Energy Future expects flak from Alcoa over profitable Sandow agreements

The bankruptcy court for Energy Future Holdings is due for an Oct. 2 hearing, with a Sept. 25 objection deadline, on an Aug. 28 motion from Energy Future for it to be allowed to assume lucrative agreements related to its operation of coal-fired power capacity and related lignite mining operations on behalf of aluminum maker Alcoa (NYSE: AA).

The Energy Future companies and Alcoa have a longstanding contractual relationship centered around power generation and lignite mining facilities and a now-shuttered aluminum smelter located near the town of Rockdale in Milam County, Texas. Due to current and projected power prices, that contractual relationship is extremely valuable to the Energy Future companies. Based on the forward price curve as of Dec. 31, 2014, the Alcoa contracts add approximately $300 million to the net present value of the estates of the Energy Future companies, and using forecast prices as of July, the Alcoa contracts are even more valuable.

Moreover, there is no default under the Alcoa contracts, so the debtors told the U.S. Bankruptcy Court for the District of Delaware that they owe no cure amounts. For those reasons, the debtors have determined, in their business judgment, to assume the Alcoa contracts.

The Alcoa contracts are effectively “cost-plus” agreements whereby the respective parties pay their portions of the current period operating costs and Alcoa remits to Luminant Generation (via the contract power price) a return on, and return of, Alcoa’s portion of plant and mine capital that has previously been spent by Luminant Generation. Generally, in times of high power prices, the Alcoa contracts benefit Alcoa, but when wholesale power prices decline, the Alcoa contracts benefit Luminant Generation.

For many years Alcoa had been on the favorable side of the various arrangements, said Energy Future. But now, with the current and forecasted longer-term power prices being lower than historical forecasts, Alcoa is out of the money.

“For this reason, the Debtor Parties anticipate that Alcoa will object to the Debtor Parties’ assumption of the Alcoa Contracts,” said Energy Future in its Aug. 28 motion to assume these contracts. “While the Debtor Parties will continue to seek consensual resolution, as they have throughout these chapter 11 cases and, as well, throughout their decades-long contractual relationship with Alcoa, the Debtors firmly believe that it is prudent to be prepared to litigate any objection to this Motion. To that end, contemporaneously with the filing of this Motion, the Debtor Parties have responded to Alcoa’s previously-withdrawn discovery requests, provided Alcoa’s counsel with a proposed discovery plan regarding this Motion, and have agreed to make the Debtor Parties’ declarants for this Motion available for deposition. Nevertheless, given the clear and sizable benefit the Alcoa Contracts provide to the Debtor Parties’ estates and their creditors, the Debtor Parties are confident that they have reasonably and judiciously exercised their business judgment in determining to assume the Alcoa Contracts. “

On April 29, 2014, the Energy Future companies filed a voluntary petition with the court under the Bankruptcy Code. They are operating their businesses and managing their properties as debtors in possession.

Notable is that Sandow Units 1-3 were retired in 2006, and Sandow Unit 5 was completed in 2010.

Some of the agreements extend to at least 2038

Robert Frenzel, the Senior Vice President and Chief Financial Officer of Luminant Holding Co. LLC, an indirect subsidiary of Energy Future Holdings  and parent of Luminant Generation Co. LLC, Luminant Mining Co. LLC and Sandow Power Co. LLC, provided Aug. 28 supporting testimony that delved into the details of the agreements.

For example:

