Regulated energy companies – natural gas pipes, gas utilities and electric utilities – have generally been seen as the sleepy cousins of more exciting energy subsectors like exploration and production, or coal extraction and production. But we have witnessed a number of events and regulatory developments in recent years that we believe are re-energizing the regulated energy subsector, more clearly distinguishing it from other members of the energy sector family and providing the potential for an abundance of opportunity for astute investors.
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Disruptions in the status quo
The regulated energy sector’s reputation is understandable. After all, the utilities and natural gas pipeline companies (referred to as “pipes” in this article) have been granted exclusive franchises by the state or federal government to provide an essential service at an allowed rate of return – which is typically set well above what an empirical analysis would suggest is the utility’s true cost of capital. Shielded in this way from competition and price volatility (like that which characterizes other commodity-based energy subsectors), these regulated utilities can be attractive to investors looking for steady return potential and long-term fixed income holdings.
In fact, the long-term performance in the energy subsector is what one would expect given this shielded environment – there have been few bankruptcies and restructurings over the years, and most that have taken place (for example, the bankruptcy of the Columbia Gas Transmission system in the early 1990s) resulted in fixed income investors recovering all of their principal, as well as accrued interest. Accordingly, many fixed income investors have taken a more passive approach to analyzing this subsector – believing that past is essentially prelude, and utility risks and potential returns are unlikely to materially deviate from their historical course.
However, events of the last several years have challenged the traditional utility investment paradigm. For example, in the United States the generally large (some would say outsized) returns earned by regulated pipelines have come under close scrutiny by the Federal Energy Regulatory Commission (FERC), with several being forced to agree to significant reductions in allowed return on equity (ROE) and subsequent reductions in earnings and debt service coverage. In addition, the rating agencies have recently taken an uncharacteristically harsh view on single-asset pipelines (companies that own a single pipe, as opposed to a holding company that owns multiple pipelines). This has resulted in a number of pipes being downgraded to high yield territory, with corresponding spread widening and forced selling that has taken many investors by surprise.
In addition, the tragic explosion of a PG&E pipeline in San Bruno, California has resulted in increased regulation of pipelines operations and a related increase in costs for more active and dynamic safety-related monitoring.
Events in Japan speak to some of the risks associated with electric power utilities. Last year’s Fukushima tragedy had a dramatic effect on the nuclear industry – both inside Japan and around the globe. We believe the owner of the Fukushima plant, TEPCO, previously one of the world’s largest utilities, would likely not have survived the crisis and its aftereffects were it not for the intervention of the Japanese government. Elsewhere, the attendant publicity and concerns around nuclear power resulted in a high degree of earnings and security price volatility for power companies in the short term and a series of longer-term setbacks to the once-burgeoning “nuclear resurgence.”
Finally, low natural gas prices have led to lower realized power prices in regions of the country where unregulated gas-fired power generators set the market price. Regulated utilities that are competing against unregulated merchant power groups (which sell electricity in the competitive market rather than selling contractually to specific customers) have been particularly hurt, and will likely continue to face pressure over the next several years as contacts to sell power at a predetermined price expire and re-set at materially lower levels.
Potential wild cards
PIMCO’s investment research team has identified a number of issues we believe have the potential to materially impact performance in the regulated energy space (electric utilities and natural gas pipelines):
Electric utilities – Plentiful natural gas supplies and correspondingly low natural gas prices should have an increasing impact on how electric utilities constitute and run their power generation portfolios. To date, we have seen the effect in a surprising amount of switching from coal to gas, as utilities run their natural gas power plants more and coal less to take advantage of the lower gas prices. Should this low gas price environment continue – and it is hard to see a dramatic turnaround given shale development around the United States – we expect to see an increasing number of utilities (many at the behest of their regulators) shift their planned capital expenditures from coal investment to acquiring or building gas plants, or re-fire existing coal units, as was the case recently with plants owned by the giant Tennessee Valley Authority.
While Fukushima concerns have added to the general stall in the much-anticipated wave of new nuclear development, a number of U.S. utilities (such as Georgia Power, South Carolina Electric and Gas) are still pursuing plans to build new nuclear units. In fact, Georgia Power’s Vogtle Plant recently received its combined operating license from the NRC to commence construction – the first new nuclear plant approved in the United States in three decades. While we understand the appeal of nuclear generation to the utility (low operation and maintenance costs coupled with fuel cost certainty, as well as the ability to put a large amount of capital into rate base in one asset) we note that these are very costly plants. In fact, it generally costs three times as much to build these plants as it costs to build a newer generation coal plant, and six times as much as a combined cycle natural gas power plant. Additionally, these development programs can expose these utilities to a higher degree of financial and operational risk than would be the case if they pursued a different route for their generation needs.
