**Editor’s Note, the subject matter below while topical is somewhat older news, however, for 10.9 billion reasons, I could not bring myself to write anything about the recent first quarter economic update for the province of Alberta delivered this week, on the off chance I said something I might regret later, like “dumpster fire of an economic plan” or “now I know what the Romans felt like while Nero fiddled…”. So instead you get the following…**

 
There has been a lot of press coverage given recently to a uniquely Albertan energy issue and it has nothing to do with oil and gas.

 

It has to do with the ongoing saga of our deregulated electricity industry and something called Power Purchase Agreements or PPA’s which are, when distilled to their basics, financial contracts sold a number of years ago that give the right to “wholesalers” to buy electricity from a specific generator at a prescribed price and resell that power into the market at the current prevailing price.

 

What has happened now is that due to a combination of factors (low price, carbon tax, accelerated closure timelines for coal plants), some of these PPAs are now or soon will be underwater so some of the PPA owners are “walking away” from their PPAs by taking advantage of a clause in these agreements (the sinister sounding “Enron Clause”) that allows them to hand back the contracts if they were to become “more unprofitable” due to, in essence, regulatory action.

 

Supposedly taken unawares by this, the NDP government is crying foul and saying that big energy comnpanies sticking it to Ma and Pa Alberta by leaving Alberta power consumers on the hook for up to $2 billion (at least according to the government, the real number is likely lower, largely depending on power prices).

 

The upshot of all this is that the Province is now suing a number of these companies, arguing that the clause in question isn’t legally binding because it was inserted at the last minute by a sneaky PC government eager to appease big corporations and wasn’t properly disclosed to the public at large and approved by Cabinet. Among the companies being sued is Enmax, Calgary’s municipally-owned electrical utility, which means that the government is kind of suing itself.

 

Phew!

 

How in the name of jumping jehosaphat did we get here?

 

First a little disclosure, then a brief history lesson.

 

A long time ago in a career far, far away, I had the pleasure of working on a consulting, valuation and M&A assignment that required a massive amount of time and effort studying and understanding what a PPA is, what its terms were, what were the implications for each party to a PPA, how to value a PPA and what were the critical elements that gave it value.

 

Note that this assignment wasn’t for Enron, so I wasn’t that close to the action, but close enough I think to figure it out and to know that the very clause the NDP says was not legit is what in many ways gave these contracts significant value. And that the lawyer enriching exercize in futility that the NDP is pursuing is precisely the reason these clauses are included in the first place.

 

At any rate, way back in 1996 the Alberta government began the process of deregulating the electricity market in the province by first deregulating new generation.  However, given the market power of incumbent generators (who under a hedging program were still basically receiving a regulated rate), it soon became clear that in order to properly deregulate prices and encourage new generation investment, that the market power of the existing coal and gas fired generators needed to be broken.

 

Enter the Power Purchase Agreement or PPA. Introduced in 1999, the purpose of the PPA was to auction off the capacity of the various legacy generators, ensure them a fair regulated type price for their electricity and have the actual power produced by them sold at market prices by the PPA owners that would then reflect a market-based price for this power.

 

The proceeds of the auction were collected by the government and returned to ratepayers via a “Balancing Pool” which basically served as a clearinghouse for electricity.

 

In order to bring stability to the market (and to maximize proceeds from the auction), the PPAs were designed with long lives, some as long as 20 years.

 

In many ways, the PPAs were financial contracts between the legacy generators and the wholesaler underwritten by the government.

 

Two auctions were held, one in 2000 and a second in 2001 that generated about $3.3 billion for the government. The province made out pretty well at these auctions, with the second auction generating way more proceeds than the first and for less capacity.

 

In all, just about half of Alberta’s power generating capacity was auctioned with the remainder held by the Balancing Pool. So, the market power of the generators was reduced, there were a large number of new entrants wholesaling power, the government got a shwack fo cash and electricity received a market price.

 

If you were in Alberta at that time, you would no doubt have been aware of the massive spikes in the price of electricity as the market signals indicated a need for significant investment in generating capacity. This price acceleration, while relatively short-lived, created windfall profits for many of the PPA holders.

 

What this also meant is that the holders of the PPAs suddenly had an asset that was worth way more than they had paid for it, at least as long as prices help up and no new generating capacity was built. While prices have since stabilized and in fact come down precipitously in the last few years such that many remaining PPAs are underwater, at the time, it was a pretty bullish situation for the new PPA holders. Which is actually kind of what the government hoped to create – a market where there was an opportunity for independent parties to participate and make a profit, whether through earlier participation via a PPA or by building new capacity.

 

What generated this value in the PPAs (either the price paid for them or their subsequent mark to market value) came from a number of factors including the length of the contract, the perceived spread between what the market price for power was going to be and the cost of that power under the PPA and, especially in the case of the longer termed PPAs, the regulatory certainty associated with deregulation overall.

 

Put another way, Company A would only be willing to pay a high price for a PPA as long as they knew that the rules weren’t going to change on them midstream. And the only way to get that certainty was to have a clause in the agreement that covered them should that prove not true.

 

Hence, the nefarious “Enron” clause which in a nutshell says, OK Alberta government, change the rules and make me lose money and you can have your contract back and figure out your own mess.

