Dominion Resources is the latest utility to announce a major
plan for negawatt investment. Negawatts are basically saved megawatts;
that’s investment made to enhance conservation and save power companies
from having to build new megawatt capacity. One negawatt equals one
saved megawatt.
Dominion’s plan is designed to save its Virginia
customers up to $1 billion in higher rates over the next 15 years by
eliminating the need to build two power plants and delaying two other
projects. The key element, as is the case with the other negawatt plans
announced to date, is installing advanced meters that allow much better
control over power flows.
The steps, which include a wide range
of new incentives for consumers and businesses, must be approved by
Virginia regulators and will cost an estimated $600 million for the
meters alone. Winning approval of that investment and recovering it are
no sure thing in any state.
Virginia, however, passed
legislation last year that set a goal of conserving 10 percent of
projected power needs by 2022, a considerable challenge considering the
rapid growth in demand of recent years in the northern part of the
state. Regulatory relations have also been historically strong, and the
company enjoys a statutory rate of return that’s among the highest in
the country, as part of Virginia’s re-regulation law.
As a
result, the company should have a far easier road to travel recovering
its negawatt investment than, for example, New York’s
Consolidated Edison
is having. Odds are enhanced by the plan’s environmental
benefits—particularly reducing carbon emissions—that are proving to be
popular this election season.
Dominion is simultaneously asking
for an 18 percent rate increase to cover fuel costs for its power
plants. Here, its odds are good as well. But the case has attracted the
scrutiny of one of the state’s US senators, Jim Webb, who wrote a
letter to the State Corp Commission stating: "In this time of economic
uncertainty, an increase in energy costs could compel individuals and
families to choose between putting food on their table and paying their
energy bill.”
Those are powerful words that should get the
attention of every utility investor. Dominion itself is entitled by law
to recover its costs. Provided the company has made its filing
correctly—a fair bet—it’s nearly certain to recover the amount for
which it files. It may increase the portion of the increase that it
intends to defer, but the company will be made whole.
The
sentiment conveyed by Webb’s letter, however, goes deeper than one rate
case. Rather, it’s a clear sign that, in an environment where consumers
are strapped, rate increases aren’t going to go down easy, no matter
how justified.
History shows what “soak the utility” actions
by regulators always backfire in the long run, as they lessen
investment in system reliability by weakening companies’ financial
health. Also, not allowing real cost increases to go into rates
discourages conservation, keeping demand that much more strained.
On the other hand, as I pointed out in last week’s
Utility & Income,
these are tough times for many utility customers. Sen. Webb’s point is
hardly radical in that context, and no doubt there are many utility
regulators who agree. Moreover, utilities, too, have much to lose by
raising rates too quickly, if they precipitate ill will and more unpaid
bills. And if people in a relatively wealthy state like Virginia are
suffering, there are many other areas of the country where things are
far worse.
The key advantage utilities have in tough times is
they provide an essential service. No matter how the economy is
running, consumers and businesses have to buy electricity. That means
steady cash flow, even as other businesses are pulling in their horns.
The
flip side is that utilities are very visible companies. Consumers may
not be able to track where their automobile was made. But they
certainly know to whom they write their check for the power bill.
And
just as utilities are vilified when storms knock out power for
inordinate periods of time, rising rates are also sure to provoke
outrage. That’s not only dangerous to utilities’ public image, but it’s
potentially threatening to their ability to recover investment as well,
no matter how needed it is.
Utilities’ public relations
challenges are currently paltry to those of the Super Oils. Big Oil has
always been viewed with extreme suspicion by large segments of the US
public.
And the record profits of companies such as
ExxonMobil at a time when prices at the pump have hit $4 and higher haven’t helped. Companies such as
BP
have come under intense scrutiny, both for sky-high gasoline prices and
for the recent string of accidents at its facilities in this country.
You
won’t find many people who will agree with this. But ironically, the
price at the pump for gasoline should actually be much higher than it
is now. Refiners have been unable to pass through the full increase in
crude oil prices into the price of gasoline because of weakness in the
North American economy. In fact, refining profit margins have basically
collapsed in recent months.
Second, what’s going on in the oil
market is almost wholly beyond Big Oil’s control. That certainly wasn’t
always the case. In 1950, virtually all oil consumed in the US was
produced here as well, and the seven sisters spun off from the old
Standard Oil
dominated. That started to change with a vengeance with the rise of the
suburbs and growing dominance of gas guzzlers on the newly constructed
roadways, which exploded demand to the upside.
