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Utilities, midstream reckon with energy transformation on the horizon

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Frequently Asked Questions 2020

Only a few short years ago, domestic natural gas and oil supplies were being discovered at an incredible pace, owing primarily to advances in extraction technology and fracking, more formally known as hydraulic fracturing. Abundant new gas supplies in the ground in the U.S. were estimated to provide the nation with adequate domestic resources to last nearly a century or more.

The use of natural gas to supply power increased meaningfully from 2005 through 2015 as environmental pressures built to reduce carbon emissions. Economic issues also played heavily into the long-term viability of the nation's aging coal-fired generating fleet — viewed by many as an obvious culprit in emissions debates. In 2016, natural gas power generation overtook coal as fuel of choice.

More recently, technological advancements and efficiencies in renewable generation, and state and federal mandates to use more renewables, have brought wind and solar development further along into the realm of real possibilities for zero-carbon emissions in the not-so-distant future. In addition, as a result of these advances, and societal changes in perception of fossil fuels, natural gas has begun to lose some of its luster. In the past year natural gas seems less likely to be the fuel of choice for power generation over the long term. According to the U.S. Energy Information Administration's most recent projections, renewables, which accounted for 19% of the electricity mix in 2019, will double to 38% by 2050.

Conventional energy resources such as oil and gas will likely remain dominant for some time in transportation, power generation, chemicals and manufacturing. However, considering the potential for evolutionary change in distributed energy, energy storage, transportation fuels and other technologies, the future is uncertain and liable to unfold along unexpected pathways.

How have utility profits been impacted during the COVID-19 pandemic?

2020 has been a tumultuous year. Thus far, the financial community has gone through two rounds of quarterly earnings calls with company managements. In general, profits have been holding up surprisingly well. Considering that the broader economic effects of the coronavirus pandemic initiated in March in the U.S., most utilities' first-quarter results did not reflect significant pandemic-related impacts. Adjusted earnings for the companies in the energy and water utility universe were up nearly 3% year over year. Despite many companies reporting that commercial and industrial sales fell in April, most management teams affirmed existing earnings guidance ranges.

Second-quarter results were a bit of a different story, as the broader economic effects of the coronavirus pandemic were in full force from April through mid-year. Many companies reported substantial downturns in commercial and industrial sales of as much as 15%, while residential sales expanded by as much as 10% as stay-at-home mandates were in effect across much of the nation. Nonetheless, adjusted earnings for the companies in the energy and water utility universe were up an average of 10.2% year over year during the second quarter. Individual company results varied widely. For those companies reporting profit expansion, cost-cutting and productivity were cited as drivers of favorable results. While uncertainty continues to exist surrounding economic recovery, most utility management teams expressed confidence with existing earnings guidance ranges.

Looking ahead to full-year 2020 profit projections, based on recent S&P Global consensus estimates, profit growth for the utility sector is forecast at a modest 2% level, with that rate trailing the 5.2% three-year historical average and the forward-looking three-year average EPS growth rate of 4.2%.

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How has the financial quality of the utility group held up through the economic downturn? Have capital spending plans changed?

Aside from the EPS tally mentioned above, detailed results thus far are only available for the first quarter. As such, based on 12-month data through March 30, the average financial quality of the energy and water utility parent companies covered by RRA showed modest signs of deterioration. Noteworthy is that full-year 2019 financial results confronted a difficult year-over-year comparison as extreme heat during the summer of 2018 bolstered results for many companies. Results of the first-quarter parent company analysis were consistent with an earlier study of subsidiary financial performance for the first quarter of 2020. Even prior to the pandemic issues, ancillary stresses had been at work in the industry for some companies, especially those heavily financially-committed to natural gas and coal, which have clearly fallen out of favor as the energy sector transitions away from fossil fuels and toward a lower greenhouse gas profile.

Looking ahead, the comparatively essential nature of utility products and the economically regulated nature of their businesses suggest that the group will likely sustain less damage financially in the current recession than more cyclical sectors. From a regulated business perspective, challenges that have the potential to erode the impact on the financial performance of investor-owned utilities will likely be addressed by state regulators. An array of cost recovery options exist that are intended to address rate treatment and thus soften the potential negative implications on companies.

While some issues have arisen regarding supply chain issues during the pandemic, capital spending plans throughout the industry remain relatively unchanged. Regarding a transition to renewables, these changes require capital expenditures, which regulated utilities may put into their rate base and grow EPS.

Additional topics of interest have been addressed through special studies that are available within the full Frequently Asked Questions report

The special studies have been crafted to deliver actionable information in a shorter-format. They are generally released as articles on a weekly basis and provide drill-down into multiple aspects of the utility industry including but not limited to the following: capital expenditures, dividend activity, cost of electricity by company and region, company valuation, mergers and acquisitions, utility bankruptcy, policy issues, returns on equity relative to betas, decarbonization and renewables as sources of earnings growth, leading states and companies in regard to renewable energy output, utilities at risk for COVID-19 driven revenue loss, impact of tax reform and deferred tax decreases on rate base and rates, utilities with resilient earned ROEs during the prior recession, and higher-performance utilities regarding equity value and financial measures as assessed through the correlations of different variables.

READ MORE: RRA Financial Focus Frequently Asked Questions regarding traditional utility and midstream coverage

Regulatory Research Associates is a group within S&P Global Market Intelligence.

For a complete, searchable listing of RRA's in-depth research and analysis, please go to the S&P Global Market Intelligence Energy Research Library.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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