All Aboard European Utility Stocks
Companies / European Stock Markets Jun 19, 2007 - 09:09 AM GMTBy: Roger_Conrad
This week, I'm writing from aboard the MS Deutschland on the first leg of my publisher, KCI Communications, Inc's investment cruise of the Baltic region. For 10 days, my colleagues and I have joined a group of subscribers and spouses, visiting major coastal cities in Sweden, Finland, Russia, Estonia, Latvia, Poland and Germany in an effort to get to know this historically interconnected and unique region better.
This time of year it's almost always daylight in this part of the world. The climate on board reminds me a lot of northern, coastal California—sunny, with temperatures around 60 to 70 degrees Fahrenheit.
That's in stark contrast to the Northeast US during the past few weeks, where we've seen temperatures more reminiscent of midsummer.
It's also 180 degrees different from the weather here for most of the year, particularly in the winter months, where it's rarely light outside.
Extreme climates like this one always make me think of energy. It's hard to believe that anyone could live here in the winter months without the benefit of electricity for heat and light. Of course, that's what Baltic dwellers did for thousands of years, once enough of the glaciers had melted to allow human settlement.
Today, with the benefit of power, the historic towns of the region have become major world cities, such as Stockholm, Sweden, and St. Petersburg, Russia, much in the same way electric air conditioning has turned US cities in the Southeast and Southwest into fast-growing megalopolises. And just like in those areas, electricity is completely essential for the population to survive and thrive.
The nations of Scandinavia have long placed far more importance on electric-power reliability than the US. Outages at US rates wouldn't be tolerable.
That fact has been recognized by industry and utility regulators for some time. As a result, they've been willing to pay higher rates to maintain a higher level of infrastructure. Utilities have been able to plan their capital spending more effectively, which has held down long-term costs.
In Sweden, reliability is especially important because of the country's dependence on staying on the cutting edge of technological development. The country has several “centers of excellence,” focused on different areas of research and backed by a host of global corporations as well as the Swedish government.
The Kista (pronounced “shay-sta”) center of excellence focuses on wireless technology development. At the center is the country's giant Ericsson, which continues to expand its markets globally and has numerous interrelationships with the myriad startups and small companies that populate the industry. There are also centers of excellence for pharmaceuticals and other areas of medicine, including biotech, aerospace, automobiles and clean energy.
These centers are regularly developing new technologies in a wide range of areas. The Swedish government has an obliging tax policy for corporations operating in these areas.
And the US government is also a player, particularly in clean energy development. Ambassador Wood has launched a major effort to encourage US investment in Swedish clean-energy companies and US corporate involvement in Swedish development projects.
The success of all these centers depends heavily on the reliability of electric power throughout the year. And to date, the Swedes have been willing to pay for it, with the result that leading utility VATTENFALL is both extremely healthy business-wise and a leader in clean-energy development, including control of carbon emissions.
As I pointed out two weeks ago in Utility & Income, “Getting Credit,” US regulators once held the point of view that reliable infrastructure is worth paying for. The resulting constructive environment enabled reliable systems to be built across the country in the 1950s and '60s, as Americans moved to the suburbs and increasingly electrified their daily lives.
That regulatory compact broke down with the inflation of the '70s as officials across the country started to rule retroactively that utility expenditures were imprudent and refused to grant returns on the investment. The result was a total drying up of investment in utility infrastructure for nearly 30 years, with the exception of the massive construction of natural gas-fired power plants in the late '90s and early '00s.
With the disaster of deregulation, US regulator sentiment has again shifted in favor of balancing ratepayer and utility interests, with the goal of enhancing long-term planning for infrastructure development. We're still a long way from fully resolving the issue of what a fair return on investment will be on a nationwide basis.
But investment is starting to revive.
The biggest test case now for how long this favorable scenario will last is in New York, where CONSOLIDATED EDISON and ENERGYEAST have proposed massive new spending to improve the efficiency of their transmission and distribution systems. If Empire State regulators go along, the result should be markedly lower power rates for consumers in the long haul at the cost of higher rates in the near term. Con Ed's plans, for example, include the use of the latest superconductor technology.
Unfortunately, there's absolutely no assurance that officials will go along. In fact, the usual suspects are already crying about possible rate increases, and the new Democratic administration in Albany is likely to be more sympathetic than the prior Republican one. That's why investors should be especially cautious about both of these stocks until we see what happens.
Regulators' willingness to guarantee system reliability with adequate returns is something utilities in Sweden—as well as neighboring Finland—don't have to worry about. But the two nations' power providers do face a critical energy challenge for coming years.
