California Drought Hits Natural Gas Markets Hard

Utilities should have seen this one coming: low water levels leads to a limited supply of natural gas.

Feb 22, 2014 at 12:30PM

California is often at the forefront of environmental and social change. That's good, but can lead to severe dislocations. For example, the state's power market meltdown at the turn of the century was a mixture of deregulation and market manipulation. Right now it's the drought that's doing a number on the state's water supply and power markets.

You need water to live
Water is a basic necessity of everyday life. That's why water utilities have such stable businesses. California Water Service (NYSE:CWT), for example, serves nearly 500,000 customers in more than 80 California communities. The company's top line has increased every year for a decade. While earnings have fluctuated, the dividend has been steadily increased, though not on an annual basis. It's a solid company with a solid business.

Moreover, it's used to dealing with water shortages in historically dry California. For example, it's spent over $30 million in recent years to get customers to use less of the very product it makes money selling. According to California Water, "water use has declined an average of 15% throughout the company's service territories since 2007."

Despite the current drought, California Water expects to have enough water to supply its customers. The same may not be true for power companies and electricity, however.

Natural gas takes a hit
California is home to about 14% of the country's hydroelectric power. So a drought means less electricity generation in the state. Essentially, the push toward such unreliable renewable fuels is complicating the state's power supply. For example, in hindsight, the closure of the San Onofre Nuclear Generating Station last year couldn't have taken place at a worse time.

With hydroelectric power down, the closure of a large nuclear plant, and the long-term shift away from coal, natural gas has increasingly been relied on to make up the difference. But there's only just so much natural gas to go around. That's why the California Independent System Operator, the state's electric grid watchdog, was forced to issue a warning about natural gas supplies in Southern California. It's asking residents to conserve.

More good news for pipelines
That's more good news for natural gas pipeline owners like Kinder Morgan (NYSE:KMI), which already has pipelines serving the state. The company has been talking about the opportunity to expand in the supply-constrained Northeast, but clearly there's just as much opportunity on the West Coast. That will be a benefit to the company's Kinder Morgan Energy Partners and El Paso Energy Partners businesses, which are the entities that operate many of Kinder Morgan's pipeline assets.

TransCanada (NYSE:TRP) is another company that is well positioned, serving both the Northeast and the West Coast, either directly or indirectly linking Canadian natural gas to key U.S. markets. Like Kinder Morgan, many of TransCanada's pipelines are held in a limited partnership—TC PipeLines (NYSE:TCP).

TC PipeLines owns two pipelines serving the California market. An obviously supply-constrained market means continued strong demand. And while TransCanada's big expansion efforts in natural gas are in Canada and Central America, TC PipeLines could see continued growth if TransCanada sells it the remaining 30% of the GTN pipeline that it doesn't own. That line runs down from Canada and connects to the Tuscarora pipeline, which touches California's boarder.

The big risk is a big opportunity
The problems that utilities are facing with natural gas supply on both the East Coast and West Coast, shows the risk of moving too far in the direction of a single fuel source for electricity. Customer won't be happy if grid reliability is compromised so easily by extreme weather conditions. However, these problems also show that there's a big opportunity for the companies that help move natural gas from where it's drilled to where it's needed—which has increasingly meant utilities.

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Reuben Brewer has a position in Kinder Morgan Energy Partners. The Motley Fool recommends California Water Service Group, El Paso Pipeline Partners LP, and Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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