 

Now I don’t know if the clause was snuck in at the last minute through some cloak and dagger activity (highly doubtful) nor do I particularly care, because that’s not the point. Without that clause, the PPA auction would have been a failure as no sane counterparty would enter into a financial contract where the rules can change mid-stream and they have no recourse.

 

And as far as no-one knowing about it? Well I knew about the clause, because I read the agreements. What’s the government’s excuse?

 

In many ways, I think the government suing over these is a bunch of noise and a further waste of taxpayer funds. They are the ones who exacerbated a low-price money losing situation for many PPA holders in the current environment by piling on extra costs, accelerating plant closures, introducing a carbon tax and otherwise changing the regulatory rules of the game such that the parties in question were forced to blow the dust off their PPAs and exercize their contractually granted right to tell the government to take their PPAs and stuff them.

 

So rather than continuing to moan about this and launch spurious lawsuits, perhaps a little more attention should be given to ways to boost growth in the province thus increasing demand for power and prices such that the returned PPAs now residing in the Balancing Pool aren’t the losers that the government has made them.

 

And please don’t take this as a political position, if this action was taken by any of the parties currently thinking they can run this province, my reaction would have been the same.

 

Do your homework. Figure out the unintended consequences. Have a plan. Slow down.

 

And when you screw up, don’t try and bluff your way out of it. Own it.

 

Prices as at August 26, 2016 (August 19, 2016)

• The price of oil ended the week slightly down after mid week volatility
  • Storage posted a surprise increase
  • Production was down marginally
  • The rig count was up
  • The market continues to positively react to prospects of a freeze with Iran now schyeduled to attend the Algiers session in September
• Natural gas rose during the week on week storage numbers

• WTI Crude: $47.64 ($48.26)
• Nymex Gas: $2.871 ($2.584)
• US/Canadian Dollar: $0.7690 ($ 0.7775)

 

Highlights

• As at August 19, 2016, US crude oil supplies were at 523.6 million barrels, an increase of 2.5 million barrels from the previous week and 72.8 million barrels ahead of last year.
  • The number of days oil supply in storage was 31.3, ahead of last year’s 26.7.
  • Production was down for the week at 8.548 million barrels per day. Production last year at the same time was 9.337 million barrels per day. The change in production this week came from flat Alaska deliveries and a decline in lower 48 production.
  • Imports shot back up to their highs at 8.642 million barrels a day, compared to 7.199 million barrels per day last year.
  • Refinery inputs were flat during the week at 16.679 million barrels a day
• As at August 19, 2016, US natural gas in storage was 3,350 billion cubic feet (Bcf), which is 12% above the 5-year average and about 9% higher than last year’s level, following an implied net injection of 11 Bcf during the report week.
  • Overall U.S. natural gas consumption fell by 5% during the week on decreased power consumption
  • Production for the week was flat and imports from Canada fell 8%
• As of August 22, the Canadian rig count was at 141 (21.1% utilization), 87 Alberta (19%), 15 BC (20%), 36 Saskatchewan (31%), 3 Manitoba (20%)). Utilization for the same period last year was about 25%.
• Oil rig count at August 19 was at 406, unchanged from the week prior.
  • Rig count at January 1, 2015 was 1,482
• Natural gas rigs drilling in the United States was down 2 at 81.
  • Rig count at January 1, 2015 was 328
• US split of Oil vs Gas rigs is 82%/18%, in Canada the split is 52%/48%
• Offshore rig count was down 1 at 17
  • Offshore rig count at January 1, 2015 was 55

 

Drillbits

• Another slow news week, with the following notables
  • Iranian production appears to have plateaued around the 3.85 million barrels a day level, which likely provides the impetus for them to attend the latest “freeze” discussion
  • The City of Prince Albert has lifted all water restrictions after the recent oil spill
  • Saudi Arabia’s cash reserves fell another $11 billion in July, making thier cash burn since August 2014 an astounding $176 billion
• Alberta Budget by the Numbers
  • $10.9 billion: deficit as impact of Fort Mac fires estimated at $500 million
  • $877 million: decline in corporate tax revenue from the budget estimate of $3.4 billion
  • $744 million increase in oil and gas revenues vs budget as prices rally past year average estimate of $42 per barrel
  • $32.2 billion: Alberta’s estimated debt, expected to almost double by 2019
  • 10.25%: Provinces debt to GDP ratio
  • 2024: The year the NDP expects the budget to be balanced
  • 3: years economist Trevor Tombe tweeted it would take to balance the budget if the government froze spending at 2015/2016 level – can we get him a job in government?
• Drumpf Watch – The WSJ surveyed all 45 members of the Council of Economic Advisers back to Nixon—both Rs and Ds: 0% support Drumpf. Drumpf also appeared to flip flop on his immigration policy, seemingly to suggest he is open to a path to citizenship for illegal immigrants, which of course is the exact opposite of what he has said previously. He also accused Hillary Clinton of being a racist, because she is taking the balck community for granted, as opposed to, say, attracting white supremacists to his campaign, proposing a giant wall to keep out Mexicans and banning Muslims. You may want to fond another issue Donnie-boy