In the summer of 2000, a steady stream of New York investment
bankers tramped down to Dominion Resources Inc.'s 12-acre campus on the banks
of Virginia's historic James River to tell Thomas A. Capps he was crazy.
Just look at the evidence, they said to the chief executive:
Energy trading giant Enron Corp. was trading at an all-time high of $90.65.
Calpine Corp. and Dynegy Inc. were posting triple-digit earnings growth. Reliant
Energy Inc. and Duke Energy Corp. were winning Wall Street kudos for their plans
to spin off lucrative generating and trading businesses.
It was time, the investment houses said, for the Richmond
company to get in line. Sell your power plants, they said. Or split off the
production business. The big money was in energy trading, Dominion was told.
With pressure mounting, Capps took a good, hard look at his
energy company. Then he simply ignored the advice. It took just a year to prove
Capps right. It took two years to make Capps look like a genius.
The industry's strategy to focus on aggressive trading and
power-generation businesses was fatally flawed from the beginning, energy experts
now acknowledge.
It was based on the idea that more and more power plants
could be built, that the price of power would continue rising, that demand would
be limitless, and that higher and higher profits would roll in, the experts
said.
But the rise of the energy powerhouses was overshadowed only
by the speed of their decline.
"We were wondering what they were seeing that we didn't
see," said Capps, who has been chief executive for more than half of his
18 years with Dominion. "We decided, nothing. We've never believed in the
herd approach to anything. We had what we thought was a good game plan.
"In fact, it has been the best game plan," Capps
said. "The fad du jour at the time was to sell off and be power marketers.
We thought that was dumb. We still think it's dumb."
Many of the energy companies that were Wall Street favorites
have fallen.
Enron declared bankruptcy. Dynegy's share price is less than
$2, a 95 percent plunge from its 52-week high. Duke recently fired two employees
for improper energy trades that inflated revenue, and several other companies
are facing similar investigations. Most energy stocks have taken a nose dive.
"It's been an extremely painful period of experimentation
for everyone in the industry," said William W. Hogan, research director
of Harvard University's Electricity Policy Group. "Some years ago, the
people who were less adventuresome looked like Neanderthals - they just didn't
get it. Now they look like prescient visionaries.
"Particularly when you get new things coming along that look sexy and exciting,
it's very hard to stick to your knitting."
But that's what Capps did.
Seductive promises
While others were seduced by the promise of reaping dazzling
returns on power production and energy trading, Capps was buying a natural gas
pipeline.
While others rushed to buy power plants at two to seven times
their value, Capps refused to add too much debt for overpriced assets.
While others were buying or building their marketing operations,
Capps allowed Dominion to trade only what its plants and natural gas wells could
produce.
These days, Dominion is trading at slightly more than $58
a share, about 10 percent less than its 52-week high of $69.99.
But the stock has held up significantly better than others
in the industry. And it recently announced a plan to buy a liquefied natural
gas plant in Southern Maryland.
Many of Dominion's counterparts are beating a hasty retreat
from strategies that were once considered bold and smart, and guaranteed to
make millions.
Like the pop of the dot-com bubble, the energy euphoria has
faded, at least for the time being, industry experts say. "The fall of
the dot-com and the energy-trading industries have taken place faster than has
happened to other industries in the past," said Severin Borenstein, director
of the Energy Institute at the University of California at Berkeley.
"If you think about the time it took other industries
to turn from profitable to unprofitable - for instance, the steel and railroad
industry - that took years and years.
"This happened at warp speed."
The energy-trading boom began soon after Congress passed
the Energy Policy Act in 1992. The act directed states to adopt policies leading
to greater competition between power suppliers and transmitters.
Energy companies were suddenly functioning in a new world.
No longer bound by regional service territories, they were free to buy, sell
and deliver power anywhere they wanted.
Things were shaping up nicely. The telecommunications industry
was growing, the economy was robust through the late 1990s, and about half of
the states had adopted electric deregulation laws.
In May 1999, Mark P. Mills and Peter W. Huber, co-editors
of the Digital Power Report wrote in Forbes magazine: "It's not unreasonable
to project that half of the electric grid will be powering the digital-Internet
economy within the next decade."
