100-Year Trends

You know it’s a rough market when investors start to question the longevity 100 year-old trends. But that’s precisely what a Wall Street Journal columnist did in an article published today.

Specifically, the author asserted that a small drop in summer electricity demand at some utilities may be due to a permanent reduction in America’s consumption, rather than milder weather or a shrinking economy. And her title, “Surprise Drop in Power Use Delivers Jolt to Utilities,” clearly suggests the sector’s status as a safe haven is now in doubt.

To be sure, utility stocks have taken on water since early September, like everything else. The sector has posted strongly positive fourth quarter returns 33 times since 1969. But getting there this time will require a nearly 20 percent surge by Dec. 31, and time is growing short for such a move.

On the other hand, at least through the third quarter earnings season, the sector is still weathering the worst US economic crisis in 80 years. As I’ve reported here, power utes generally came in with very solid third quarter numbers, even as the US economy actually shrank. The shortfalls that did occur were, in management’s words, almost wholly due to weather-related drops in demand, as this past summer was considerably milder than the one before. And with the exception of companies that produce oil and gas--which have been rocked by a 60 percent drop in prices since mid-summer--company managements have largely held to guidance for both the fourth quarter and 2009.

In this risk-phobic market, we’ve seen even the strongest companies can literally take 10 percent one-day losses for no fundamental reason. But coupled with the general lack of credit concerns after a half decade of debt reduction, this is the picture of a very stable industry.

For one thing, dividends, with very few exceptions, look secure as ever. Payout ratios are averaging in the 50 to 60 percent range, based on trailing 12-month earnings. In fact, there have been more than a few increases announced this fall, including the 8 percent boost announced today by Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF).

The biggest fundamentals risk to power utilities isn’t the present, but the future. Some months ago, the Edison Electric Institute released a report it had commissioned from The Brattle Group, asserting the US power industry would have to spend $1.7 trillion over the next 20 years to meet the demands of a 21st century grid. The majority of the money, it was suggested, would have to be spent on upgrades to the country’s transmission and distribution system, and for environmental mandates such as reducing carbon dioxide (CO₂) emissions.

Brattle’s number has recently been updated to the $1.5 to $2 trillion range. It also now assumes 38 percent of what would have been new supply will be offset by new grid efficiencies, up from 17 percent in the prior report. The study asserts that all manner of plants will be built but that 40 gigawatts of renewable energy capacity will have to be constructed just to meet state laws now on the books. And it looks for smart grid technology and new power lines to integrate the growing renewable energy fleet to make up much of the new spending.

Since the report was first released, utility executives have approached its findings with a general wariness, and for good reason. For one thing, we’ve heard similarly bullish projections before. For another, heavy investment always runs the risk of regulatory disallowances. And the bigger the outlay, the greater the danger to a company’s very financial health.

Earlier in this decade, for example, Vice President Dick Cheney’s still-secret task force estimated the US needed to build at least one major new power plant a week to keep up with demand in the current decade. Four years later, those who bet on that “projection” had lost their shirts. By mid-decade, the last company continuing to build, Calpine Corp (NYSE: CPN), had filed for bankruptcy, from which it’s now emerged as a much leaner, more conservatively run company. As for the US power market, it settled into a multi-year glut that was only soaked up in the past couple of years.

Going back further, the last major building boom for the US power industry was during the 1960s and ’70s. The plants built then are absolutely vital to the US economy now, including virtually all of the nuclear plant fleet that meets 20 percent of US demand currently. But when they were completed in the ’80s, the economy was in recession and the rapid power demand growth of the ’60s had slowed markedly. Moreover, inflation in raw materials and rising wages had increased the overall cost of many plants to several times initial estimates.

The result was the highly contentious ’80s and ’90s. Faced with the prospect of raising customer rates dramatically in a sluggish economy, regulators instead forced utilities to fight for every penny of cost recovery.

Dozens of companies wrote off billions of dollars of power plant investments, forcing dividend cuts and even bankruptcies. And the rate increases that did occur left a deep scar. In fact, they were major incentives for consumer advocates and regulators to (mistakenly) back the extremely destabilizing utility deregulation in the ’90s, as a way to roll back rate increases even more.

With this history, it’s no wonder utility management and investors are always wary entering a new building boom. My contention since this one got under way is that regulatory relationships will prove the difference maker between recovering investment and boosting earnings, and having to potentially write off billions. That makes regulator watching--particularly on the state level--easily the most critical factor in picking utility stocks for a portfolio.

The good news is most states now are fostering a cooperative relationship with companies, enabling long-term planning to meet needed capital spending with the least rate shock to consumers. My feature article in the December Utility Forecaster rates regulatory relations in the states in the wake of the 2008 elections, which ironically changed very little.

This is something we utility investors are going to have to watch as long as we hold our stocks. And the unfolding recession promises to stir things up at least in some states, as companies ask for higher rates to cover everything from higher fuel costs to needed capital improvements.

On the plus side, natural gas and coal prices have come off since the summer. That should mean less upward pressure on the fuel cost component of rates, which in most states is automatically passed through to customers. That in turn will take pressure off regulators when it comes to trying to get utilities what they need to stay healthy without hurting the economy.

On the other side of the coin, however, are rising financing costs. Once again in the third quarter, most power companies managed to reduce their interest expenses, the result of systematically controlling and reducing debt from levels earlier in the decade.

