, and
o Accelerating liquefied natural gas (LNG) exports
• We believe that higher economic growth should eclipse the approximately 1.9% growth in supply (some 1.4BCF/Day) in 2017 projected by the EIA
o Our optimism wouldn’t be warranted under the economic environment of the last 6 years or so, which saw annual average economic growth of just above some 1.5%
o Our optimism is based on the expected accelerating economic activity brought on by the expectant reduction in corporate tax rates and enhanced by an expectant cut in personal income tax rates as well; we believe that these new economic and tax policies will create a positive virtuous economic cycle that would propel GDP growth beyond 3%, which should quickly absorb a 1.9% growth in natural gas supply, in our opinion

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