The long-term performance in the energy subsector is what one would expect given this shielded environment – there have been few bankruptcies and restructurings over the years. Events of the last several years have challenged the traditional utility investment paradigm.
—Josh Olazabal, vice president in the credit research group, PIMCO, et al
The regulated energy sector’s reputation is understandable. After all, the utilities and natural gas pipeline companies (referred to as “pipes” in this article) have been granted exclusive franchises by the state or federal government to provide an essential service at an allowed rate of return – which is typically set well above what an empirical analysis would suggest is the utility’s true cost of capital. Shielded in this way from competition and price volatility (like that which characterizes other commodity-based energy subsectors), these regulated utilities can be attractive to investors looking for steady return potential and long-term fixed income holdings.
In fact, the long-term performance in the energy subsector is what one would expect given this shielded environment – there have been few bankruptcies and restructurings over the years, and most that have taken place (for example, the bankruptcy of the Columbia Gas Transmission system in the early 1990s) resulted in fixed income investors recovering all of their principal, as well as accrued interest. Accordingly, many fixed income investors have taken a more passive approach to analyzing this subsector – believing that past is essentially prelude, and utility risks and potential returns are unlikely to materially deviate from their historical course.
However, events of the last several years have challenged the traditional utility investment paradigm. For example, in the United States the generally large (some would say outsized) returns earned by regulated pipelines have come under close scrutiny by the Federal Energy Regulatory Commission (FERC), with several being forced to agree to significant reductions in allowed return on equity (ROE) and subsequent reductions in earnings and debt service coverage. In addition, the rating agencies have recently taken an uncharacteristically harsh view on single-asset pipelines (companies that own a single pipe, as opposed to a holding company that owns multiple pipelines). This has resulted in a number of pipes being downgraded to high yield territory, with corresponding spread widening and forced selling that has taken many investors by surprise.
In addition, the tragic explosion of a PG&E pipeline in San Bruno, California has resulted in increased regulation of pipelines operations and a related increase in costs for more active and dynamic safety-related monitoring.