The utility sector has long been considered boring. The business of producing electricity in a central location and distributing it to customers is neither flashy nor exciting.
The boring quality of utility stocks may soon change, however. Pessimistic sentiment in the utility sector has increased to levels not seen in five years. The shares short for the utility industry ETF, Utilities Select Sector SPDR Fund (NYSEMKT:XLU), now make up almost 13% of the float, the highest since September 2009.
The cost of hedging against losses in the utility industry ETF with options is also at a 5-year high.
So why are investors and analysts growing pessimistic on the sector?
Treasury rates rising
Because of their stable and predictable cash flows, utility stocks have long been regarded as fixed income. As treasury rates rise, fixed income bond values typically fall as investors choose the safety of treasuries over other fixed asset instruments.
In this case, utility shares are no different and are likely to fall as the 10-year rises. The 10-year Treasury yield recently reached a two-year high, with yields over 3%. As the economy continues to improve and the Federal Reserve begins tapering, treasury yields may continue to rise and put pressure on utility shares.
According to Bloomberg, the utility sector also has the highest debt to total asset ratio among 10 S&P 500 groups at 35%.
The high debt-to-asset percentage makes utility profits more vulnerable to rising rates.
Distributed energy in the long term
In the long term, the utility sector is likely to come under duress from distributed energy. As solar costs come down, rooftop solar will deprive utilities of customers while increasing the cost of maintaining the transmission grid. With less customers and higher costs, utilities will have to raise prices, causing more customers to leave.
More efficiency adoption
As the recent ban on the import and manufacture of 40-watt and 60-watt incandescent light bulbs illustrates, the U.S. is taking steps to be more energy efficient. Increasing energy efficiency is important because it is one of the easiest ways to reduce greenhouse gas emissions. For utilities, however, increasing energy efficiency is bad news as it reduces future revenue and profit growth. While some states have made laws to reward utilities for promoting energy efficiency, most states have not.
The bottom line
I wouldn't short utilities. Shorting should only be considered if there is a definite catalyst ahead that will cause the market to adjust accordingly. It is hard to see a definite catalyst.
In many ways, German utilities are where American utilities may be in six years. The U.S. has a target of getting 20% of its energy from renewables by 2020. Because of Germany's generous renewable energy subsidies, renewable energy currently makes up 22% of Germany's energy portfolio. The high renewable percentage and the cost of dealing with variable renewable energy output has put great strain on German utilities. The performance of those German utilities has not been pretty. Germany's largest utility, E.ON, has seen its share price retreat by three quarters from its peak.
With all that being said, there is still time for American utilities to adapt and prepare. In German utilities, American utilities have the luxury of seeing the future today. Utilities can push for friendly laws. They can incorporate distributed energy into their business models. They have survived and thrived since the time of Thomas Edison and Nikola Tesla. They can do so yet.