Unfortunately, that’s likely to come to an end in the fourth quarter, at least for any company seeking to refinance significant levels of debt, or taking on more to finance capital spending. The good news is overall interest rates are still very low on an historical basis, thanks to the massive decline in the 10-year Treasury note yield in the wake of the global financial panic. But the spread between even A-rated utility bonds and Treasuries has widened to near historic proportions. It’s likely many companies will see these interest costs rise because of that, particularly if they’re in a building mode.

The ironic upshot: Even a temporary reversal of America’s 100-year uptrend in electricity demand could be a very good thing indeed for power companies--as it would reduce capital spending and thereby the odds of devastating disallowances of investment by regulators. In fact, coupled with the big decline in raw materials that’s accompanied this recession, costs even for investments that can’t be avoided have the potential to come off sharply.

Don’t get me wrong. Recession or no, I’m not buying the argument that a century-old trend of rising electricity usage has suddenly come to an end.

Since Thomas Edison threw the first switch back in the late 19th century, Americans have progressively used greater and greater amounts of electricity. Demand hasn’t risen every year. In fact, as I pointed out in the November issue of UF, power demand has actually dropped in three calendar years since World War II.

In 1974, the combination of an oil embargo and recession triggered a 0.4 percent decline in underlying US power use. A more severe drop occurred in 1982, when stagflation ripped into industry and demand dropped 2.8 percent. Finally, in 2001--a year marked by the dot-com bust, the attacks on Washington and Wall Street and finally a mild recession--demand slid a little less than 1 percent.

Following each of those years, however, demand recovered and went on to even greater levels. Recessions have come and gone. Industrial demand in particular has waxed and waned. But year in year out, the US economy--and in fact the entire world--has become increasingly electrified, and use has continued to rise.

For the first six months of this year, power demand continued to rise. That did change the last three months, at least in some areas. For example, Midwest and Rocky Mountain-based Xcel Energy (NYSE: XEL) reported a 3 percent drop in sales to homes for the August-through-September period. Duke Energy (NYSE: DUK) saw an even steeper drop in the Midwest and Carolinas. American Electric Power’s (NYSE: AEP) residential demand across its 11-state franchise fell 7 percent from last year’s levels.

As reported in the WSJ article, executives of all three companies are wary about breaking ground on new projects. And that’s certainly been born out industry-wide by the reduced capital spending planned by many companies for the coming year.

But jumping to the conclusion that a 100-year trend has been broken is premature, to say the least. In fact, it’s a little like theorizing about global warming based on a day’s weather. Perhaps we have hit an inflection point for global electricity demand. But there are just too many alternative explanations to reasonably draw that conclusion now.

The main thing is the weather, which utility after utility reported was considerably milder than the summer of 2007. Historically, the mercury has been the primary catalyst for how much juice residential customers use. And while some companies, such as Xcel, have encouraged conservation, there’s really not much in the numbers to suggest permanent demand destruction even in its service territory.

Bottom line: The reasonable assumption is that it’s still the weather driving demand.

Again, be it the weather or something less ephemeral affecting power demand, this is still an exceptionally strong sector with the ability to withstand these unfolding tough times. I’m no technician. And I also must admit that a reader pointed out a head-and-shoulders top for the sector some months ago, and he’s been proven right.

My policy, taught to me long ago by my longtime friend Stephen Leeb, has been not to react to a technical indicator unless there’s a reason grounded in market fundamentals. In this case, the reason was the unfolding financial crisis. I didn’t foresee the magnitude of it, and utility stocks haven’t been immune from it.

Looking ahead, however, we’re just not seeing the kind of weakness in the power companies’ businesses that would justify even the losses their stocks have suffered thus far. And at the share prices and high yields they offer now, it sure looks like we’re a lot closer to a bottom than ever, and it seems a good time for measured, incremental investing.

Again, as I pointed out last week, energy and commodities are another story. The price of oil cracked $50 this week. That’s some $40 below the downside target of $90 I advised Canadian oil and gas producer trust owners on back in June of this year.

The current level of prices is unsustainable given the cost of producing oil, let alone replacing rapidly diminishing existing reserves. But it’s a clear sign of the fear running through this market. And although I feel in my gut we’re a lot closer to a bottom than a top, I don’t have the clairvoyance to call a bottom from here.

Rather, the best approach with energy stocks is to be sure of what you own. If your companies have strong reserves, manageable debt and demonstrated capable management, you want to hold on, and possibly buy some more though at a gradual pace. That certainly applies to Super Oils, which are the best bargains in the market for conservative investors.

Dividends paid by flow through entities like unit trusts, limited partnerships and Canadian oil and gas producer trusts are going to fluctuate with energy prices. One of the big surprises to me so far--given the 60 percent-plus drop in oil and gas prices since summer--is that distribution trimmings haven’t been more severe. That’s in retrospect due to just how conservatively run many of these operations are, as management used the windfall from higher prices earlier this year to do needed development and cut debt.

Make no mistake: If energy prices do fall further, they’ll have to cut again. And if oil goes to where some of the bears see it--$30 or less--the cuts could be somewhat severe.

In my view, that’s the kind of scenario these shares are already reflecting in this emotional market. Enerplus Resources (TSX: ERF-U, NYSE: ERF), for example, really does sell at the same price it did back in late 2001, when oil was under $20 a barrel, gas was scraping $2 per million British thermal units and the Canadian trust was a far smaller and arguably less valuable company.

Again, I’m no technical analyst. But those are the kind of values that only appear close to a bottom, and they’re certainly worth holding on for.