At the same
time, the rich, cheap reserves that the country had run on for its
entire history—and proved invaluable winning two world wars—began to
tap out, leaving only higher cost, harder-to-get resources. And a
series of spills heightened public awareness to the environmental costs
of oil production, leading to the strict limits set on offshore
production and more-remote, environmentally sensitive areas. That took
a large quantity of proven reserves off the market.
Big Oil’s
logical response was to start going overseas to meet the American
public’s voracious thirst for black gold, despite the lingering bitter
taste from Mexico’s nationalization of their assets there in the 1930s.
Political risk was accepted because resources were far cheaper and more
profitable to pump than available domestic sources of energy. The
tradeoff, however, was that Big Oil had to traverse ever-greater
distances to go to less politically secure places to tap into ever-more
difficult places.
By the ’70s oil crunch, most US oil was
flowing from overseas, with a large chunk from the Middle East. The
skyrocketing prices then were more a function of political control of
oil supplies by sometimes hostile nations. But they demonstrated
clearly that Big Oil was no longer in control of global oil production
or setting its price. And the situation grew worse, as rising resource
nationalism around the world shut off even more possibilities.
The
pendulum did swing back to Big Oil’s favor later that decade, as the
discovery of the vast deposits under the North Sea temporarily shifted
the balance of resource ownership away from the Middle East. That was a
major factor that ultimately broke oil’s price down by the mid-’80s, as
Saudi Arabia abandoned its role as “swing” producer. And most of the
Big Oil companies got more than their share.
US dependence on
imported oil outside Big Oil’s hands, however, soon began growing
again. The North Sea reached peak output in the ’90s and has been in
decline since. Meanwhile, Russia has become more assertive in its
resource rights, largely kicking out
Royal Dutch Shell and
making life miserable for BP. And Venezuela—to the extreme detriment of
its own industry—has effectively booted many of its former Big Oil
partners, including ExxonMobil.
Today, the US imports more than
80 percent of the oil we use. Less than 10 percent is from reserves run
by Big Oil. And despite some promising projects by certain companies
off the coast of West Africa and in the former Soviet Union, that share
continues to slip.
Big Oil, of course, still has its hands on
the downstream side of the business, such as refinery, petrochemicals
and distribution. That’s not worth what it used to be, however.
The
US is still the world’s most important market for oil. But unlike in
previous cycles, upturns and downturns in the US economy don’t have
nearly the same impact on the price of oil.
Mainly, in the
second half of last year, as energy prices were beginning their
historic run, US and European demand for oil was dead flat. In previous
times, that would have meant flat demand for oil and, with the North
American economy slowing down, falling prices. This time, however,
demand from other nations, notably China, more than picked up the
slack. And the trend has accelerated this year.
The upshot: The
price of oil is no longer set in the US. Rather, the major factor going
forward will be demand from the developing world, notably China. And
with the Chinese consuming less than 10 percent per capita what the
average US consumer does, they’ve still got a lot of room to grow.
Higher
demand from China means that the price of oil will increasingly depend
on how that economy performs. If it does slow meaningfully in coming
months, it could take oil prices lower. But if it doesn’t, oil is
certain to stay at high levels, even if the US economy does sink into a
deep recession.
All of this puts Big Oil—now more accurately
dubbed Super Oils after the recent wave of mergers—in a very difficult
place. On the one hand, companies are making record profits and are
sitting on record hoards of cash. On the other hand, they have no
control over the price of oil, limited opportunities to expand
production and the growing enmity of a public that doesn’t fully
understand the position they’re in.
Add to that the still
growing unpopularity of the current US president—who is closely
associated with them—and it’s no wonder the Super Oils have become the
whipping boys of American politicians everywhere. A proposed tax on
Super Oils’ alleged “windfall profits” looks dead for now. But it’s
almost certain to be resurrected in the Congress that will come to
power in 2009, with oil prices still at very lofty levels and after a
winter that promises to come with record home-heating prices.
Super
Oils do have two aces up their collective sleeves. First, they’ve
become truly global companies, making it very difficult to impose any
kind of truly punitive tax on their overall operations. And any attempt
to do so will no doubt be met with shifting funds to more hospitable
climes.
Second, as popular as socking it to the oil companies
may be, politicians are even more scared by what would happen if they
were seriously weakened. The Super Oils may not have any real control
over either global oil supplies or global demand for energy. But the
piles of cash they control do represent the best chance to invest in
America’s energy future.
