Market Wisdom and Horse Power

Remarks to the Dallas Friday Group
Rick Priory
Chairman, President and CEO
Duke Energy

Thank you, Jim (Jim Young, DFG chairman).

I am delighted to have this opportunity to spend some time with you this afternoon, so thank you for inviting me. This is a much better invitation than some energy company CEOs are receiving these days!

It is always a pleasure for me to be in the fine state of Texas, energy capital of the world. Or as you say here in Texas, the energy capital of the universe!

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Duke Energy’s corporate headquarters are in Charlotte, North Carolina, home of some big banks, small-town charm, NASCAR, Michael Jordan—before he was a Bull or a Wizard—and a meandering, magnificent river called the Catawba that Mr. Buck Duke, the founder of our company, harnessed to electrify the Carolinas close to 100 years ago.

We also have a significant presence in Texas. We have 2,100 employees in Houston, five businesses headquartered there, and more than a million square feet of office space.

We own and operate 28 gas processing plants in Texas, 23,000 miles of pipeline, and we produce 4 billion cubic feet per day of natural gas. Our Field Services business has more than 1,100 employees across the state who help us do all that.

In Fort Worth, we have a team of 50 nuclear engineers and other professionals. They’re doing work for TXU Energy and other regional clients.

So we have roots growing deep down here in Texas.

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Today I want to share with you my perspective about a topic I feel very passionately about: The power of the market to respond in good ways to tough times, and how we are seeing that in the news right now.

Winston Churchill once said: “Some regard private enterprise as if it were a predatory tiger to be shot. Others look upon it as a cow that they can milk. Only a handful see it for what it really is: the strong horse that pulls the whole cart.”

That’s as true a statement as I know about free markets. Something goes wrong somewhere, or things get difficult, and for many, the first instinct is to rush in and shoot the tiger—to regulate away all the risk, and in the process, all the best opportunity.

Sometimes, the problem comes about in the first place because someone else looked at the free market, as Mr. Churchill said, as a cow that they could milk. We’ve certainly seen that lately.

But if you look at what happens if you play by the rules—the real rules, not just what sounds good at the moment or what looks like you can get away with—you find that the market literally rises to the occasion, as Churchill’s strong horse that pulls the whole cart. When we get out of the way and let market forces act, they work for the benefit of consumers, producers, vendors, investors, and everyone. I’m going to touch on three examples: Enron, California, and the dot-com crash.

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As Enron came crashing down, considerable panic set in. At its peak, Enron handled one in four wholesale deals for electricity, natural gas and other energy products. Grave concerns were expressed from public, private and regulatory corners as to whether the overall economy—let alone the energy industry—would weather such a hit to a key market player.

But the market turned out to be wiser than those who would rush in to save it.

When the EnronOnline trading exchange shut down on November 28, there were trading entities that ably and aggressively stepped in, ensuring uninterrupted trading and power supply. Trades continued. Customers were served. Infrastructures and systems remained intact.

We were reminded that our energy marketplace is the composite of many strong players—and the sole domain of none. Market liquidity was provided by many active trading and marketing companies—companies with solid risk management practices and sound capitalizations behind them.

The energy market came through because that is what free markets are created to do. And the economy didn’t exactly plunge into depression, either.

Market responsiveness got us through the critical crisis period. It will also serve us well longer-term. The seismic effects of Enron’s implosion are being felt across and beyond our industry. Regrettably, a number of energy companies are struggling, which could ultimately mean the halting of some share of planned new generating capacity. In that case, concerns of a pending power glut will be replaced by the need to address potential shortfalls once the economy improves. It could also mean that the energy field narrows further, as our market exerts its Darwinian force.

Enron characterized itself as a “market maker,” and others readily agreed. Enron certainly did infuse our industry and marketplace with its share of innovation, and accelerated the pace of online commodity trading. But while companies can nudge and help shape markets, they cannot make—and they cannot break—a market.

Already there’s consensus agreement that no single company will fill the role of Enron in our industry. And I believe the marketplace will be better served by a strong and deep bench of talent than it was by a sole king-size player.

One more thing—Enron ought to be a wake-up call in at least one way. We have to remember—and we have to preach—that everybody has to play by the rules, and the rules have to be enforced.

The financial community is pretty shaky right now, wondering if they’ve been making their decisions based on the real facts. And some people are already using that as a pretext to attack the very fundamental idea of free markets. So when something like this happens, we can’t afford to make excuses. We have to expose and denounce the abuses, because the people who work against free markets don’t want the rules enforced. They want the rules altogether changed—so it’s not much of a free market at all.

We’re seeing a push to lift the veil of complexity and corporate-speak from our financial reporting, and that’s a good outcome.

The investing public deserves—and should demand—reliable information, candor and accountability. They need to be able to understand a company’s basic measures of success and failure. And they need to be able to trust and verify the validity of the information provided. Free markets require full disclosure.

At Duke Energy, we’ve always provided financial depth and detail—and we’re improving on that even more. We’re working to provide greater context and clarity around our accounting practices, risks and exposures. And we’re sharing desired information related to mark-to-market vs. accrual accounting, mark-to-market realization periods, and daily earnings at risk.

I expect that as we all move forward, we’ll get a clearer idea of what level of detail is desired and valuable. In the meantime, we must be proactive in making our earnings more visible, our financial reporting more transparent, and the characterization of our business more credible than ever. In my mind, that is a very positive take-away.

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Let’s move on to the golden state of California for another example of the market working—even against great odds!

The heart of the problem in California was a refusal to acknowledge the market fundamental of supply and demand. Power demand far exceeded supply in California. And while the demand for electricity had risen dramatically for a decade—thanks to robust economic growth—the state had built no new meaningful capacity in that same timeframe.

