Great News! Long-Term Contracts Jeopardized

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Dow Jones Newswires

NEW YORK (Dow Jones)–Those looking for even the slightest bit of good news for the state of California can find it in Friday’s San Jose Mercury News.

“California is in danger of losing more than 40% of the power it has lined up in long-term contracts,” says the lead of a major article, because Republicans in the state legislature didn’t back the $12.5 billion bond deal last week. Getting out of most of those contracts would be the best thing to happen to California in a long time.

Since the state went on its long-term buying binge, forward prices for power in the western U.S. have been falling steadily. Gov. Gray Davis announced $43 billion in purchases lasting up to 20 years on March 5. Contracts for summer power at Palo Verde, Ariz., a key western trading hub that feeds a lot of power into California, have fallen to $390 a megawatt-hour from a high of $600/MWh in late March. Further out, power for 2004-2006 at mid-Columbia River, a key trading hub north of California, has fallen from $58/MWh in February to $49/MWh today.

Companies like Calpine Corp. (CPN) and Dynegy (DYN) that took advantage of the state’s buying binge are looking pretty fat and happy. In fact, they have affectionately started calling the governor Gravy Days. Enron Corp. (ENE), which has been selling aggressively for two months, according to traders, is looking like a genius as usual. Generators that held out, like Reliant Energy (REI) and Duke Energy (DUK), may be sorry that they did.

It’s been a long time since those long on western power have felt serious pain in the markets, but that time has come. Power generators may not make as much profit this summer as last, and power traders that have taken long speculative positions may liquidate supplies for far less than they bought them. As was seen in the eastern U.S. power markets last summer, long positions can turn out just as painful as short positions.

For California, the good news is that maybe spot purchasing costs this summer won’t be as bad as once expected. The bad news is that the state government is by far the biggest “long” in the bearish forward market. It’s safe to say that the $43 billion in contracts signed in March have declined in value by 15%, or $6.5 billion. That’s almost as big of a financial disaster going forward as everything that has gone on since last summer until now.

Granted, this is a sort of damned-if-you-do-damned-if-you-don’t situation. Barring the utilities from the forward market during the first three years of deregulation was one of the most expensive public policy mistakes in U.S. history. California should do some forward purchasing now, and it’s such a behemoth that it will move the market up when it does so. And, when it gets done buying, prices will come down simply because it stopped.

But that’s a footnote to the mismanagement of the financial side of the energy crisis. Early this year, when the state started down the path of mega-purchasing, there was no shortage of advice not to do so. Long-term prices were embedded with too much of today’s supply-demand imbalance. The state would have been much better off dealing with the imbalance first – since it would have to do that anyway – and gradually securing forward power as declining prices reflected the improving situation.

Since then, the state has done a great job of crushing demand. Electric usage is already down 9% from where it was expected to be thanks to a conservation efforts and a slowing economy, and people haven’t even seen their 30% higher bills yet. Similar reduction has been seen in power consumption in other western states and in natural gas usage nationally. This is likely what has been behind much of the downturn in forward power prices in the West.

This column started with a false “good news” lead. It would be great for the state if, after the state’s credit rating sinks further, sellers exercised their option to tear up the five- and ten-year contracts. But they won’t do that.

The prices are too good from the sellers’ perspective. Calpine, which has signed three such contracts for the state, said immediately that it has no intention of reneging on its agreements. And Gary Ackerman, director of the sellers’ association, told the Mercury News that he didn’t expect power companies in general to back out of the deals.

But there may be some real good news for California. The Davis administration hired dozens of people that have little or no experience in energy trading to purchase billions of dollars of power. Perhaps they are quick learners. This week presented an excellent opportunity for the state to pick up what it needs – summer power for this year only – on sale. Low prices in the daily market Monday and Tuesday drove the summer contract prices down to $325/MWh, which is cheap by recent standards. The contract price moved up to $390/MWh, but the state took advantage of the opportunity while the window was open.

“The week’s condition in the market place helped. We were able to procure some energy for June through September,” said state spokesman Oscar Hidalgo.

And, hey, there were no blackouts this week.

-By Mark Golden, Dow Jones Newswires; 201-938-4604;

[email protected]

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