Duke Energy (NYSE:DUK) is set to report its third quarter earnings on Thursday. In Q2, the company reported encouraging results, supported by rate increases in the Carolinas and strong industrial load. From the third quarter, the company will begin to consolidate the results of Progress Energy, which became a wholly owned subsidiary in July following the completion of the merger.
We expect the company’s Q3 margins to be negatively impacted by less favorable weather conditions in terms of lower cooling degree days and maintenance expenses relating to the Crystal River power plant in Florida. We also expect that cost synergies resulting from the merger with Progress Energy and the company’s increasing shift towards natural gas to partially offset any margin decline.
Synergies From Merger Will Begin To Take Effect
The merger with Progress Energy makes Duke the largest electric utility company in the United States, serving a customer base of about 7.1 million. We believe the merger will give the company the scope to prune down costs by eliminating duplicate functions, increasing scale in power generation, reducing manpower and combining dispatch centers. The company projects that non-fuel operating expenses can be reduced by 5% to 7% while savings relating to fuels and transmission are expected to be at least $650 million over the next 5 years.  The merger is not expected to have an immediate impact on the company’s pricing power since rate increases for utility services involve significant regulatory approvals.
Shift Towards Natural Gas Could Help Margins
Coal presently accounts for about a half of Duke’s generation capacity, however, the company is beginning to shift away from the fuel due to stricter emission norms by the EPA and low natural gas prices. The company is being forced to upgrade its coal fired plants with expensive equipment to comply with stricter EIA emission norms, boosting coal derived electricity costs. The abundance of cheap natural gas has made the fuel an attractive substitute for coal. A coal fired plant costs around $3,000 per kw of generation capacity while a modern natural gas fired power plant costs just about $1,000 per kw. Emissions are also up to 70% less than that of coal.
The company has operations in Kentucky, Ohio and the Carolinas that have a close proximity to one of Americas largest gas reserves, the Marcellus shale. Duke is currently constructing over 2 GW of natural gas fired through its subsidiaries in the Carolinas. Progress’ energy generation mix includes solar, wind and significant nuclear assets.
Maintenance Costs Could Be Higher
The acquisition of Progress Energy makes Duke one of the largest nuclear power operators in the US. Following the merger, Duke now controls the crippled Crystal River nuclear power plant in Florida. The plant has been inactive since 2009 due to cracks formed in the concrete containment building during maintenance. Earlier this month, the company warned that the costs related to repairs of the plant could go up to $3.4 billion, almost double the previous estimate. The plant’s insurance contracts cover damages up to $2.25 billion, which exposes the company to absorb any excess costs, including costs related to purchase of replacement power for 1.6 million customers of its Progress Energy Florida subsidiary. The costs relating to replacement power have already exceeded the $490 million covered by insurance, and the company could be forced to absorb additional costs going forward.
We will update our price estimate for Duke Energy following the earnings release.Notes: