It feels like investors and analysts have spent the better part of two decades arguing that power prices in regions like the Midwest and Mid-Atlantic should be higher than they are. Along the way, several independent power producers ((including Dynegy (OTC:DYNIQ)) have faltered badly as consumer-friendly regulators and stubbornly lower power prices have made this a perennial "wait 'til next year" market. With power prices recently testing historical lows, Exelon (NYSE:EXC) shares have been quite weak. Is this an undervalued high-quality utility story, or just another utility doomed to struggle with lower-than-expected power prices in its core regions?

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Low Fossil Fuel Prices Eroding the Edge
Exelon is America's largest nuclear power generator and typically enjoys pretty competitive power costs (approximately $15/MWhr) as a result. In normal times that would be valuable, but the rock-bottom prices of natural gas and the falling price of thermal coal is shrinking some of that advantage. With fuel costs so low, power prices in the Mid-Atlantic and Illinois markets where Exelon operates have plunged. In fact, forward prices in the PJM region have recently tested historical lows. At these levels, then, dividend coverage could actually become an issue for Exelon around 2014 or so.

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Regulators not Helping
Making matters worse, Exelon doesn't operate in the most utility-friendly regions. In fact, regulators in Illinois, Pennsylvania and Maryland by and large have the reputation for being consumer-friendly. That makes it more challenging for Exelon to get generous rate allowances and puts more pressure on the company's return on equity. Although the company can offset some of this with improved operating efficiency (including the benefits of the merger with Constellation) and non-regulated operations, there's a limit. Ultimately this regulatory environment will represent a headwind for Exelon's comps relative to other utilities in like Duke Energy (NYSE:DUK), American Electric Power (NYSE:AEP) or NextEra Energy (NYSE:NEE).

A Dividend-Heavy Play on Natural Gas?
There is another way to think of Exelon - that is as a high-dividend play on higher natural gas prices. Investors don't really have a lot of high-yield options among operating companies focused on natural gas ((Chesapeake Energy's (NYSE:CHK) 1.7% dividend yield, for example)), and while Exelon is of course not a natural gas producer, it should see substantial benefits if and when prices increase. As power prices are often set by the cost of natural gas-fired generation, higher gas prices ought to translate into higher power prices.

Exelon's valuation today arguably already presumes natural gas prices of $4/MMbtu in the future, but if prices rise into the $5 or $6/MMbtu range, the per-share earnings power at Exelon could be north of $5 per share. That's a pretty substantial upgrade, to say nothing of the incremental dividend potential that could go with it.

A Few Drawbacks
This isn't a perfect play, though. In addition to those above mentioned regulatory pressures, there's the new reality of nuclear power in the United States and the future of interest rates. Nuclear power is no longer in favor here and while that may change, it could represent a long-term challenge to Exelon's model if the company cannot replace aging plants with new facilities. Likewise, utilities pretty much always carry high debt loads and the Fed's efforts to sit on rates through 2015 raise the prospects of higher interest rates down the line. If there's good news, it would be that neither of these issues are more significant than the near-term balance between power prices, natural gas prices and Exelon's generation costs.

The Bottom Line
I'm generally not a utility investor, but I'm far more interested in the risk/return characteristics of individual stocks than I am at maintaining any sort of investment fidelity to particular industries. With that in mind, Exelon is looking pretty interesting today. Assigning a 10% haircut to Exelon's 2013 EBTIDA forecast (to account for a less-favorable regulatory exposure), Exelon shares look as though they ought to be worth about $43 or so today. There is a fairly wide spread to these estimates (at least for a utility); the high end of the range would push the fair value to roughly $50, while the low end cuts it down to $32.

All things considered, I think that's a solid risk-reward trade-off, particularly when coupled with a nearly 6% dividend yield. I do think that low power prices are a threat that investors (especially long-term dividend investors) cannot afford to overlook, but I think the fundamentals broadly support Exelon as an undervalued utility company pegged to higher natural gas prices.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.