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How To Build A Utility Portfolio

|About: Exelon Corporation (EXC), Includes: AES

Most investing articles focus on one or two specific stocks or offer a laundry list of potential research targets. Articles on Seeking Alphaconcerning the utility sector are no different. However, it is important to dovetail specific utility selections into an overall sector approach and an overall portfolio strategy.

There are several distinct sub-sectors within the utility sector, each with potentially different investment characteristics. For instance, many investors buy utilities to add yield and income to their portfolio, but not all utilities offer the best yields. For example, water utilities historically offer about half the yield as regulated electric utilities. Gas distribution firms may also offer substantially lower yields than their regulated electric counterparts. The most widely viewed utility sub-sectors are:

  • Regulated versus Non-regulated
  • Regulated Electrical
  • Non-regulated Merchant Electrical Power
  • Regulated Natural Gas Distribution
  • Regulated Electrical Transmission
  • Regulated Water Distribution
  • International

Within the utility sector, investors can also choose investments based on underlying trends. For example, electricity pricing in the East Coast and Midwest is currently very depressed and electrical power in these markets is sold based on a rolling three-year auction. These specifics have put pressure on merchant power producers' profitability and there is not much of a turnaround seen until 2016. There is the potential for eastern U.S. merchant power producers to gain momentum as power pricing improves.

The low cost of natural gas used for electrical generation is also putting pressure on competitive coal-fired plants, hastening coal plant closings because their economics are becoming more unprofitable. Utilities with higher exposure to coal-fired plants will either have to increase capital expenditures to comply with tighter EPA regulations or close their plants. Smaller and older facilities are more likely to be mothballed than newer, larger facilities. Overall, upwards of 10% of all coal-fired power generation will be closed, and represents about 5% of total U.S. power generation. This reduction in generating capacity will drive electricity prices higher - eventually. The ability to replace coal-fired with "green" generating sources is problematic at best as the majority of coal facilities are used as "base-load" or consistent generators of electricity.

Wind and solar are unattractive as "base-load" facilities as wind is variable and the sun does not shine for a large part of the day. The countries of Europe are further ahead than the U.S. in deploying "green" power and the imbalance of power generation on sunny and windy days is starting to have a pronounced impact on electricity markets. From an article in Bloomberg in Sept 2011:

The 15 mile-per-hour winds that buffeted northern Germany on July 24, 2011 caused the nation's 21,600 windmills to generate so much power that utilities such as EON AG and RWE AG had to pay consumers to take it off the grid.

Rather than an anomaly, the event marked the 31st hour this year (2011) when power companies lost money on their electricity in the intraday market because of a torrent of supply from wind and solar parks. The phenomenon was unheard of five years ago.

According to Mario Gabelli, an investment manager and portfolio manager of the Gabelli Utility Fund (MUTF:GABUX), there are more U.S. utility companies than needed and has driven a consolidation within the in utilities sector. From GABUX 2010 Annual Report:

For several decades, utility companies have acquired other utilities and utility assets for the sake of gaining economies of scale and efficiency or divested non-core utility assets to focus on core competencies. Despite over 90 completed utility mergers/acquisitions since 1993, the electric and gas utility sector remains fragmented, with over 60 electric utilities and 30 gas utilities. This is 50 more than we need from the standpoint of economic efficiency.

The balkanized structure of the industry is inherently inefficient, and competitive forces combined with constant changes in regulatory policy pressure marginal players. The big companies feel the need to be bigger to achieve scale economies or gain a strategic benefit, while the small companies are selling out as the cost of staying in the game rises. It is only because of a complex and lengthy merger review and approval process that the industry remains as fragmented as it currently is. Our investments in regulated companies have primarily, though not exclusively, focused on fundamentally sound, reasonably priced mid cap and small cap utilities that are likely acquisition targets for large utilities seeking increased bulk.

In addition, as the merchant power market has been extremely weak since the recession began in 2008, many merchant power producers have been buying their regulated peers in an attempt to smooth out earnings and cash flow stream. Exelon (NYSE:EXC) and AES Corp (NYSE:AES) are great examples of this trend. Gabelli also offers an interesting list (pdf) of the larger utility merger deals over the past three years, since 1/1/10:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.