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Insights: Investing

The California utilities mess is driving down utilities stocks nationwide, creating appealing bargains
Mario J. Gabelli, Tim O'Brien
From the Print Edition:
The Cuba Issue, May/Jun 01

In the October 1999 edition of Cigar Aficionado, I wrote a column titled "These Are Not Your Father's Utility Stocks," which detailed how the deregulation of the utilities industry was dramatically altering the investment fundamentals for what were still largely perceived as stodgy old utilities stocks. My conclusion was that selected utilities stocks presented excellent investment opportunities. In 2000, utilities stocks excelled and the Gabelli Utilities Fund gained 16.4 percent compared to the Lipper Utility Fund Average's 7.5 percent advance.

This year, utilities stocks have been under pressure, in part due to the much publicized problems of California's largest publicly held utilities companies, Pacific Gas and Electric and Southern California Edison. In the following column, Tim O'Brien, the portfolio manager of the Gabelli Utilities Fund, details what went wrong in California and why we think the market fallout from California's problems has produced another great buying opportunity in the utilities sector.

California Scheming

In late January, the California legislature appropriated $10 billion of taxpayers' money to keep the lights on as Pacific Gas and Electric and Southern California Edison teetered on the brink of bankruptcy. While this may halt the bleeding temporarily, it will not heal the wounds caused by California's poorly conceived deregulation plan.

What went wrong in California? In 1996, California politicians were seeking utilities rates cuts they could wave in front of the voters on Election Day. Utilities companies were willing to oblige if the state would relieve them of "stranded costs" that were the legacy of expensive investments in nuclear power plants and uneconomic long-term supply contracts with independent power producers. Major industrial and commercial customers wanted the opportunity to shop for a better deal in a competitive wholesale power market.

A complex deal was struck. The publicly held utilities would auction off their power generating assets at a profit and use the gains to offset some of their stranded costs. The balance of the stranded costs would be securitized by state-issued bonds that would be paid off by a charge to the utilities' customers. Retail electric rates would be cut and then frozen until the stranded costs were fully recovered or until the transitional period ended in 2002. At that time, utilities would be able to pass on wholesale power costs to retail customers. PG&E and Edison would be required to buy, and all of the wholesale generating companies serving California would be required to sell, electricity in a spot auction market administered by the California Power Exchange. Long-term contracts between the utilities and the power generators were not permitted.

This would prove to be a costly mistake.

The hastily constructed deal worked just fine for a few years. But it was doomed to fail, because it ignored basic economic principles. Electricity is a commodity. In a truly competitive commodities market, price changes send signals to producers and consumers. When prices rise, producers increase output to take advantage of the higher prices and consumers conserve or substitute to save money. For example, when corn prices rise, farmers increase production while consumers eat oatmeal or Wheaties instead of corn flakes. Rising supply combined with weaker demand eventually brings prices back down. However, electric power is a more volatile commodity than corn, because electricity cannot be stored for future use and because consumers really can't substitute something else when prices are high.

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