As we all learned in Econ 101: when a commodity is in short supply, prices go up—and sometimes they go up a lot!

In addition to ignoring the need for new power generation, the market rules developed in California limited the ability of electric utilities to manage price volatility through long-term contracting.

Temporary price caps were put in place, which interfered with proper market signals. Price caps are not a wise or desirable long-term solution. They actually reverse much of the progress toward building an efficient free market.

Again, think back to Econ 101: when prices are high, new entrants flood the market, balancing supply and demand, reversing the price trend. That natural correction simply won’t occur in a market of artificial pricing.

Response to market signals had noticeable effects in California. Higher prices for electricity dampened demand. Californians turned off their hot tubs and adjusted the thermostat. Market response was significant enough to move the needle on demand downward—by more than 11 percent.

The state still needs longer-term solutions that will correct the supply and demand imbalance and restore market stability, but I submit that the market, despite political tampering, prevailed in California. It sent the right signals; and those signals were heeded.

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My last example is the dot-coms’ rocketing up... and crashing down. It’s paradoxical that this so clearly demonstrates the wisdom of markets, but the dot-com crash is an example of market discipline—a good thing—that often produces what can feel like a bad thing: a painful pruning of what doesn’t work.

The dot.com frontier was much like the oil boom days of old: opportunity, risks and wildcatter mentality. Paper fortunes were amassed, and of course a lot of these fortunes were the collected investments of those who believed that this or that Internet idea was going to be transformed into cash—and lots of it.

The Internet was an unknown quantity back then, and optimism was a lot more popular—and a lot easier—than careful analysis. And in the defense of some investors, analysis of this new frontier was often a roll of the dice.

In the end, the market sorted circumstances by a simple rule: you can’t build real profits on unreal businesses. Stratospheric valuations based mostly on potential or concepts couldn’t stay up forever, and they didn’t. In the face of a failure to produce financial substance, the irrational exuberance that Alan Greenspan cautioned against faded.

What was lost in the crash was not a world of successful businesses caught in a squeeze, but enterprises that simply provided something that no one wanted—at least not right now.

From Enron to California to the dot.com phenomena, our markets work, teaching the often difficult virtues of balance, performance, competition and growth.

Competitive markets provide the checks and balances needed for long-term stability. They promote innovation, creativity, a constant stream of new market participants, price discovery and efficiencies.

They are also amazingly self-correcting. And it is the resilience of markets in general—and energy markets in particular—that that will help fuel America’s economic recovery.

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Electricity and the economy are inextricably linked—in the U.S. and around the world.

Consider this: Over the last quarter of a century, growth in electricity use has almost exactly matched growth in real U.S. GDP, and electricity has powered a doubling of the U.S. economy.

Energy and economic interdependence works both ways. Prolonged high-energy prices can dampen economic growth. The last three recessionary periods in the U.S.—those of 1990-91, 1980-82, and 1974-75—were preceded by spikes in the price of oil. Abnormally high energy prices affect business operations, corporate budgets, consumer confidence and spending.

On the flip side of that, reliable, reasonably priced power supplies can invigorate economies, spur growth, open new markets and foster innovation.

In advancing nations, and in advanced nations such as the U.S., electricity is imperative to economic recovery and growth.

Even in light of a faltering global economy, we see electric demand growth ahead. The U.S. Energy Information Agency predicts that world energy consumption will increase by more than 50 percent by the year 2020. In the U.S., demand continues to grow by 1 to 2 percent annually, which is significant when you consider the fact that a one percent increase in demand equates to nearly 10,000 MW of required new capacity each year.

We need to factor into those projections the fact that the U.S. electric generating system is aging rapidly. With nearly 100,000 megawatts of our present capacity over 40 years old, we will need replacement as well as new capacity.

Supply won’t be a problem here in Texas! Unlike California, Texas has brought 22 cleaner-burning, gas-fired plants on line since 1995—with 15 more slated for completion by year-end. And your abundance of electricity will provide positive benefits for all other sectors. Deregulated energy markets that have been structured wisely—as you’ve done here in Texas—encourage new and expanding business investment. Energy supply fuels a surge of constructive economic activity—exactly what is needed as we strive to move out of the current recessionary period.

In conclusion, let me say this: the hard lessons of the past year teach us a lot. But the lesson is definitely not how markets have failed. In fact, what we’ve learned is that, given the freedom to respond, producers, vendors, consumers, investors, and all other players act to build stability and recovery.

The micro-management that some now demand is just the opposite of what we need—because whenever we completely shield market players from the consequences of risk, we destroy the fundamental governors of the market itself, those governors being caution, transparency, the law of supply and demand, and corporate and individual comfort with any given level of risk versus return.

In short, this is no time to pull back from what we know works best for the economy. Enron represents the bankruptcy of the seventh largest company in America—but it didn’t trigger a depression. A year ago the nation was panicked about the California energy crisis—but not today. The dot-com bust looked like the end of a lot of good times, but what we really lost were inefficiencies and more than a few businesses with nothing to sell and no one to sell it to.

You should know that all eyes are on Texas. We need examples of workable energy markets—and we need to be encouraged and motivated by economic market vitality. I believe the two go hand in hand, here in the Lone Star state and elsewhere in the world where markets perform their magic.

The wisdom of the market is peerless. But perhaps that is too suggestive of lofty, ivory tower academics. In fact, our marketplace is also scrappy and street-smart. It’s a school of hard knocks—and great rewards for those who dare.

It teaches us tough lessons—and it teaches us good lessons—time and time again. And that’s why it works—like no other system on earth!

Thank you.