Eastern Alliance: Energy Investment in the U.S. and China

 |  Includes: AES, CVX, DUK, SO
by: Roger S. Conrad

When it comes to energy, it’s hard to find two countries whose interests are more conjoined than the US and China. Together the pair accounts for 40% of the world’s carbon dioxide (CO2) emissions, putting them squarely in the crosshairs of governments worldwide that are looking to do something about global warming.

The two countries are both heavily reliant on coal to generate electricity, in part because they enjoy massive reserves of the black mineral. Both have enormous potential to develop wind power, thanks to diverse geography and urbanizing populations. They’re also ranked first and second in global oil consumption, with Chinese demand rising 10.2% in October and rapidly approaching the top spot.

Historically, energy relations between the two countries have been far more competitive than cooperative. Even as all manner of commerce and investment have grown, both countries have tended to view the other as a rival for locking down the essential resources needed to run 21st century economies.

Chevron’s (NYSE:CVX) acquisition of Unocal earlier in the decade, for example, was achieved mainly because the US Congress made it clear it favored a national champion over a rival Chinese bidder.

Ironically, it’s now the private sector taking the lead in an unprecedented push toward energy cooperation. The chief vehicle is a series of alliances inked between major US power companies and Chinese counterparts to develop new technology and solutions and invest in facilities, to economically meet rising demand for power and resolve environmental concerns.

The biggest deal to date: The acquisition of a 15% stake in US power producer AES Corp (NYSE:AES) by China Investment Corp (CIC), the Middle Kingdom’s largest sovereign wealth fund (SWF). CIC, which has an estimated $300 billion in assets, has also signed a letter of intent to purchase a 35% stake in AES’ wind power unit.

The $1.58 billion stock purchase is just one of some $4.25 billion in investment deals recently inked by CIC in countries from Canada to Hong Kong and Indonesia. These deals have essentially involved taking minority rather than controlling stakes, which is far more palatable in an era of resurgent resource nationalism in many countries.

The AES investment, for example, needs the approval of US regulators but will be much harder to block than an outright takeover. The deal should boost CIC’s investment income immediately.

Meanwhile, the advantages and potential breakthroughs for AES are immense. CIC, for example, receives some 100 business proposals a day and is well connected throughout the Chinese market, which AES has targeted for expansion particularly in renewable energy.

It also hands AES a huge chunk of change at a time when the company is in the middle of an aggressive global construction program expected to grow earnings 13% to 15% a year well into the next decade. And it should help the company ease Chinese regulations governing what equipment is used for power plants in the country, a potentially big crimp to overall efficiency and profitability.

CIC’s purchase price of $12.60 a share has raised the ire of some investors, who noted in the third quarter conference call that AES had recently declared its stock “undervalued” and bought back shares at $14 a share. That puts pressure on AES to make this alliance work.

And it puts pressure on CIC as well, whose ability to buy assets in other countries will be judged by regulators depending on how well this works. Time will tell, though AES’ 39% boost in third quarter cash flow is a good sign it’s otherwise very healthy.

For Duke Energy (NYSE:DUK), alliances in China are attractive in three ways. First, they’re a potential source of financing for US projects at a time when regulators in many states may be loath to grant rate increases to pay for them until the economy bounces back.

Second, they’re opportunities to share information on new technologies to remove CO2 from coal power plant emissions, as well as other processes to improve efficiency. Finally, Chinese partners are ideal for investing abroad.

Duke reached a deal last month with closely held Chinese firm ENN Group to jointly develop solar power projects in the US. And it’s keen to develop projects in South America as well, where it currently realizes about 10% of its overall income.

The company’s Duke Energy Generation Services unit already operates 630 megawatts (MW) of wind power plants in the US and will add another 350 MW by the end of 2010.

And it’s developing wood waste-to-electricity power plants in the US with a unit of France’s AREVA (France: CEI, OTC: ARVCF). Biomass is set to be a big deal in Duke’s native southeast, which lacks the natural wind resources of states out west, for example.

Southern Company (NYSE:SO) plans to deploy its integrated gasification combined cycle (IGCC) technology--developed with the US Dept of Energy--in China at a plant operated by Dongguan Tianming Electric Power Co in Guandong province.

Slated to operate in 2011, the plant would demonstrate proprietary “TRIG” technology, which will also be deployed at a planned 582 MW plant in Mississippi. That plant would include 65% carbon capture and sequestration.

US power company investment abroad has a long and checkered history. Most investment has involved direct purchases of operating utility companies, with very mixed results. Southern Company, for example, earlier this decade divested a stake in a British after deciding it was too difficult to manage and not profitable enough.

So has almost every other US firm that’s tried to expand abroad, and their exits have typically been on far less favorable terms than Southern’s. Even AES and Duke took huge hits earlier in the decade, as they were forced to deal with stark economic conditions and hostile regulators.

Only time will tell if the budding wave of eastern alliances will escape that fate. And at least some US utility managements remain deeply skeptical of investing in a country where the national government is so deeply enmeshed in economic decisions.

