Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Here's a chart that should make anyone owning utility stocks feel all warm and fuzzy and simultaneously a bit cold and clammy.

Powering Ahead
Utility stocks are close to all-time highs and are up by a third since power generation peaked in 2007
Source: Bloomberg, Energy Information Administration
Note: Indexed to 100 in 1949.

Using net generation from U.S. power plants as a proxy for electricity demand, this market stopped growing almost a decade ago. Yet shares in utilities have never been higher. The extra dividend yield they offer compared to the S&P 500 has sunk below 1 percentage point, around the lowest since 2008.

Sorry, Widows and Orphans
The premium yield offered by utilities relative to the broader market has shrunk to a pittance
Source: Bloomberg
Note: Dividend yield for the Dow Jones Utility Average less the yield for the S&P 500 index.

One big thing driving investor demand is that, while electricity sales hit a ceiling after 2007, bond yields fell through the floor.

Right Said Fed
The collapse in Treasury yields to less than 2 percent boosted dividend-oriented utility stocks
Source: Bloomberg
Note: Indexed to 100 in Jan. 1990.

The other is that, even when demand isn't growing, utilities have to invest in maintaining and upgrading their grids. And every dollar spent on a regulated wire, transformer or some other power paraphernalia -- the regulated asset base -- demands a regulated return on investment. In utility-land, more than anywhere else, you have to spend money to make money -- and annual investment virtually doubled between 2010 and 2015.

Piling On the Pylons
Annual spending on wires almost doubled between 2010 and 2015 but now looks set to slow
Source: Evercore ISI
Note: Data for 2016 through 2018 are forecasts.

As you can see, though, spending is forecast to level off. Falling costs for distributed energy such as solar panels and smarter approaches to energy efficiency -- along with a desire by some commercial customers to break away from utilities -- mean these pressures aren't going away. All in all, analyst forecasts for utility earnings to grow by about 5 percent a year for the foreseeable future, according to data compiled by Bloomberg, look a bit suspect.

This is right about where the clamminess starts to make its sweaty presence felt.

In a report published last month by the Lawrence Berkeley National Laboratory, three researchers attempted to quantify the impact on utility valuations if expected annual growth in their regulated asset base was cut by 2 percentage points or, gulp, cut to zero . In the less-aggressive case, both low-growth and high-growth utilities saw their valuations tumble by about 14 to 15 percent (using the median impact). In the zero-growth case, low-growth utilities drop by more than 18 percent, at the median, but their higher-growth counterparts fell by more than a third.

The juxtaposition of historic highs in the utility index with flat demand and ultra-low interest rates leaves the sector looking precarious. At a crude level, imagine a utility with a cost of capital of 8 percent, paying a $1 dividend expected to grow by 4 percent, year in and year out. Now raise the cost of capital by 2 percentage points and cut the expected growth rate by the same amount. Hey, presto! That stock just halved.

Little wonder utilities are paying high multiples to gobble each other up, with NextEra Energy's acquisition of Oncor, valuing it at $18.4 billion, just the latest example. A debt-fueled M&A boom in a highly valued sector facing epochal change -- what could possibly go wrong?

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. According to the report, the typical growth rate for its sample of utilities is 4.6 percent.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net