A light at the end of the tunnel

By Pam Boschee

I can’t resist. Yes, for some companies just put on notice by FERC regarding their roles in the California summer of infamy (check out our cover story), that light may be an oncoming train. At a minimum, it’s a searing interrogation lamp.

FERC said there were “epidemic” efforts to manipulate electricity and natural gas markets. Dozens of power suppliers—in this case, not just the usual suspects—have been called upon to defend their practices.

The state of California said power generators often bid prices much higher after the California grid operator declared an emergency knowing that the ISO would need all available power “and would be willing to pay any price to get it.” The behavior was so widespread that it was “the rule among suppliers, not the exception.”

The list of offenses reads like a rap sheet (HBO’s Tony Soprano might learn something here):

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“- “Megawatt laundering” or “ricochet trades,” where suppliers created artificial scarcity by exporting “vast amounts” of electricity out of California, then imported the same power inside state lines to sell at much higher prices.
“- Fake load schedules
“- Congestion games
“- Collusion
“- Double selling of capacity
“- Improper sharing of information

At press time, the meter was running on the 21 days FERC stipulated for companies’ responses.

These companies as well as others are still dealing with the financial fallout from California, 9-11 and Enron. The subsequent revamping of criteria used for credit ratings threw even some of the big guys into headlong tumbles.

Stepping out of this muck to take a broader view seems like a good idea, and that’s just what the securities firm, Bear, Stearns & Company Inc., did in their equity research report, “Electric Utilities, So Much for Being Defensive,” released in March. (Bear, Stearns & Co. is initiating formal coverage of Dominion Resources, Duke Energy and Southern Co.)

They provided interesting background, which in some cases countered what is generally accepted as “conventional wisdom” about utility stocks.

For example, utility stocks have often been viewed as “defensive plays”—low-risk plays for investors’ capital during rough markets. Investors often look to this sector, even when markets are in better shape, as a good place to park their capital while they consider their next investments.

Historically, investors regarded long-term investment in utility stocks as a higher-reward (with low risk) alternative to the 10-year Treasury because of the associated dividends.

However, “this isn’t your father’s (or grandfather’s) utility stock.”

At the close of 2002, the S&P 500 and Dow Jones Industrial Average indexes were down 23.4 percent and 16.8 percent, respectively, for the year; however, the S&P Utility Index and Dow Jones Utility Index were down even more—about 1,000 basis points more, 33 percent and 26.8 percent—in the same period. Bear, Stearns & Co. commented, “So much for being defensive plays in this down market.”

They then compare this recent performance to the past three decades. Here’s where “conventional wisdom” really fell apart.

The Dow has outperformed the Dow Jones Utility Average in all but eight years in the 30-year period from 1972 to 2002, including five of the nine years in which the Dow posted negative returns. In 2000, the utility index did post a whopping 45.5 percent return as compared to a 6.2 percent loss in the Dow, but a year later, in 2001, the Dow Utility index fell 28.7 percent vs. just 7.1 percent for the Dow Industrials.

Seems grim, but don’t write off this group just yet. Here’s where I see a promising flicker of light at the end of the tunnel.

Bear, Stearns & Co. pointed out that while utilities have lagged behind the S&P 500 or Dow historically, they continue to substantially contribute to overall U.S. economic profits.

Consider that the utility industry currently carries only about a 3 percent weighting in the S&P 500 index, but it contributed almost 10 percent of reported S&P 500 earnings in 2001. The securities firm added that 2001 was a very good year for some companies on an operational basis, with several onetime items like mark-to-market gains on energy trading contracts boosting earnings. But even after backing out some of these gains, the utility sector still generated about 6 percent of S&P 500 operating earnings—double the utility sector’s weighting in the index.

This wasn’t a one-shot deal either. Over the last 11 of 12 years, utility sector earnings as a percentage of S&P 500 total earnings outpaced the utility sector’s weighting.

We’ve been parsing and analyzing our sector for more than two years now. (Any regular readers of this commentary know I’ve certainly done more than my fair share of parsing.)

However, when looking at the utility sector in its broader context, it seems that the “sum is greater than the parts.”

The challenge now is for CEOs to deliver this message to investors and other stakeholders. The companies that emerge as the “bright lights” in this sector will reap rich rewards.

Be sure to check out our new exclusive equity indices on page 13. Each month, The C Three Group will provide comparative data for utilities, merchant companies and local distribution companies (LDCs).

Pam Boschee, Managing Editor

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