Energy companies get jolt in arm

By Peter V O'Brien

Friday 7th March 2003

Energy distribution and line network companies maintained their positions as solid defensive stocks in the seven months since July. They received a boost from decisions to lift retail prices and/or line charges and the forecast rundown of Maui gas by 2007.

A substantial fundraising exercise last year from Powerco to finance the company's acquisition of assets from United Networks affected the former company's share price performance.

It may be better to refer to "energy" rather than "electricity" companies when discussing the sector, because gas and electricity are inextricably intertwined in the New Zealand context.

A considerable amount of electricity is generated from gas, particularly for major industrial users.

Problems likely to arise from the eventual depletion of the Maui gas field were indirectly highlighted recently when distribution failed for a few hours, sending the spot electricity price to unprecedented levels.

Any limitation of energy flows and resulting higher prices would increase industrial users' costs.

Energy companies reckon there would be a minor effect on domestic consumers. That claim is flawed although possibly valid in terms of direct household charges.

Domestic consumers use New Zealand industrial companies' output. An increase in the latter's costs moves through the manufacturer-to-consumer chain, with percentage markups at every stage.

Assume a current base selling price from a generator to a manufacturer of $1000 for a given amount of energy. Additions of, say, 10% along the chain (to keep things simple) means the manufacturer would pay $1100.

A 10% rise in the generator's costs would price the output at $1100 and a similar increase to the manufacturer lifts the latter's input to $1210, an increase of 10.9%.

Energy is only one input cost in any business but even this simple example shows energy costs finish up having an accumulating impact on retail prices.

Prudent investors in energy companies should be wary of that scenario, despite apparent market euphoria, seemingly based on potential returns to producers and distributors. They should remember a shortage of supply increases prices in the short term.

Higher prices result in consumption cuts for any product and producer returns react to that factor.

Oil and gas-based energy companies have a problem peculiarly different from operators in other industries because they deal in depleting inputs. Gas is running out, unless there are notable discoveries; there is considerable opposition to more hydro development (despite the recreational/tourism potential gain from lakes behind the dams); coal-use raises hackles; and nuclear power is unlikely to be an option in the foreseeable future.

Everyone has to use company-supplied energy, unless they can afford the initial cost of solar panels, have sufficient waste to recycle on site or are able to erect windmills.

Energy companies are on a high but investors should be cautious about the future.

Some investors could find themselves in the paradoxical position of cutting energy consumption while hoping higher prices help their investments.

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