Glut of Natural Gas? Cheaper Electric Generation and Home Heating ... Less Pollution.

America's glut of natural gas weighs on prices and the prospects for drillers. But surely all that extra supply helps big customers like independent power producers?

Reality is more nuanced. Electricity prices are set by the last generating plant to be switched on. In most U.S. markets, that generator burns natural gas. That makes the revenue of all merchant generators highly susceptible to gas prices. For those that actually burn gas, falling prices also reduce input costs, offering protection for margins. For those burning coal, margins are squeezed.

The overhang of newly developed gas resources at home, as well as expanding capacity to ship liquefied natural gas to the U.S. from overseas, could keep gas prices trading in a range of $4 to $7 per million British thermal units well into the next decade.

In one sense, that is good for all independent power producers. They were set up to expand as more states deregulated electricity markets. Stable prices could help open the door to further deregulation.

Then again, future growth opportunities are of questionable value in a sector struggling already with average net debt to earnings before interest, tax, depreciation and amortization, or Ebitda, of 4.1 times. And a new reality of moderate, calm gas prices carries significant risks to profitability.

The biggest risk is for coal-fired generators. Consider an unhedged plant burning coal in a market where an older gas-fired plant sets the electricity price. Assume gas costs $8 per million BTUs and coal $50 a ton. The gas-fired plant has to burn 10 million BTUs of gas to make one megawatt hour of electricity, giving total fuel costs of $80 per megawatt hour. If you add in some operating expenses and a return, then the price of electricity set by the marginal generator is about $90 per megawatt hour.

The coal plant's costs, meanwhile, come to about $33, leaving a gross margin of more than $55 per megawatt hour.

Now plug in a gas price of $5. Even if coal costs fall to $40 per ton, the coal plant's margin is cut almost in half. Then add in an eventual cost for carbon emissions. At $20 per ton, it lifts the electricity price overall. But because burning coal emits almost twice as much carbon dioxide as gas, the coal plant's implied margin is now about $20 per megawatt hour.

There is an added complication. Industrial demand for electricity, 29% of the market, was down 12.5% from a year earlier in July, according to the Department of Energy. Andy DeVries of CreditSights points out that removing that amount of demand obviates the need to run older gas-fired plants, leaving more efficient power plants to set the market price instead. Based on the simple model described above, a power plant burning only seven million BTUs of $5 gas sets an electricity price of about $41 per megawatt hour. That cuts the coal-fired producer's margin to about $13. Factor in a carbon cost, and they make a loss.

Gas-fired generators don't do so well either in such a weak market. But they do at least enjoy a hedge in the form of lower fuel and carbon costs. Of the independent power producers, Calpine stands out with efficient gas-fired plants accounting for more than four-fifths of its portfolio. Against that, its net debt to Ebitda is 5.3 times. Mirant, in contrast, carries less than one times Ebitda in net debt. But it has the oldest fleet of plants of any independent producer and relies heavily on coal.

The independent producers are relatively new and their stocks tend to trade together. In their short lives, they have faced crises involving Enron and California, and several bankruptcies. With further dislocations stemming from the natural-gas market and climate-change proposals looming, investors need to be far more selective.

Write to Liam Denning at liam.denning@wsj.com

Printed in The Wall Street Journal, page C10