  • Unit 4 Agreement – It has been amended several times in the past thirty years, and currently obligates Alcoa to provide 100% of the fuel to Sandow Unit 4 and for Luminant Generation to provide Alcoa with approximately 83% of the total generation output of Sandow Unit 4. Of that 83%, 398 MW is “firm” energy, meaning that if Alcoa needs energy for purposes of operating its smelter facility when Sandow Unit 4 is not running, that power must be obtained elsewhere by Luminant Generation and provided to Alcoa at the contract price. The 398 MW of “firm” energy was determined because that constituted a significant portion of the smelter’s load requirements when it was operating. If Alcoa does not consume its share of the generation output of Sandow Unit 4 at the Rockdale Facility (or in satisfaction of the Mine Load Obligation), that “excess energy” is transferred to an energy reserve account (ERA) and repurchased monthly by Luminant Generation—half at an agreed market rate (the ERCOT Real Time Settled Price), and half at the contract rate. The Unit 4 Agreement is effective through Dec. 31, 2038, and continues in effect thereafter unless terminated in writing by either party upon three years’ notice.
  • Unit 5 Agreement – Originally, this agreement set forth terms governing the design, construction, ownership, and operation of Sandow Unit 5 and provided for Alcoa to supply the lignite that powers Sandow Unit 5. The Unit 5 Agreement has since been amended to transfer to Sandow Power the responsibility for supplying lignite to Sandow Unit 5. Pursuant to a related ground lease, Luminant Generation leases from Alcoa the real property upon which Sandow Unit 5 is located. The Unit 5 Agreement is effective through Dec. 31, 2038, and continues in effect thereafter unless terminated in writing by either party upon one year of notice.
  • Agreement Regarding Ownership of Lignite Interests – This agreement establishes the ownership of the interests in the lignite reserves in the Three Oaks Mine—Alcoa owns the lignite supplied to Sandow Unit 4 pursuant to the terms of the Unit 4 Agreement, and Sandow Power owns the lignite supplied to Sandow Unit 5 pursuant to the terms of the Unit 5 Agreement. Each party bears responsibility for the payment of royalties attributable to their respective ownership and leasehold interests in the lignite reserves in Three Oaks Mine.
  • Contract Mining Agreement – Under this agreement, Luminant Mining acts as a contract miner to mine the lignite reserves at Three Oaks Mine, which are owned by Alcoa and Sandow Power, in order to satisfy Alcoa’s obligation to supply 100% of the lignite for Sandow Unit 4 and Sandow Power’s obligation to supply the lignite for Sandow Unit 5 pursuant to the Unit 4 Agreement and the Unit 5 Agreement, respectively. The Alcoa Leases, already assumed by the debtors, further support the operation of Sandow Unit 4, Sandow Unit 5, and Three Oaks Mine. The Alcoa Leases include, but are not limited to, the Unit 5 Premises Lease, the long-term lease by Luminant Generation and Sandow Power of other real property used in connection with the operation of Sandow Unit 4 and Sandow Unit 5, the lease of an office building owned by Alcoa and used by Sandow Power in connection with the operation of Sandow Unit 5, and the lease by Sandow Power of a portion of Alcoa’s mining rights to certain lignite reserves at Three Oaks Mine.

The Energy Future companies now seek to assume all of the remaining Alcoa Agreements that are not Alcoa Leases previously assumed under the court’s prior Lease Assumption Order.

Frenzel noted that under the Unit 4 Agreement, Alcoa’s obligations currently total about $125 million per year—an amount that is projected to remain constant over the next few years—of which around $80 million constitutes Alcoa’s portion of a return of and on previously invested capital. The Contract Mining Agreement has a similar construct and value as the Unit 4 Agreement.

Frenzel added that Alcoa will undoubtedly argue that there are material defaults under the various Alcoa Contracts that must be cured before Luminant Generation may assume the Alcoa Contracts. “The Debtor Parties vigorously dispute any such assertion,” he wrote. “In fact, the Debtor Parties are owed money under the Alcoa Contracts as Alcoa has improperly withheld approximately $11 million owed to Luminant Mining. In 2013, Alcoa unilaterally wrote-off from its books the value of a large sum of its lignite reserves in Three Oaks Mine, and invoiced Luminant Generation for a portion thereof. Luminant Generation disputed those charges on the grounds that the Unit 4 Agreement expressly provides that Alcoa cannot invoice the Debtor Parties for any costs associated with lignite before its actual consumption at Sandow Unit 4. Alcoa proceeded to offset payments due to Luminant Mining under the Contract Mining Agreement, thereby inappropriately retaining $11 million. To date, Alcoa has yet to reimburse the Debtor Parties for those improper withholdings. The Debtor Parties reserve any and all rights with respect to such claim and any other claim that may exist under the Alcoa Contracts.”

About Barry Cassell 20414 Articles
Barry Cassell is Chief Analyst for GenerationHub covering coal and emission controls issues, projects and policy. He has covered the coal and power generation industry for more than 24 years, beginning in November 2011 at GenerationHub and prior to that as editor of SNL Energy’s Coal Report. He was formerly with Coal Outlook for 15 years as the publication’s editor and contributing writer, and prior to that he was editor of Coal & Synfuels Technology and associate editor of The Energy Report. He has a bachelor’s degree from Central Michigan University.