"No one ... had a clue'
Energy analysts predicted 40 percent to 50 percent growth
over the next five years, growth not seen in 20 years. "It was a thesis
that people believed was going to be true," said Paul B. Fremont, a utilities
analyst at Jefferies & Co. Inc. "There was no pre-existing experience
in this country for a free market [in] electricity. ... They had operated in
a regulated monopoly market for years. No one inside or outside of the industry
had a clue what it was going to look like."
But the rush began.
Utilities began shedding their sleepy, low-yield investment
image.
Some, such as Enron, adopted an "asset light" strategy
in which the company sold commodities it did not own or produce. Some went on
a power plant purchasing frenzy that transformed them into independent power
producers. Some, such as Potomac Electric Power Co., took the less-risky path
of selling plants and focusing on the delivery business.
Many integrated companies such as Duke, which owned plants,
trading operations and delivery businesses, decided to take advantage of both
by spinning off production and marketing businesses.
In Baltimore, Constellation Energy Group Inc. was no different.
On Oct. 23, 2000, chief executive Christian H. Poindexter
stood with his top executives in front of a backdrop of the company's bustling
trading unit and announced that the 184-year-old utility would split into two
billion-dollar companies.
Constellation would pursue an aggressive, unregulated strategy
to produce and sell electricity into the wholesale market. The other company,
BGE Corp. would become a slow-growing, regional delivery company that would
include its regulated utility, Baltimore Gas and Electric Co.
Almost everyone, including Constellation, rushed to announce
plans to construct more power plants.
"The growth was based on irrational expectations,"
said Fremont, who wrote a report in November 2000 warning energy companies that
the supply and demand for energy would reach an equilibrium by 2002.
"It was absurd to assume the economy was never going
to contract," Fremont said. "Supply was going to outstrip demand.
It was only a question of when.
"We put out a piece that said we thought the generators
were overvalued. Our predictions were particularly out of favor in the past."
Enthusiasm for energy businesses continued to grow. And with
the dot-com meltdown that began in 2000, investors quickly switched their allegiance
and money from high-tech to energy.
Then, early last year, the lights went out in California.
Power prices shot up. Pacific Gas and Electric Co. and Southern
California Edison, which had sold their power plants without arranging contracts
to buy back electricity, began racking up debt. By the time PG&E declared
bankruptcy, other companies nationwide had begun experiencing similar difficulties.
The problem, experts say, is that power is a different type
of commodity. It can't be stored. As soon as it is produced, it has to be used.
So many factors influence prices, such as weather, demand and government regulations.
With the resulting volatility, prices can shoot up from $10 a megawatt hour
to $10,000 a megawatt hour. It isn't a market for the faint of heart.
It didn't take long to discover that flawed deregulation
laws in many states were not prepared to deal with such a fickle market.
In New England, New York, Montana and most of the West, electricity
prices rose. Concerns about power shortages grew, and confidence in the electricity
industry faltered.
On top of that, the economy slowed further.
That led Constellation to pull back its plan in October,
a year after the announcement and just as Enron's stock price began to plummet.
Constellation called off the split, paid Goldman Sachs Group Inc. $355 million
to end their trading partnership, canceled major power projects and cut 900
employees from its work force.
Poindexter later stepped down as president and chief executive,
replaced by former Alex. Brown chief Mayo A. Shattuck III.
And just as California seemed to be recovering from its deregulation
fiasco, Enron went bankrupt , sending the energy industry into free fall.
"Enron has dragged everything down," said John
Sodergreen, publisher of the Scudder Publishing Group in Annapolis, which puts
out five energy newsletters. "Credit and access to capital has absolutely
dried up."
Accounting shenanigans
More problematic is evidence that many companies besides
Enron were playing fast and loose with the rules. As the Securities and Exchange
Commission looks into accounting shenanigans, many energy companies are stepping
away from mark-to-market accounting, which allowed them to count a multiyear
contract as current earnings.
In addition, the Federal Energy Commission is investigating
allegations of power price manipulation in Texas and California, and sham trading
practices used by companies to falsely inflate revenue.
Trading volumes have shrunk, liquidity has dried up, and
many companies are backing off from trading businesses. Many companies, including
Allegheny Energy Inc. in Hagerstown and Texas-based Williams Cos., have canceled
major power plant construction projects, reduced earnings forecasts and laid
off hundreds of workers. Aquila Inc. in Missouri said Tuesday that it was abandoning
the wholesale energy and marketing business completely, having cut 550 jobs
since May.
