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Power Outage

You never realize how much you need electricity until the power goes out at your home or business. As I write, the electricity is off in large stretches of the Northern Virginia suburbs, utility crews are working in overdrive and residents are on a slow boil as the mercury rises on an early summer day.

Unfortunately, it looks like we’ll be looking at more outages nationwide in the coming months, particularly in areas prone to storms. As outages go, this one–which occurred in the wake of a run-of-the-mill electrical storm–is relatively minor, affecting only a few thousand customers. But if history’s any guide, others won’t be so benign.

Some of the blame must go to utilities, regulators and even customers. Up until the 1980s, power was a vertical monopoly and electric utilities were guaranteed a generous return on investments in power plants and power lines. This regulatory compact broke down in the ‘80s, due in part to rate increases instituted to build nuclear power plants, which customers were reluctant to pay. Utilities were forced to eat billions of dollars in costs, driving some to the brink of bankruptcy.

The attempt to deregulate the power business made the situation worse. Rates of many companies–including Virginia Power–were frozen for several years, utterly discouraging investment. Meanwhile, the supposition that competitors would enter the infrastructure business proved false.

The result is that much of the nation’s power infrastructure is ancient. With regulatory relations generally positive, some companies are now proposing major upgrades to their systems, the cost of which will be added to their rate base, boosting earnings.

Xcel Energy (NYSE: XEL), for example, announced a $1.3 billion plan to build three new high-voltage lines connecting its territory in Minnesota and South Dakota. The project is in alliance with smaller investment-owned utilities in the area, as well as municipalities and cooperatives. UIL (NYSE: UIL) and Northeast Utilities (NYSE: NU) are exploring system buildouts in New England, where the network in many places is 75 years and older.

The good news is we can expect to see many more of these projects in many areas of the country. More lines will inevitably improve service and resistance to outages. In addition, customer opposition to paying for such reliability-enhancing measures as tree-trimming measures, burying lines and so forth appears to be waning, as reliability becomes increasingly important, particularly to businesses operating out of the home.

With utilities now focused on growing their regulated businesses, this is an ideal avenue to grow earnings, at least as long as the favorable regulatory environment lasts. And all else equal, it will improve system reliability going forward. So will adoption of new technologies like superconductors, which have advanced primarily because of demand from the US military.

The bad news is much of the nation’s reliability problem in coming years is likely to be out of the hands of utilities. More investment will lessen the consequences and keep the lights on, a plus for both customers and utility companies, which lose sales and incur additional expenses when the lights go out. But it won’t prevent the outages that will occur.

The reason is the weather, specifically higher temperatures. Few people I know were complaining when the winter of 2005-06 proved to be the mildest on record. Most will think differently if the mercury proves similarly elevated in the summer. That was the case in the full year 2005, which was the hottest on record and had the most major storms.

There were 28 named storms in 2005, of which hurricanes Katrina, Rita and Wilma were the largest and most deadly. The hurricane season extended well beyond its normal November close, with the last storm hitting at the end of December. It was also the first with three Category 5 storms.

This year, the National Oceanic and Atmospheric Administration forecasts “an 80 percent chance” of an “above average” hurricane season, with four to six major storms. With several storms already making the news–including a recent near-miss in Florida–that forecast could prove very conservative.

The relationship between more frequent storms and rising temperatures is accepted scientific fact. Rising temperatures heat water, giving storms more energy. Higher temperatures in the Gulf of Mexico–after the cooler water of the Atlantic Ocean–gave Hurricane Katrina the deadly force it used to wreak its havoc.

Consequently, the hotter the weather gets, the more storms we can expect. That means more uncomfortable power outages, which will hurt consumers and utilities alike.

The desire to limit the impact of storms on earnings is a major reason FPL Group (NYSE: FPL)–the utility serving south Florida–has built a fast-growing portfolio of wind and nuclear power plants. And it’s a big reason why the company wants to merge with Maryland’s Constellation Energy (NYSE: CEG). The success of that strategy was showcased in the first quarter, as earnings surged despite sluggish utility results.

Entergy’s (NYSE: ETR) plan to bring its New Orleans unit out of bankruptcy may involve simply kicking it off to the city. That’s if the federal government fails to come through with promised aid. Both utilities are hard at work to shore up their finances against the impact of future storms.

The really good news is regulators and state officials are working with the utilities, rather than expecting them to bear all the burden of rising storms. As a result, financial risks from weather to companies operating in the Gulf region are still not critical.

On The Hot Seat

There is another risk to utilities emerging from the uptrend in volatile weather: the increasing likelihood of regulation of carbon dioxide emissions from power plants.

This week, I viewed the movie “An Inconvenient Truth,” a documentary on former Vice President Al Gore’s ongoing crusade for controls on CO2 emissions. No doubt many U&I readers still harbor uncomfortable feelings toward Mr. Gore, and I’ll wager more than a few are deeply skeptical of his arguments and perhaps even his motives.

The movie pretty much lays out what the rest of the world has already accepted as established fact, that CO2 emissions from human sources are increasing global temperatures, which in turn are boosting storms.

Every major developed country in the world save two has now signed the Kyoto Protocol to the United Nations Framework Convention on Climate Change (Kyoto Protocol), which call for countries to reduce their CO2 emissions by a variety of means. The only holdouts are Australia and the US.

In this country, the Kyoto Protocol’s staunchest opponent is the Bush administration, which terminated US participation in the agreement. That was a 180 degree reversal from the Clinton administration’s position and proposals, which were shaped in large part by Vice President Gore. President Bush has also dropped 2000 campaign promises to regulate CO2 like a hot potato.