Given the compelling confluence of interests between the US and China, however, it’s a good bet that at least something good will come out of this trend, at least for the early movers. That’s certainly been the pattern for US utilities reaching out to foreign partners in the past.

And it bodes well for AES, Duke and Southern, which are strong companies with or without a Chinese connection.

Question of the Week

Every week I answer a question frequently asked by readers. Send yours to utilityandincome@kci-com.com.

Here’s this week’s question:

  • I’m an income investor who’s very worried about inflation, which I think the government understates, and a collapse in the US dollar, which I don’t think it can prevent. How can I protect myself?

The Federal Reserve has kept the monetary spigots fully open for about a year now. The M-1 measure of the money supply continues to grow at a double-digit rate, and the US dollar has come down about 10% this year versus a basket of trading partners’ currencies.

Finally, gold is at an all-time high at over $1,100 an ounce, though it’s still well below the $3,000 my colleague Yiannis Mostrous says would equate with the $800 an ounce reached in 1980 adjusted for inflation.

Those are all warning signs that inflation is a growing risk to income investments. However, there are a couple of caveats here.

First, as long as unemployment is over 10%, there’s no chance of seeing the kind of wage push-inflation that was the hallmark of the 1970s. Also in contrast to that era, unions are spending all their time fighting to keep companies from cutting jobs, rather than pushing up wages.

I also have a problem with US government measures of inflation, which pay too much attention to some items and too little to others. On the other hand, however, almost every government program is indexed to them. And with the Consumer Price Index actually below where it was in mid-2008, there’s no chance of “cost of living” rate increases pressuring inflation higher either.

That leaves rising commodity prices as a potential catalyst. But as long as the economy is this weak, they’ll actually be more of a contractionary force, as consumers have to cut spending for example to pay their gasoline and heating bills.

And gold notwithstanding, prices of many commodities remain depressed, including most of what’s used in heavy industry.

I agree that such a loose monetary policy as we have now will eventually bring on inflation. That’s been the case every time money has grown at this rate for this long. And there’s nothing to suggest now that the Fed won’t continue to pump things up as long as it’s afraid of a “Big W” recession, in which we’re on the verge of starting a second down-leg before a final recovery.

However, income investments--at least everything this side of US Treasuries and investment-grade bonds--won’t be at risk until the US economy has really picked up the pace.

For one thing, utilities, real estate investment trusts (REIT), master limited partnerships (MLP), Canadian trusts and other high-yield investments haven’t been really interest rate sensitive since the fall of Lehman Brothers in September 2008. Instead, they’ve been extremely economy sensitive, rising and falling with the latest economic news.

Put another way, utility stocks have traditionally rallied on days when the benchmark 10-year Treasury note has rallied. But for well over a year, they’ve done precisely the opposite, mainly because the institutional investors who dominate trading have been afraid to hold even them for fear of a Big W.

Keep in mind that institutions have different objectives than individuals living off their investments should have. Managers of giant funds are evaluated on quarterly total return, with yield very much secondary if not irrelevant. They could care less about long-term wealth-building and income, which are our primary objectives.

The biggest drag about the past year’s trading pattern is our utilities, MLPs and so on are historically cheap relative to benchmark Treasury bonds, as they’ve failed to rally on lower rates.

The biggest benefit is that if those benchmark interest rates start to rise, they’d have to go up a long way to really compete for yield dollars with, say, a high-quality utility like Duke Energy, which reliably increases dividends year after year.

In my view, that translates into a great deal of inflation insurance for any high-income equity that’s backed by a strong business. In fact, shares of utes, REITs, et al, are likely to rise as the economy recovers and their perceived credit/dividend risk diminishes, even if the benchmark rates do start to rise and inflation picks up.

When it comes to a long-term uptrend in inflation, growing dividends backed by healthy underlying businesses are a great antidote. There are, however, a handful of yield-generating investments that would actually gain ground. And the more inflation there is, the fatter the returns will be.

There’s never been a major bout of inflation without energy prices heading higher. And there’s nothing to suggest anything would be different the next time inflation stirs. In fact, energy prices remain by far the most likely catalyst.

That makes energy producers paying yields some of the best inflation insurance money can buy. Canadian income trusts are the best option because they’re priced in and pay dividends in Canadian dollars. And the Canadian dollar, or loonie, basically tracks oil prices over the long haul.

Buying utilities denominated in foreign currency is another great way to hedge out inflation and a potential US dollar collapse. Again, that’s because the currency they’re priced in and pay dividends in would appreciate, driving up their US dollar value. Utilities also always track the health of an economy, and there are several foreign countries slated to grow faster than the US over the next few years.

Finally, even though gold has risen sharply this decade, I still think there’s no better disaster hedge out there. The drawback is most gold stocks yield little or nothing and the hybrid securities some brokerages offer are too complex for most investors. But they’ll more than make up for that with price appreciation, should things really cut loose.