Natural gas pipelines – The impact of shale development on the U.S. natural gas infrastructure space as a game-changing event cannot be easily overstated, in our opinion. For years, the U.S. pipeline and natural gas storage sector has been characterized by well-traveled routes, with the commodity flowing from the Gulf Coast along traditional pipeline corridors to population centers like Chicago and the Northeast. Shale development – particularly in areas like Pennsylvania’s Marcellus Shale formation – upsets this traditional dynamic, and creates the need for entirely new infrastructure to support these new sources of supply: new pipes, new processing and storage, etc. Pipelines that were underutilized for years are now coming back in demand given their proximity to shale, while certain long-haul natural gas pipelines now face serous bypass risk in this new environment.
Long-haul gas pipelines have been in operation for many years and have valuable rights of way that cannot easily be replicated today. We view these as potentially hidden assets, some with a great deal of flexibility. For example, in the wake of shale development and oil pipeline constraints, we expect that some pipes will look to adapt to the changing market by (a) reconfiguring gas pipelines to flow crude, refined products or natural gas liquids (NGLs), or (b) building new interconnects and storage to take advantage of emerging production or other emerging themes (e.g. coal to gas power plant switching).
Finally, following San Bruno, we expect that increased regulatory scrutiny of pipeline safety will continue, to be accompanied by significantly higher operation and maintenance costs. Much, if not all, of these costs can be recovered through the regulatory process. However, we believe that over the longer term we will see more opposition to pipeline development or expansion in urban and suburban locales – a particularly challenging issue given the infrastructure development needs.
Electric utilities, gas utilities and pipelines – The high allowed rates of return granted regulated energy companies is no secret -- the issue can be seen as the proverbial elephant in the room in rate cases over the years. Specifically, a regulated process designed to provide the utility with a fair and reasonable return on equity capital has often produced allowed returns on equity well in excess of what traditional financial models (e.g. the Capital Asset Pricing Model or CAPM) would suggest are warranted given the lower-risk nature of many utility operations. During rate proceedings, utilities themselves argue that a higher rate of return is required to incent development, especially in regards to technologically advanced projects that are potentially higher return but higher risk by nature.
While this argument has been made compellingly over the years and has historically carried the day, we note that the spread of average returns allowed by regulators over the 10-year Treasury (used as a proxy for the “risk free” rate) is at a historical high – more than 800 basis points, versus a historical average of just over 600 basis points since 1995, according to data from Regulatory Research Associates and Bloomberg as of 31 December 2011. Several utilities have seen large cuts in their allowed returns (160 bps in one recent case), but our assessment of the market leads us to believe that these cuts were on the high end of the spectrum and that we will probably see an average reduction of 50 to 100 bps in allowed returns on equity over the next five years.
We expect utilities to adapt to this pressure in a number of ways, with the most successful among them looking to (a) emphasize investment in areas (primarily power transmission) where regulation is at the federal rather than the state level, as the federal government has shown a willingness to permit higher allowed ROEs to incent development, and (b) focus on investments designed to meet 2015 environmental regulations mandated by the EPA, as well as Renewable Portfolio Standards (RPS) mandated by most states.
An abundance of alpha potential?
We believe winners and losers will be more apparent in this new utility paradigm, with much more differentiated investment performance among subsectors and specific credits than has been the case in the past. We believe that potential for alpha (returns beyond those generated by an index) will be ample in this new paradigm and suggest that investors take a rigorous and exhaustive approach to identifying value in the sector, one that focuses on an understanding of:
- Supply and demand dynamics
- Interactions across the various commodity supply chains
- Overall macro environment and impact on specific names and subsectors
- Regulatory and political environment
- Operational and safety issues
Savvy fixed income investors can use this understanding to help identify best-in-class names in each subsector, as well as to identify tactical opportunities created by event-driven dislocations. While a sector that is no longer sleepy can certainly bring its share of unexpected risks, we believe it could also present attractive opportunities for investors willing to do their due diligence on a somewhat arcane, but irrefutably crucial segment of the national and global economy.