Since the oil shocks of the '70s, Sweden and Finland have been very concerned with being self-sufficient with the energy they use. Both nations have been blessed to be close to the North Sea oil find of the past few decades. But unlike in the US—where the urge to be energy independent largely petered out in the '80s—those countries continued the hard work of weaning themselves off foreign energy sources.
In the past decade, a new goal has taken shape: the desire to diversify energy supplies away from carbon, i.e., fossil fuels. In the US, a heavy reliance on coal-fired power plants has made the desire to be energy independent and the desire to control carbon emissions almost at odds. And that will be the case until we see the development of new technologies to control carbon emissions without limiting the use of coal-fired power.
In Sweden and Finland, however, there's little in the way of homegrown fossil fuels. Consequently, kicking carbon and reducing foreign energy dependence are pretty much two sides of the same coin. In other words, the more energy independent these countries become, the less fossil fuels they'll burn and the less carbon they'll emit.
Today, Sweden's energy mix is approximately 44 percent hydroelectric--thanks to the stark elevation changes between the interior of the country and the sea--47 percent nuclear power and 9 percent biofuels. The last is largely courtesy of the country's massive forestry industry.
Finland's breakdown is similar, except hydro is far less important.
That's because of the relatively small elevation changes in the country. The forestry industry is correspondingly more important in generating energy.
The critical element of both countries' energy mixes is clearly nuclear power. Both have built a number of reactors and rank among the top countries in the world for reliance on the atom, as well as for plant performance.
That would seem to be an ideal platform for further expansion of nuclear energy in both countries, particularly with the rest of Europe increasingly dependent on Russian natural gas and global-warming concerns growing. Ironically, there's also still considerable anti-nuclear sentiment in the country.
Just as many Americans have been fearful of nuclear power since Three Mile Island in 1978, so many Europeans have been wary of nukes since the Chernobyl accident. That's persisted despite these countries' solid operating records for running plants efficiently and economically and growing anxiety over global warming.
In Sweden, a referendum passed in 1980 calls for shutting down all of the country's 10 remaining nuclear power plants by 2020. The current government is opposed to that policy and, in fact, has approved the expansion of production at those plants.
Coupled with the sheer impossibility of replacing that much power that quickly with wind and renewables, that makes it extremely unlikely that the country's nuclear plants will wind up being shut down. Likely political opposition, however, means the government is delaying efforts to expand nuclear production for at least the next four to five years.
The Finnish parliament, meanwhile, recently voted to open another nuclear power plant beginning in 2011. The vote betrayed a split among lawmakers, despite the country's simultaneous goal to reduce dependence on fossil fuels, chiefly imported natural gas.
How the Scandinavian debate breaks could have broader consequences as the arguments are debated again and again outside these nations' borders. Germany, for example, has also passed laws requiring the shutdown of its nuclear capacity with a deadline of 2020.
That's set off an explosion of wind-power-plant construction. But it's hardly enough to displace all the nuclear capacity slated to be shut. Nor is a push for solar and renewables going to come anywhere close to cutting it.
Instead, that nation—like most of the rest of Europe—has only one choice: import greater amounts of natural gas from the former Soviet Union. That's in addition to the gas that's already being imported in anticipation of the rollback of coal power use to reduce carbon emissions.
In my view, it's likely that Europe and the US will eventually place a lot more emphasis on nuclear energy--not only keeping existing plants running but also firing up new ones. There are about a dozen new nuclear reactors in various stages of design and siting in the US, mostly in the Southeast and sites that already house nukes.
It remains to be seen how many of these get built and to what extent what's generated is offset by nukes that must ultimately be shut down. As I reported two weeks ago, utility executives currently expect less than a dozen plants to be sited and built by 2020.
Rather, they expect to meet carbon regulation that's increasingly likely by 2009 to be met by burning a lot more natural gas. The current generation of gas plants built in the late '90s and early '00s—some 90 gigawatts of ultra-efficient, low-heat-rate stations—emits less than half the carbon of the typical coal plant.
These plants bankrupted their builders earlier in the decade as natural gas prices soared and power prices fell, making it impossible to service the huge amount of debt needed to build them.
Today, the supply glut created by their construction has dried up, and power prices have again risen enough to make them profitable to run. Moreover, these plants are in stronger hands.
