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Calpine (NYSE:CPN) is an independent power producer, generating electricity and selling it into wholesale power markets. Calpine runs what is perhaps the most modern fleet of natural gas (NYSEARCA:UNG) fired combined cycle and cogeneration turbines. Calpine has 28,000MW in electricity generation capacity, and is probably the purest play in terms of natural gas-fired capacity you can find in the stock market.

It would seem that in a world of incredibly low natural gas prices, a power producer heavily reliant on natural gas-fired generation would always come out well ahead -- especially if it had one of the most advanced and efficient fleets. The market saw it that way too, up to a point, with Calpine being up 11.4% year to date and now having a rich forward 2012 P/E of 60. And, sure, the earnings estimates had some upside as well, with consensus for 2012 moving from $0.18 per share to $0.30 per share in the last 90 days.

But is Calpine's gain in this environment a certainty?

Unfortunately, no. On the one hand, very low natural gas prices will ensure that Calpine's fleet will see much higher utilization and, at times, better margins. This is certainly what was helping Calpine's estimates move forward in the recent past.

But on the other hand, there's also an effect that is unfavorable. This is where natural gas defeats itself. The problem is that natural gas is usually the fuel that sets power prices. Power prices are dictated by the most expensive power plant that completes the necessary capacity to meet demand. That plant is usually running natural gas. If natural gas prices drop, the price of the power provided by the marginal producer will be lower -- and that will mean every other producer that dispatched before it will also get the lower price.

What this means is that when natural gas prices fall, power prices fall. And natural gas-fired generators, although they get lower prices for their feedstock, also get lower prices for their output. The same does not necessarily happen if coal (NYSEARCA:KOL) or uranium (NYSEARCA:URA) prices fall; then, coal-fired or nuclear generators will see lower production costs, but since they're not usually at the margin setting the electricity price they won't see lower power prices.

Could something change this dynamic?

Yes. If coal generation gets hit with the need to buy carbon credits, not only will natural gas generation substitute coal generation at a higher price point for natural gas, but increasingly the power price would be set on the margin by either a coal-fired plant or an inefficient natural gas-fired plant. Either would mean much higher utilization and much higher margins for Calpine.

Also, as renewable energy starts comprising a larger part of the generation capacity, the electric grid will demand greater flexibility. This flexibility can be better provided by natural gas-fired generation capacity, which ramps up and down much easier than coal-fired or nuclear.

Conclusion

Because of the way power is priced, it's not a given that low natural gas prices favor natural gas-fired generation greatly. While it's certain that the input costs are lower and the usage factor is much higher, this capacity also receives lower power prices due to natural gas usually being the marginal producer setting the price.

Moreover, as I expect natural gas prices to go up both in 2012 and 2013, this development might run contrary to the Calpine long thesis of "low natural gas prices forever." In short, Calpine's rich valuation, together with a turning point in natural gas, makes it a dangerous investment right now, while natural gas having a continuing low price isn't incredibly favorable either. So I can't recommend buying Calpine.

But I do believe something along the lines of Exelon (NYSE:EXC) is more sensibly valued and better adapted to the turning market, even if it suffered considerably from the lower natural gas prices.

This opinion could, however, change drastically if some form of cap-and-trade CO2 credit scheme was enacted, as that would favor both Calpine's usage factor and margins.

Source: Calpine And How Natural Gas Defeats Itself