Frontlines
August 2003
Butterfly Nets and Crystal Balls
By Richard Stavros
Forecasters seem at odds over timing for recovery of power prices and earnings.
Like the rise in the Dow and Nasdaq this summer, optimism in the energy sector is on the increase as utility earnings improve. But as there is disagreement over the strength of the U.S. economic recovery, there is considerable discord in predictions of the utility industry recovery. Much of the unease comes from conflicting and disparate forecasts. Depending on whose report you read, the recovery in power prices is expected within 4 months, 12 months, 3 years, or 6 years (some even say 10 years). Certainly, the variation in forecasts must be attributed to the different assumptions about the effect a broad economic recovery would have on power demand and supply.
For example, in a report issued July 8 by UBS Warburg, equities analyst Lawson Steele said average U.S. peak electricity prices were expected to rise 48 percent in 2003 from the previous year, owing in part to higher prices for natural gas. Thus, Steele predicts power price hikes ranging from 21 percent in the Mid-Atlantic states to 27 percent in the Midwest, 58 percent in the Western states, and 74 percent in gas-dependent Texas. Yet others see this vision as "all wet," to borrow some jargon from investment bankers. Those critics say it's overly optimistic from a generator's view because UBS fails to take into account the current power demand and supply fundamentals. Notwithstanding that UBS based its report on forecast power costs from the nation's 50,909 generating stations.
Moreover, consultants Wood Mackenzie, in their Summer Power Outlook, say the summer of 2003 will be marked by weak electricity sales and peak-demand declines. Furthermore, weak electricity demand will provide some relief for the natural gas markets, as year-over-year consumption declines, Wood Mackenzie says. Not to mention, the DOE's Energy Information Administration, in its July 8 Short Term Energy Outlook, says most of the 1.3 percent jump in electricity demand came from the first quarter, driven largely by weather factors (heating demand). "If normal temperatures prevail for the remainder of the year, little or no additional net weather-related demand growth is expected," the EIA concludes. Naturally, a drop in demand does not necessarily mean that prices can't be high, but with the current power glut, I interpret these prices to be low. In respect to the power supply situation, even UBS's Steele does not predict a return to a normal supply-demand balance in power, which he says is 15 to 20 percent, before 2008. While Fitch Ratings, in its Global Power Quarterly, says power supply comes into balance with demand beginning approximately in 2006 or 2007, depending on the region, through 2010 and 2012.
Growth in Earnings, Earnings, Earnings
In much the same way the supply and demand forecast are at odds, so are recovery projections of the power industry's earnings. Merrill Lynch equity research analyst Steven Fleishman, in a report, expects second quarter earnings for utilities to be down 18.5 percent quarter-to-quarter, with the "key drivers being mild weather, continued drag from pension and benefits expenses, share dilution from the balance sheet restructuring over the last twelve months, and of course continued weakness in merchant results." Fleishman finds that for the full year 2003, earnings will decline 6.1 percent as compared with 2002. He predicts that core growth and a pickup in the economy in 2004 will support 4.6 percent earnings growth in the industry.
Morgan Stanley equity research analyst Kit Konolige, while also forecasting earnings improvement in 2004, finds new utility growth rates to be much lower than Merrill Lynch's forecasts. Konolige finds that new growth rates should average 3 percent, but not until 2005 (noting that in many cases utilities will exhibit growth below First Call estimates). He notes that another drag on earnings, and an industrywide concern, are "rate cases (a feature of the regulated industry somewhat in eclipse over the past two tumultuous years), which could occur more frequently and lower regulated earnings caps because of low underlying interest rates."
Furthermore, by looking at the credit picture, one can understand the pessimism that these analysts continue to show for utility sector growth. Ronald Barone, managing director at ratings agency Standard and Poor's (S&P), still believes that many companies have significant credit issues they must overcome before growth comes into the picture. "Until the fundamentals of the business change where you get greater pricing, I'm not sure that [growth] is going to happen for a few years. The economy has to pick up. Right now, if you look across the country, reserve margins in almost every NERC region are greater than 25 and 30 percent. The economy will eat into some of that, as well as retirements of coal facilities.
But why retire a coal facility when they are making money, especially against gas plants? Given that no one wants California power prices, state regulators may be a bit more leery of allowing closure of inefficient coal power plants," he says.
In another report, S&P says that the percentage of stable utility rating outlooks has not moved from last year's first quarter of 53 percent. But the percentage of outlooks that are negative (31 percent) has risen and continues to strongly overshadow positive outlooks, which stands at less than 1 percent, the report concludes.
Certainly, the future outlook of the industry looks uncertain, at best. Exelon CEO John W. Rowe told Fortnightly recently, "if you can see two to five years ahead [you're] doing pretty well." Given the discord in industry forecasts, by that standard we could do worse.
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