Trillions of dollars lost in stock declines. Spooked investors fleeing markets. Historic investment banks closing doors. Hundreds of billions in government bailouts. Credit unavailable for borrowers in need. Fears of a new great depression. We’ve all read the headlines. But how will the financial crisis impact the natural gas and electricity industries? Is it all bad news – or is there a silver lining? Our guess is some of both, but that times are better for energy than for most industries. In fact, some energy companies are well positioned to use the downturn to grow market share and benefit greatly from the next round of growth. Let’s take a look at how the crisis may impact various key sectors as well as environmental initiatives such as climate change policy and renewable energy development.

Gas and Electric Utilities and Pipelines

Utilities and pipelines are typically highly capital-intensive, requiring large amounts of short-term borrowing to provide working capital to keep gas and electricity flowing, as well as substantial equity and borrowing to build new infrastructure. The utility industry is currently undergoing a wave of new infrastructure investment. But while capital needs expand, an economic downturn will likely result in falling sales coupled with rising interest rates. At the same time, utilities will likely feel significant pressure from regulators to hold down rate increases, perhaps squeezing earnings. Sound like a recipe for disaster? Indeed, the Dow Jones Utility Average has fallen significantly further than the Composite Average this year, bottoming out at a full 40% below the January 2008 index value. (See chart below)

But things may not be so dire. Everyone still needs gas and power, albeit a bit less in uncertain times. Most utilities are considered a safe investment. In fact, the two largest bond rating agencies, Moody’s and Standard and Poors, have both independently reported that the outlook is stable for utilities. Both expect that utilities will have adequate liquidity and will be able to refinance debt as it expires. For investors worried about markets and looking for a safe place to put their money, utilities with an authorized return in the range of 10 to 12% are suddenly a very attractive investment. Especially utilities that pay stable dividends. So we would expect that utility stock prices will improve more quickly than other sectors. And once credit markets rebound, utilities will be an attractive place to lend money. In the meantime, well financed U.S. or foreign utilities may see this as an opportunity to expand through acquisition at bargain prices. We have already seen Warren Buffet’s MidAmerican Holdings recent purchase of Constellation after its dramatic stock decline following the collapse of Lehmann Brothers and subsequent loss of a large credit line. And more may be in store.

A concern remains over where the investment will come to build needed infrastructure such as pipelines, smart grids, transmission lines, and power plants. In an economic downturn and with many large investors short on cash, will there be enough investment to get infrastructure built? In the short term, utilities may cut back on all but the most critical investments. But our infrastructure problems won’t go away, and governments may see utility building as a good place to generate new economic activity. So we may see regulators encouraging utility investment in infrastructure. Once this occurs, investors will see utilities as a safe and attractive place to put their money.

Merchant Generation

Like the utility sector, the merchant generation sector is also highly capital-intensive. The major difference is that merchant generators don’t have the protection of ratebase treatment. When utilities build projects that are approved by regulators, they typically then get to recover their costs plus profits in rates. But merchant generators recover costs and make profits only if their projects can sign profitable power purchase agreements or sell output profitably in spot markets. Thus, given the higher levels of risk, it is more difficult for this sector to obtain credit, which may result in declining growth. Shares in energy companies with a large presence in merchant generation such as Calpine, Mirant, NRG, Dynegy, and Exelon have fallen on average by almost 50% since the beginning of the year. (See chart above)

But again, all is not necessarily bleak. A lack of available credit for new construction boosts the value of existing generation, especially since many markets are already tight on capacity. And falling natural gas prices have boosted the value of the many gas fired-units in the merchant generators fleets. The result may be a significant opportunity for mergers and acquisitions. Just recently we saw Exelon make a $6.2 billion offer to acquire NRG Energy. Companies that survive the temporary difficulties may be able to pick up valuable assets at low prices and will be well poised for future growth.