Beyond the White House, opposition to CO2 regulation is wearing very thin. To date, the primary support for regulation has been coming from the states. Eight states’ attorneys general are currently suing the Environmental Protection Agency and major CO2 producers–primarily major coal-burning utilities–to impose CO2 regulation.

Moreover, some two-dozen states have passed legislation requiring power producers to use renewable resources to meet at least 20 percent of their electricity needs by 2020. That means nuclear or wind power, which emit no CO2.

On the federal level, neither the 2005 Energy Act nor election year legislation currently being pushed have any mention of CO2 regulation. That’s a clear demonstration of the power of those lobbying against controls, namely the oil and automobile industries, as well as several major coal burning utilities.

The latter camp is showing distinct divisions. About a month ago, I highlighted in U&I a panel I moderated at the Las Vegas Money Show. One of my questions to the panel–which included executives from Allete (NYSE: ALE), Duke Energy (NYSE: DUK) and PNM Resources (NYSE: PNM)–concerned the possibility of CO2 regulation, and how their respective companies were preparing for it.

What still stands out in my mind is the inevitability with which the trio seemed to view CO2 regulation. While they viewed new regulation with trepidation–as should any business–they seemed more concerned with establishing a framework that made sense, while they enjoyed a friendly Congress.

In fact that’s the position taken by several major utilities, including Duke and Exelon (NYSE: EXC), which are currently lobbying the current Congress for precisely such action. The motivation of these companies is two-fold.

First, many of the biggest utility proponents of action on CO2 are nuclear companies. Any financial burden on coal utes for CO2 makes nuclear energy that much more competitive and profitable. The same holds for wind power, the use of which is growing rapidly across the country.

Second, action now will head off what could be more radical and less industry-friendly measures later, in what could be a more radical Congress. The Clean Air Act (1990 Act) signed by the first President Bush in 1990, for example, set up a system that’s allowed coal-burning utilities to dramatically reduce emissions of sulphur oxides and nitrogen oxides (which cause acid rain) during the past 15 years or so, and without taking a real financial hit. The Clean Air Act basically created credits that allowed coal utes to pollute for a price. The beneficiaries were other utilities that made the necessary investment to reduce emissions.

In recent years, the cost of these credits has skyrocketed. That’s in large part due to high natural gas prices, which have made it economic to run most coal-fired plants, including very old ones. Running those plants means companies have to buy more credits, which pushes up their price. That in turn has induced the owners of those plants to commit the money to upgrade them and reduce emissions.

The bottom line is the credit system launched with the Clean Air Act has worked to reduce pollution in an economic way. In fact, its success has been so widely acknowledged that it’s been used as a model for reducing CO2 emissions globally. And it would also be the logical model in the US.

A system of credits and incentivized investment in this way could actually be beneficial to utilities. Southern Company (NYSE: SO), for example, is spending $6 billion on its system over the next five years or so to reduce power plant emissions. That investment will be added to rate base, which will increase earnings. The utility is literally cleaning up in two ways.

If the Clean Air Act model is applied to CO2 controls, the financial result on most utilities would be relatively benign. It’s distinctly possible, however, that we’ll see something far less flexible and much more burdensome in the coming years.

For one thing, this Congress seems unlikely to buck the Bush administration’s oft-repeated view that global warming is a myth and CO2 regulation would be nothing short of a catastrophe for the economy. That makes action before the November 2006 elections highly unlikely.

If the Republicans hold serve in November, proponents of “cap and trade” should have another opportunity to get benign legislation passed. And the odds could actually increase, should one or both houses of Congress go Democrat, since the president would continue to hold veto power.

The greatest danger of radical action will come if there’s nothing done before the 2008 presidential election, and there’s a change in party control of Congress as well as the White House. To date, most casual observers have assumed Senator Hillary Clinton would be the Democrats’ nominee.

But there’s also precedent for a Gore candidacy, which would be guaranteed to catapult the CO2 issue back to the forefront. Hardcore members of both parties will be deeply offended by this analogy, but back in 1960, Richard Nixon came within a handful of votes–some would say those of deceased Chicagoans–of succeeding Eisenhower as president. Al Gore had a similar experience in 2000, actually winning the popular vote handily but losing the presidency as the US Supreme Court voted 5-4 to uphold similarly Third World-esque results in Florida.

Both men were deeply affected by the results and many counted them out. By 1968, however, Nixon was riding a comeback wave, spurred by Democrats’ mismanagement of the war in Vietnam and creeping inflation and deficits. “Tanned, rested and ready,” he stormed back into the White House he thought he should have won back in 1960.

It’s a little early to call a repeat in this case. But with violence in Iraq continuing unabated–despite the administration’s assurances that assassinating Zarqawi would be a turning point–and the president polling at very low levels, there are enough similarities for a possible Gore presidency to be taken seriously.

In any case, the longer CO2 regulation is put off, the more storms we’re going to see and the greater the pressure will become for radical action. That’s a good reason for utility investors to look to the rapidly consolidating club of nuclear utilities, which are sure to benefit: Dominion Resources (NYSE: D), Constellation, Duke, Entergy, Exelon, FPL Group and Southern Company. Wind power companies like AES Corp (NYSE: AES) and FPL are also in excellent position to take advantage of inevitable CO2 regulation, whether it’s benign or radical.

As for companies vulnerable to CO2 regulation, my view is it’s still a bit early to pull the plug. But Ameren’s (NYSE: AEE) exposure to volatile Illinois regulation is a good enough reason for conservative investors to steer clear now. The state so far has stayed on target to hold an auction for power that will see prices rise sharply from currently controlled levels to market prices. What’s less sure is whether or not regulators will allow those costs to be passed on through higher rates. It’s not necessarily a chance worth taking, especially given that the company’s key business is running coal-fired power plants.

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