As a result, the new generation of gas plants is profitable once more. Recent hot weather in the Northeast has further tightened power and gas supplies. And with carbon regulation certain to push up the cost of generating power from coal, profit margins are set to rise further. That adds up to rising demand for natural gas, making sharply higher prices inevitable, as well as the need for substantial imports of liquid natural gas (LNG).
Gas prices in the US are still being largely governed by weekly inventory figures. This long-term trend will push them much higher.
And it makes stocks such as CHESAPEAKE ENERGY extreme bargains at today's prices.
Despite public opposition to nuclear power plants, those that are allowed to run will be increasingly in the sweet spot of the energy picture. On the one hand, nuke owners will benefit—as they have in recent years—from the rise in power prices, which in many states are tied to natural gas prices.
On the other, their costs will remain relatively stable. And with new nuclear plants so difficult to build, there won't be much, if any, competition. Moreover, the leaders in the nuclear industry are the only realistic candidates to build the new generation of plants.
The other group in the sweet spot is renewable developers, particularly those building wind-power plants. Thanks to healthy subsidies, mandates in two dozen states forcing utilities to use a certain percentage of renewable energy, rising power prices and advances in efficiency and cost controls, wind-power development is now an extremely profitable business for the handful of companies that dominate it globally.
The problem with investing in renewable and nuclear power in the past few months has been the high prices of the developing companies as utilities across the board have pushed higher. That's started the change somewhat during the past couple of weeks because of the recent spike in interest rates.
The rise in rates moderated late last week as consumer and producer price inflation seemed to moderate. Unfortunately, that may not be over for this cycle.
As I posited last week, there's still considerable sentiment for higher rates, particularly with nations around the world pushing up rates to control their inflation rates. That means there's likely to be more damage to rate-sensitive investments.
Utility stocks' historic vulnerability to interest-rate swings is one of the most widely known relationships in the equity market.
What's less widely known is that rate spikes alone have never been a good reason for selling out utilities from portfolios.
Even the worst spikes have triggered drops in the utility averages of less than 20 percent and have been over in less than a year. Only pullbacks triggered by the collapse of industry fundamentals have been worth selling into, and they've literally occurred only once a generation: in the '30s, the early '70s and 2001-02.
Each one of these selloffs was due to an utter meltdown of underlying businesses. The most-recent collapse—which took the Dow Jones Utility Average down 59 percent from its late-2000 high to late-2002 low—was triggered by a huge overinvestment in gas-fired power plants and misadventures in trading energy, even as the leader in that sector, ENRON, imploded.
The good news is this time around we're nowhere close to a collapse in fundamentals in the utility industry. In fact, underlying business conditions haven't been as favorable since the late '60s.
As I pointed out two weeks ago in U&I, the coming surge in utility capital spending poses some challenges. Those that are able to recover what they put out will be extremely prosperous. Those that aren't allowed by regulators to make back their investment will be increasingly strained.
It's going to be some time, however, before even the most-vulnerable companies feel any pain. For example, because of this coming capital challenge, utilities have generally held their payout ratios on the low side during the past few years, plowing the funds back into debt controls and share buybacks. In addition, credit ratings have also been on the rise.
The big picture here is there's little or no case for a 2001-02 style utility sector meltdown. Consequently, this selloff should be viewed as a buying opportunity for stocks of well-positioned utilities when they come back to reasonable prices.
The good news is we're already seeing some emerging bargains in energy's sweet spot: the renewable and nuclear energy area, including several companies with considerable room to grow fundamentally. The country's leading wind-power developer—FPL GROUP--retreated this week into the upper 50s. It's still not yielding much at that price, but it's very cheaply priced based on the upside from its renewable energy growth.
As for income investments outside the utility universe, the key is also to own good businesses. As long as a company is growing at a healthy, sustainable pace, it will weather the ongoing rate spike, even if it goes to the upper end of Bill Gross' new range of 6.5 percent.
One group worth a look now is Canadian income trusts. The Conservative Party government has at last passed its budget, which contains a plan to begin taxing trusts like corporations beginning in 2011.
The ho-hum reaction in the market is yet another clear indication that trust taxation was priced in within a couple weeks of the government's original announcement on Halloween 2006. Rather, success or failure in the trust sector boils down to identifying, buying and holding good businesses that will be profitable regardless of how they're taxed.
Some of these are in the energy sector and will profit as demand and prices for natural gas rise in coming years. Some are outside oil and gas and, therefore, a good deal more steady. Together, they're the cheapest investment class in the global high-yield universe.
If you own good trusts, hold on. If you don't, it's a good time to take a look at the best of the bunch.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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