Gas Exploration and Production

Exploration and production (E&P) is yet another capital-intensive energy sector. E&P firms must borrow large sums upfront to fund finding and drilling for new gas supplies. But payouts come years later as the gas is produced and sold into the market. In recent years, drilling has been robust, driven by high natural gas prices and easy credit. And this drilling has been successful – the U.S. entered 2008 with the highest level of proven gas reserves in thirty-one years. But now the market looks less bullish. Driven by plentiful supplies, fears of shrinking demand, and commodity index investors fleeing the market, physical spot prices at Henry Hub have fallen from over $13/MMBtu in mid-July to close to $6 in late October. (See chart below) Futures prices have seen a similar decline. This means a lot less revenue for existing production and difficulty in obtaining credit to continue drilling. Many gas companies are reporting plans to slash drilling budgets by 30% or more going into 2009.

So how will this impact the E&P sector? Again, consolidation is likely with larger more liquid firms buying up smaller ones to obtain reserves on the cheap. And lower investment in E&P probably means that in a couple of years we can once again prepare ourselves for concerns that gas supplies are getting tight followed by an inevitable run-up in gas prices.

Energy Trading and Marketing

Energy trading and marketing have perhaps been the most affected of the sectors. Many in the business see history repeating itself as the loss of key players such as Bear Sterns and Lehman Brothers is reminiscent of the fall of Enron, Dynegy and numerous other marketing companies in 2001/2002. Like then, physical buyers and sellers have found their list of creditworthy counterparties slashed as many key players no longer have the credit necessary to keep trading. And those with deals with Lehman Brothers find themselves holding the bag, and returning to the markets for replacement deals.

In the near term, we are likely to see more traders leaving the market. But producers still need to find customers, and load-serving entities and consumers still need to buy supply. And just as it did in the years following 2002, trading will come back. The traditional banks as well as the reconfigured Goldman Sachs and Morgan Stanley will likely grow their presence perhaps along with sovereign wealth funds from foreign countries that hold significant cash reserves.

On the retail marketing side, changes are also likely in store. We have already seen the exit of some marketers due to loss of credit lines, especially those that were closely tied to failed or struggling trading companies. An example is Catalyst, a gas marketer in Georgia that had to close down after Constellation/Lehman Brothers could no longer provide gas supply or financial credit. Reliant is another example. Its credit lines, provided by Merrill Lynch, were closed after Merrill Lynch was acquired by Bank of America. This was followed by a significant drop in sales volumes after Hurricane Ike, and the untimely sale of expensive power at a loss during a cool August. The result has been a need for cash, the low-price sale of a portion of the company to the private equity firm First Reserve, and a reported three-fold increase in financing costs. We again expect to see the stronger and larger firms snapping up smaller firms with the result being a few large retail marketers dominating most markets.

Energy and the Environment

And just how will the crisis impact two key trends in the energy business – the movement to carbon regulation and the growth of renewable energy? Will concerns over financial issues become paramount, resulting in politicians and regulators setting aside environmental concerns? The answer remains to be seen. Some renewable projects apparently have had promised funding pulled in the last few weeks. And some pundits have already begun to suggest that in a world rocked by financial problems the last thing we can afford is new carbon regulation that would raise electricity prices. But a counter argument has already begun to be heard. Many believe that the new Obama administration, may see energy efficiency, renewables, and advanced cleaner traditional fuel technologies as a road to create new jobs and boost the economy with an eye towards future sustainable growth. And at least early indications are that Obama will move quickly to pursue carbon regulation and other environmental initiatives which could include a national renewable portfolio standard.

So What Does It All Mean?

Once the markets settle a bit, the financial crisis may ultimately benefit the energy business. Consumers will see lower prices, at least temporarily. Energy companies with sufficient means to take advantage of consolidation opportunities will acquire assets on the cheap. The steady earnings from many energy companies will be attractive to investors afraid of other markets. And we may see government investment in the industry as a means of restarting the economy.

In the longer run, the future also looks positive. The long-term need for new supplies, new infrastructure and new technology won’t go away – though it may be delayed for a few years. Many energy companies are well positioned to wait out the hard times and will have low-cost assets on the ready to benefit as demand returns. Those employed in the energy business, are arguably in an attractive spot. Jobs are more secure than most, and given the overall age of the workforce, opportunity will grow quickly as the economy springs back.

(1) Average level of stock prices of Calpine, Dynegy, Exelon, Mirant, and NRG.