While some investors are beginning to fret over utility stock dividend yields versus the climb in 10-year Treasury yields, a bigger problem is the lack of price increases in the PJM pricing model going out to 2016-2017. This lack of pricing power will hurt Northeast and Midwest utility investors greater than comparable yields.
Tackling the easy subject first, below is an excerpt from a previous article:
In reviewing the initial periods of interest rate environments transitioning from a medium-term dovish stance to a medium-term hawkish stance, dividend stocks and utilities have performed pretty well. Below is a table outlining three periods of initially rising rates: January 1994 to February 1995; May 1999 to May 2000; and May 2004 to June 2006. The table includes the Fed Fund rates, 10-yr Treasury yields, the total return (capital gains plus dividends) for the Dow Jones US Select Dividend Index (NYSEARCA:DVY), the total returns for the S&P 500 (NYSEARCA:SPY) and the total return for the S&P Utility Index (NYSEARCA:XLU). XLU was not introduced until 1998, and although the DJ Select Dividend Index was not available until 2003, it can be back tested to 1991.
DJ US Select Dividend DVY
S&P 500 SPY
S&P Uts ETF XLU
Source: economy.com, Morningstar.com
From a historic viewpoint, in two of three turns in interest rates, large-cap dividend paying stocks have outperformed the overall large-cap market. The utilities sector has a one for two performance history, as the index was not available in 1994 and there is no backdating offered. As of March 2013, utilities were the largest sector and comprised 30% of the DJ US Select Dividend Index. Consumer Goods and Industrial sectors combined comprised an additional 33% of the index weighting.
Based on the above, over the next few years, utilities should continue to reward investors with adequate comparative returns, based on an improving economy and slightly rising rates in response.
However, electricity pricing in the Northeast and Midwest is becoming a larger negative factor along with increasing supply. PJM Interconnection published its annual report last week and has put a damper on the utility sector. PJM administers the wholesale market for 60 million consumers from North Carolina to New York and out to Illinois. PJM said its pricing reliability model going out to 2016/2017 accounts for a record increase in production of 5,463 megawatts and that imported capacity from other regions in the U.S. and Canada could double to an additional 7,483 MW. With the potential of an addition 13,000 MW of new capacity, offsetting much of the potential of coal-fired reductions, PJM auction pricing remains weak.
From the press release announcing the annual study's availability:
"Capacity prices were pressured by a combination of factors," said Andrew L. Ott, senior vice president - Markets. "Prices were generally lower than last year's auction due to competition from new, gas-fired generation, low growth in demand because of the slow economy and increased imports from other regions, primarily to the west of PJM. These factors also contributed to a reduction in commitment of demand resources." The PJM capacity auction procured 12,408 MW of demand response. The auction also procured 1,117 MW of energy efficiency, about 21 percent more than last year. "The results of this year's capacity auction reaffirm that well-designed, mature markets are a powerful tool for procuring new resources at competitive prices," said PJM president and CEO Terry Boston. "Again this year, we see record amounts of new conventional generation and strong showings from renewables and energy efficiency."
Adding the future lower pricing model to the negative pricing impact of alternative electricity generation from wind and investors should re-evaluate the regions served by their utility company investments. More information on the negative impact of wind power generation on traditional power markets and the amount of negative pricing some utilities are experiencing can be found in a SA article here. Of interest is the amount of time Exelon (NYSE:EXC) operates its nuclear plants at a negative pricing mode.
Exelon, the largest U.S. nuclear operator, says a surplus of wind power is making negative pricing a problem in Illinois, where it owns six nuclear plants and a wind project. Prices for markets served by Exelon's Clinton and Quad Cities reactors trade below zero between 8% and 14% of off-peak hours, said Joseph Dominguez, Exelon's senior vice-president for governmental and regulatory affairs and public policy.
Barron's has an online article concerning the downgrades of some utilities by Credit Suisse. Deutsche Bank downgraded some electric utilities because of the potential lack of future pricing as well. Bloomberg also published an article outlining these problems and it can be found here.
If the problem is not competitive yields to 10-year Treasuries but rather a lack of pricing power going out to 2016, what are investors to do?
It would seem smarter to focus on those geographical areas not as affected by both PJM pricing models and wind power generation. Although the national power grid is expanding and the negative effects of both of these will be a factor going forward, it may be smarter to evaluate electric utilities in the Southern U.S.A.
Wind generation's physical requirements are not as favorable for placement in the Southeast as it is in the Midwest, and PJM pricing models reach only as far south as North Carolina. In addition, southern public utility commissions have been historically more utility-friendly than their counterparts in other regions.
The list of southeastern utilities is relatively short with Southern Company (NYSE:SO), Duke (NYSE:DUK), Dominion Resources (NYSE:D) and Scana (NYSE:SCG) leading the pack. TECO (NYSE:TE) owns Tampa Electric, NextEra (NYSE:NEE) owns Florida Power and Light, and Entergy (NYSE:ETR) has operations in several southern states.
Investors should begin focusing their attention not on competitive yields but rather on long-term electric power pricing and the service areas of their electric utilities.
Author's Note: Please review important disclaimer in author's profile.
Disclosure: I am long EXC, SO, D. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.