Electric Utilities: A Victim of Commodities
Posted on: September 3, 2008 - Email Article - Printable Version
As it becomes more apparent that the economy has slipped into a recession we historically have seen investors flock towards equities that present the three S’s: stability, sustainability and 
safety. Markets teetering in and out of bear market territory rarely are comprised with many investors bullish on banks with sub prime issues or companies tied to a housing bubble. However, a sector typically seen as a safety net in a time of economic turmoil, the utilities’ sector, has come upon its own fair share of hardship, in particular the old mainstay electric utilities. This array of stable but slow growth companies known for comfortable dividend yields has mirrored the sluggish performance of the markets as a whole. Since January 1st of this year the Utilities SPDR, XLU [XLU: 31.375, -0.105 (-0.33%)], whose top ten holdings are all electric utilities companies, has been down just over 11%, while the S&P 500 has been marginally worse with a return around -12.5%. Who/What is the culprit you ask? Commodities, commodities, commodities.
The Spark Spread
For many unfamiliar with the utilities sector the most vital financial figure is something referred to as the spark spread. The spark spread is defined as the difference between the market price of electricity and its cost of production. In layman’s terms, how much money a company makes from their energy production versus how much it costs that company to produce that energy. Obviously, the larger the spread, the better. The most substantial variable cost for an electric utility company, of course, is the price of fuel, in particular coal and natural gas prices. Although commodity prices are typically volatile, the summer of 2008 has seen a run-up (and a sell off) rarely exhibited in the commodity market. The bottom line: coal and natural gas prices are up approximately 150 and 30 percent respectively from January 1st, 2008 (as of August 31st). Furthermore, coal and natural gas account for 49 and 22 percent respectively of electricity production in the United States. It should not be too difficult to see that this is clearly devastating for margins at electric utility companies as their spark spread continue to dwindle along with their value on the street.
The Climb of King Coal
With coal accounting for nearly 50% of electricity production, it is an input that warrants a close eye from electric utility investors. Since January 1st this year, coal prices have nearly tripled from $55 per ton to a startling $140 per ton and for good reason. Demand worldwide for this fossil fuel has progressively increased 
as China, India, and other Asian nations, are using the source to essentially fuel nationwide commercial and residential growth. To complicate matters, floods in Australia, snowstorms in China, and infrastructure difficulties in South Africa have helped maintain the upward pressure on coal prices. In addition, due to regulatory pressure, the United States has shifted toward Powder River Basin (PRB) coal from Wyoming as opposed to coal from the Appalachian region. PRB coal is a cleaner burning fuel but subsequently does not produce as much electricity. Therefore, the supply of United States coal has not grown as fast as worldwide demand, once again pushing the price of coal up.
The Nat Gas Story (Again)
Natural gas is by no means a secret anymore. Its has been nearly impossible not to hear a bullish story through a financial media outlet on the prospects of the fuel source including an in-depth article on this site as well (“The Bullish Case for Natural Gas”). But just to reiterate, the market has fallen in love with natural gas primarily due to environmental reasons. With carbon legislation likely on the horizon, natural gas is the effective yet “cleaner” input source as it leaves 60% less of a carbon footprint of crude oil. In addition, compared to crude, natural gas is extremely undervalued. On average, since 1980, natural gas generally trades at a ratio of 8.5:1 to crude. That is $8.50 per unit of natural gas, measured in MMBTUs, to the price of 1 barrel of crude oil. Currently, the ratio of crude to natural gas is hovering around 15 to 1. Unless crude continues its steep march downward, natural gas prices will increase back to its typical trading levels.
Not all Doom and Gloom
A typical trait of electric utilities is they operate in a regulated environment. As regulated entities, these companies have little wiggle room when it comes to rate hikes and price increases. However, historically in terms of commodity prices, regulators have shown favorability in rate hikes to help these companies maintain their margins and financial health. Plain and simple, electric utilities are a staple in everyday life in the United States and it is in everyone’s best interest that their business line remains attractive. The problem? There is a lag. Price increases take time, especially in times of economic hardship. When it is all said and done, the next 2-4 quarters may be a struggle for this sub-sector, particularly if the economy remains in a rut. Nevertheless, in due time, electric utilities will return to be the stable and consistent investments you and I have become familiar with over time.
-T.J. Smith
Disclosures: None
The Following Stocks Were Mentioned In This Article: XLU
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Interesting…
What’s the next commodity ? In the IT world, with the idea of cloud computing taking off, servers and networks don’t seem far from becoming one. I suppose that keeps people innovating in the higher level areas, but for an old hardware guy it’s a little sad.
lower electrics last blog post..Stuck in a bad cell phone contract ? Negotiate !
Commodity markets are hard to predict as evident this year. Huge run-ups and big sell offs are not uncommon. While it certainly is not the next commodity, i think natural gas as the fundamentals to appreciate substantially over time. Since nat gas is a much cleaner fuel, new legislation will increase its usage subsquentially increasing demand. Furthermore, nat gas only accounts for 1% of transportation fuels today, so with renewable energy expansions we will be able to use nat gas less to produce electricity and more to run our motor vehicles.