Many are returning to what they know best, the unexciting,
but reliable business of power delivery.
But energy trading is not dead, experts say.
"There are a lot of similarities to the fall of the
dot-coms, but there is a big difference," said M. Ray Perryman, founder
and president of the Perryman Group, an economic and financial analysis firm
in Texas. "Clearly, there was some speculation that took place. There was
also that rush and euphoria to buy that dot-coms had, too. The difference is
that dot-coms couldn't generate the profits.
"In energy trading, that is a market that has a future.
It is a core business that is going to persist."
Experts point to dot-com survivors such as eBay and Amazon.com.
"Some of the dot-coms made money and are still in business,"
said Borenstein, director of the University of California's Energy Institute.
"Some of the power traders are doing fine. So you can't say in either case
that everybody screwed up. In both cases, we went from having a whole lot of
perceived wisdom that was self-reinforcing. In both cases, it ended up being
wrong. That's not unusual in new industries."
In light of Enron's downfall, few remember the bankruptcy
of Power Co. of America in 1998. The Greenwich, Conn., company filed for Chapter
11 protection when it defaulted on $236 million in contracts because it was
unable to deliver power it had agreed to sell to others.
The culprit? A heat wave that sent power prices soaring as
high as $7,000 per megawatt hour in the Midwest. Several other companies defaulted
also. The failures led trading firms to tighten credit policies and improve
hedging practices.
"After that, the systems got better and the processes
got better," Sodergreen said. "This time around, there were some significant
risks that people weren't prepared to deal with, and the timing of this downturn
has just hit the industry very hard. There is a such a microscope on the market
right now.
"The problems in the industry are not systemic,"
Sodergreen added. "There are some bad eggs, but this is not an industry
of crooks. When the smoke clears, this is going to be a force to be reckoned
with."
It won't be easy to get there.
"We have a lot of kinks to work out in energy trading,"
said Jeffrey Gildersleeve, a utilities analyst at Argus Research. "This
is such an old and mature industry that's becoming very progressive, very new.
I constantly tell clients that we have an 80-year-old grandfather meeting his
15-year-old grandson. It's going to take time."
Playing it safe
Without a crystal ball, Capps says, he is playing it safe.
"We like being in the generating business," Capps
said. "You have a chance to make money on electricity and you can make
money on gas. We're not a trading house, but we do trade around our assets.
We won't sell electricity where we can't crank up a generator and produce it."
Dominion plans to continue trading on assets that it owns.
The company also will depend on its traditional utility franchises - which serve
nearly 4 million retail customers in five states - to contribute to earnings
and cash flow.
Dominion plans to continue to expand its power production
capacity by about 18 percent over the next three years. To minimize the risk
of spikes in natural gas prices, it spent $8.9 billion to purchase Pittsburgh-based
Consolidated Natural Gas Co. in 1999, and the company jumped at the chance last
fall to purchase Louis Dreyfus Natural Gas for $2.3 billion in cash, stock and
assumed debt. Last week, the company announced that it would purchase Williams'
liquefied natural gas plant in Southern Maryland.
As other utilities deal with huge debt and credit problems,
many cash-strapped utilities are selling their power plants at heavily reduced
prices. Capps is ready to snap up those assets. Dominion already has several
fossil-fuel, hydroelectric and nuclear facilities.
"We don't want to be a one-trick pony," Capps said.
"We haven't cornered the market on smarts. We're just pretty conservative.
Because the New Economy and dot-coms were predicting 30 percent growth, people
started believing you had to have double digit growth, too. But this business
is an infrastructure business.
"Many people need electricity and many need gas. The
public doesn't use electricity because it's available. They only use it when
it's needed. We've been in this business too long and have too much basic common
sense to realize that our growth rate will not get those kind of results."
That kind of thinking has led Dominion to 13 straight quarters
of meeting consensus earnings estimates. Two years from now, will Capps still
look like a genius? Possibly, experts say, but it's hard to say.
"We don't know what the market will look like,"
said Borenstein, of the Energy Institute. "We don't know what the model
of a successful business will look like in that market. The market rules and
environment have to be determined. Until that's settled, we're going to remain
in this state of uncertainty. It's very much in the air."