Rather than chase them out with
punitive measures, it’s far more likely Super Oils will see more of a
carrot-and-stick approach in coming years. That is, companies will see
incentives to invest in technologies and processes that increase
America’s power in the energy market as a consumer nation.
Some companies are already moving aggressively.
Chevron Corp, for example, is spearheading development of utility-size solar power facilities in a partnership with
Google and
Goldman Sachs.
It’s also a leader in developing biofuels, though the bulk of effort in
coming years will be in a series of projects around the planet to
increase conventional fuel production.
That’s the kind of
innovation that ultimately will shift the balance of market power from
the producer nations to consumer nations again, where it was from the
mid-’90s until early this decade. As the aftermath of the US windfall
profits tax on energy in the ’70s showed, punitive measures don’t do
much to bring down energy prices or even to slow the oil companies
other than the domestic producers that could be hit with it.
As
for demand, if such a tax were used to put money back into consumers’
pockets, it could ease some of the pain being felt now by many.
Unfortunately, it would also send a potentially disastrous signal to
consumers: that today’s high oil prices are the result of
Enron-like greed in Super Oil management, not epic, long-building shifts in supply and demand.
To
be sure, there’s plenty of greed to go around in American boardrooms,
and not everyone is on the up and up. But a mindset that blames
everything on Super Oils will only be more resistant to the kind of
changes in behavior needed to really change consumption habits. And
that’s the only thing that really breaks the back of commodity bull
markets like this one.
The key for investors is, of course, how
increasingly hostile public relations can impact profitability of
energy utilities and producers. For Super Oils, it may be a few cents
off the bottom line or, in any case, a drop in the bucket compared to
the impact of volatile energy prices.
The bottom line is it
doesn’t really matter what the government does on the taxation front.
As long as energy is in a bull market, Super Oils are going to profit
richly. And if prices do back off in the interim, they’ll get their
chance to invest.
The vulnerability of regulated electricity
companies, on the other hand, is considerably greater. Power companies’
operations are generally confined to certain geographic areas. That
means states they operate in have control over how much they earn.
One
of the key reasons utilities have performed so well over the past five
plus years is that regulation has been generally favorable. That’s even
true in states that have historically kept utility rates artificially
low and companies financially weak, such as Nevada.
At this
point, the industry is as strong as it’s been since the ’60s. Companies
have been able to jack up dividends at the same time they’re improving
credit quality, by cutting debt and operating risk.
That could
change in a hurry in states where regulation turns harsh. Again,
crippling the utility in the name of higher rates is a self-defeating
proposition, as weakened service providers have higher financing costs
and a tougher time paying for needed capital spending. And with $1.5
trillion in needed expenditures for the US power industry by 2030, it’s
a formula for disaster.
Most politicians, however, have a
history of not looking past the next election cycle. Others almost seem
to be habitually anti-big company and relish the idea of punishing a
“greedy,” big, visible corporation on camera. That makes for mischief.
And utilities and their investors who get in the way will suffer the
consequences.
At this point, we really haven’t seen a lot of
carnage outside a few states. New York, for example, has reverted to
its bad old days of utility regulation. Both the commission staff and
an administrative law judge is recommending the full regulatory
commission reject
Iberdrola’s bid for local wires and pipes company
EnergyEast.
That’s
despite a pledge by the Spanish giant to invest more than $2 billion in
renewable energy in the state. Like many northeastern states, New York
is heavily reliant on traditional sources of energy such as coal and
natural gas, and it’s projected to see rapidly narrowing reserve
margins in coming years.
Nonetheless, the staff and the judge
are still trying to extract more, including sharply lower rates. And if
the commission goes along with them, Iberdrola will walk away, leaving
the state with an independent utility but no new investment. In fact,
it’s certain most power companies will take the rejection—combined with
Consolidated Edison’s sudden inability to win needed rate increases to
encourage conservation and efficiency—as a reason to shun the state
entirely.
New York attorney general Andrew Cuomo is also opposing
Entergy Corp’s
plan to spin out its unregulated nuclear power plants into a separate,
50-percent-owned entity. The company’s existing shareholders will get
the rest of the company, as well as holding their shares of the
four-state
Mid-South power utility.
The state has
limited jurisdiction over the deal, which is still likely to close in
the third quarter. But the signal is crystal clear: The Empire State is
no longer friendly ground for utilities. In fact, with little clear
policy agenda besides apparently keeping down customer rates, it has
the potential to become downright hostile.
The good news is the
contentiousness still apparently hasn’t spread outside New York. But
watching the states is increasingly the key to success in this industry.
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