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With natural gas prices low at the moment, it would seem to make sense for more natural gas power plants to be built. But it is because natural gas prices are low that many developers are hesitating.

Natural gas power plants have two critical shortcomings. First, though they are the current administration's choice for replacing environmentally damaging coal-fired stations, they are still major polluters and a significant source of greenhouse gases (GHGs) -- they emit 50-65% of the carbon of coal plants. And because natural gas power plants are major GHG polluters, they, like coal plants, will likely be subject to increased regulation and financial penalties over time. Until federal and state emission rules are finalized, though, the net production costs of a new plant will not be known. And without knowing all production costs, it is impossible to predict margins, and few bankers will underwrite new investments with unknown returns.

The other shortcoming is the vexing problem of cost leadership; natural-gas power plants are rarely cost leaders. The villain is the fuel. Even at current prices, natural gas is almost twice as expensive as coal (the EIA puts the 2009 average at $2.21 per MMBtu for delivered coal and $4.70 for delivered natural gas). Fuel is a major component of power-production costs and production costs determine the merit order in which utilities have their power distributed across the national grid. According to EIA data, over the last decade, the delivered price of natural gas has averaged 200% to 500% higher than coal.

The other major component of production costs is the heat rate -- how efficiently a power plant can convert fuel into electricity. The only way a high-cost natural gas power plant can displace a coal plant is if that gas plant is more fuel efficient. With gas having a two-to-one fuel-cost disadvantage to coal, any efficiency difference would have to be compelling.

Production costs only part of the competitive issue, however. The other is delivered costs. Delivered costs are production costs plus transportation costs, so the geographic location of the power plant is a critical success factor. There are several regions in the country where transmission lines are constrained and unable to accept additional power. In those cases, even a very efficient power plant using low-cost fuel may not be able to compete with local generation.

So, how are is power from the various plants dispatched and stacked up to meet demand? The first in line are the "must-run plants", such as wind generators that will produce power notwithstanding their economic merit. Next in the stack are hydroelectric plants, if available, because their productions costs are small. Next are nuclear power plants, which generally have the lowest production costs of all steam turbines. When all available nuclear plants have been dispatched, coal comes next. Only after all the efficient coal plants have been dispatched are natural gas plants considered. As hourly demand increases, all the plants previously dispatched remain in the stack and progressively less efficient gas plants are added until supply equals demand. The last plant accepted in the stack is 'on the margin' and sets the market clearing price for all plants in the stack.

When natural-gas fuel prices decline, the merit order remains essentially the same until the inefficient coal plants and very efficient gas plants meet in the merit order. With lower natural gas prices, it is possible some coal clunkers are being displaced by some highly efficient natural-gas plants. Lower prices also mean the gas plant on the margin fetches a lower market clearing price, causing all plants in the stack to lose margin, with nuclear and coal plants losing the most. Comparatively, the margin loss for natural gas plants is small, because, unlike nuclear and coal, its fuel costs have fallen.

The merit order reveals some interesting opportunities. First, the most profitable plants, from a gross-margin perspective, will almost always be nuclear power, particularly existing nuclear power facilities. Second, efficient coal-power plants also provide profitable margins, albeit less margin than nuclear power (assuming the coal plants are reasonably efficient). Third, natural-gas power plants generally earn the lowest gross margins, because their cost structure is higher than nuclear or coal and their revenue is equal. Fourth, as long as natural gas is more expensive than nuclear power or coal, natural-gas power plants has lost any possibility of cost leadership; they must compete among themselves to secure the best position in the stack after nuclear and coal-plant power is dispatched.

One way to avoid the perils of single-fuel plays is to invest in those utilities that have not undergone deregulation. Strong companies like

Southern Company

(SO) - Get Report

and

SCANA

(SCG)

offer investors opportunities to participate in all power assets simultaneously -- nuclear, coal and natural gas.

For a rifle shot, though, why not look at nuclear power plays, particularly fleets of older nuclear plants, particularly companies like

Exelon

(EXC) - Get Report

,

Entergy

(ETR) - Get Report

and

Dominion Resources

(D) - Get Report

. Combined, these three companies own and operate a third of the nation's nuclear power plants.

While natural gas may have been declared the nation's fuel of choice, it's the owners of existing nuclear fleets that are set to see the highest gross margins in the industry. To make matters even more profitable, those same fleets have already been depreciated and have low interest costs; the distance from their EBITDA to their earnings is the shortest in the industry.

And the inevitable rise in gas prices has meant a push for diversification into new, cheaper nuclear plants, with

Constellation Energy

( CEG) leading the way. In a

Wall Street Journal

article on Mar.29, company Chairman and CEO Mayo A. Shattuck III linked Constellation's future nuclear power investment to natural gas prices. "The proposed new reactor is a long-term bet on higher gas prices," he said. If that's where Shattuck's putting his money, where do you want to put yours?

Glenn Williams has more than 30 years of experience in power and fuels, including design, engineering, construction, startup and operations of large-scale power projects. He has had direct involvement with coal plants, natural gas facilities, and approximately half of the nation's nuclear power facilities and designs energy strategies for regulated and unregulated energy organizations. He received a bachelor's degree in electrical engineering from Northeastern University and a master's degree in technology management from the University of Maryland.