Sunday, March 4

Week 35 - Electric utilities, railroads, and gas pipelines

Situation: Electric power-plants are the most essential node in the infrastructure of any nation’s economy. In most countries, coal and natural gas are the main “feed-stocks” for power-plants. Notable exceptions are France and Japan where nuclear power also plays a major role. In any given week, raw goods (coal, lumber, grain, etc.) account for most cargo being moved by railroad cars, with coal dominating. This results in the fortunes of many railroads being tied to coal; some (e.g. NSC) own extensive coal-producing properties. It’s not uncommon for coal-fired power-plants to also hook into natural gas pipelines to fuel gas burners that can be turned on quickly to provide “peaking power.” The use of natural gas to provide baseline electricity is growing, even though it costs more than coal. Some of the reasons for this migration are that natural gas requires a smaller & cleaner plant with fewer workers, emits 55% less carbon dioxide, and has no need for smokestack “scrubbers” that remove toxic pollutants. Natural gas has also become remarkably cheaper through improved technology--horizontal drilling combined with hydrofracking. 

Taken together, these three industries (electric utilities, railroads for hauling coal, and pipelines that carry natural gas) form an economic triad that is characterized by interdependency and high fixed costs. Profitable operation is difficult to achieve because electricity prices are heavily regulated, and projects to build or modernize power-plants depend on the availability of cheap long-term loans. Over the years, governmental bodies have come forward to build a regime of subsidies, tax breaks, and debt guarantees that allow this triad to function. For investors, this should be good news because there is little likelihood of bankruptcy or even back-to-back losing years. This frees up cash, since the investor no longer has need of an off-setting position in risk-free bonds. However, investors do need to take more trouble to understand the economics. The payoff is a low risk:reward ratio.

Unfortunately for investors seeking company information, the financial press finds stories about these stocks to be either too boring or too technical to cover. The good news is that our ITR blog readers have already read a number of interesting things about one railroad and one utility, Norfolk Southern (NSC) and NextEra Energy (NEE), that shows each to be a potent and reliable money maker. Prior blogs (Week 10, Week 20 and Week 26) introduced issues related to production, transportation and marketing of commodities.

In the process of combing through data on utilities, railroads and gas pipeline companies, we’ve found two more companies that are on the verge of meeting current ITR requirements for inclusion on the Master List (Week 27): Wisconsin Energy (WEC) would be qualified but for having 9 yrs of dividend increases instead of the required 10. Plains All American (PAA), a gas pipeline company, has a BBB credit rating but the ITR requirement is a BBB+ rating. In addition, we find 6 other companies that have a “durable competitive advantage” on Buffett’s Buy Analysis (Week 30). This distinction makes these 6 worth tracking, in part because their growth over the next 10 yrs can be estimated with some degree of precision. The group includes 3 regulated electric utilities, which have projected growth rates of 1.6-5.7%/yr: Sempra Energy (SRE), Southern Company (SO), and NSTAR (NST). The other 3 companies are railroads, which have projected growth rates of 8.5-13.4%/yr: Union Pacific (UNP), CSX Railroad (CSX), and Canadian National (CNI). 

With so much interdependence found between railroads, regulated electric utilities, and gas pipeline companies, one is reminded of  a 3-legged stool. What would happen if the stool lost a leg? An article in the New York Times on 2/19/12 by Elisabeth Rosenthal compared projections for energy use by type in the US through 2035. Coal and natural gas use are approximately the same in terms of energy (BTUs consumed) at present but going forward natural gas use will grow 1.2%/yr vs. only 0.3%/yr for coal. By 2035, half again as much natural gas will be produced than coal. All other sources of energy (wind & solar power, oil for fuels, and nuclear power) together will not quite equal natural gas production. But 25-30% of energy use will still be coming from coal, even though wind & solar will have grown to provide 15-20% of power requirements. For power-plants, the takeaway is that coal use won’t change much but gas use will grow 50% by 2035.

Bottom Line: We will begin to separately track each of these 3 stable industries and file periodic reports for our readers. For now, the bottom line is that this economic triad of railroads, electric utilities and gas pipeline companies is going to grow in importance and the separate industries will become even more intertwined.

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