A couple of Saturday's ago, The Wall Street Journal's Weekend Interview column was devoted to a discussion with Tom Fanning, the chairman and CEO of the Southern Company (SO-NYSE). The title of the column was "The Natural Gas Skeptic," but it wasn't so much a discourse on skepticism about the universally endorsed view of the existence of a century of natural gas resources at historically low prices, as it was about the need for a balance in fuel supplies. The discussion focused on utility company business models that actually create long-term risk for customers and shareholders due to their focus on fads and reckless actions designed to drive above-average short-term growth.
The Southern Company is an electric utility with operations in four Southeast states--Alabama, Florida, Georgia and Mississippi--and power generation opportunities in six neighboring states. The company's service territory spans 120,000 square miles and is serviced by 12,222 megawatts of power generation capacity. Southern Company has 33 hydroelectric generating stations, 34 power plants fueled by coal and natural gas, three nuclear facilities, 13 combined-cycle cogeneration plants, two solar farms and one landfall gas plant.
One could conclude this company has a conservative philosophy regarding its portfolio of fuel supplies. Mr. Fanning explained, "Southern may not be exciting, but we're dependable and we work like crazy to be dependable."
In the interview, Mr. Fanning pointed out that his company is still building coal fired plants along with natural gas powered ones. Southern Company is constructing the nation's first nuclear power plant since the late 1970s and it is also building a waste biomass generating plant. He characterized the company's power diversity strategy as similar to investors diversifying a portfolio of stocks. This philosophy was characterized by the interviewer as positioning Mr. Fanning as "one of the most trenchant critics of the transformative switch to gas from coal." Explaining his concern over totally embracing natural gas, Mr. Fanning says, "It just doubles down your risk into one segment that looks promising today but nobody can sit here and tell me that it's going to be safe forever, safe in terms of economics and reliability."
The flip side of embracing natural gas is Mr. Fanning's concern about the regulatory push to ban the burning of coal. "It's terribly unwise in my view to create a regulatory regime that bans one of the nation's most plentiful resources. We own 28% of the world's coal reserves -- we have a blessing of wealth. It should be brought to bear here in America. If not, due to regulatory policy, it will be burned for the benefit of the citizens of China or India or elsewhere." His views come even as Southern Company has reduced its dependency on coal from 70% in 2007 to 35% now, while natural gas-fueled power has increased from 16% to 47%. The company's divergent trends in energy use are reinforced by statistics showing that since 1990, power companies have opted for new coal-fired plants for only 6% of their new generation capacity while over the same period 77% of new capacity is being fueled by natural gas.
Mr. Fanning is skeptical about the nation's growing dependence on natural gas given the fuel's historical price volatility and its potential consumption growth. As he put it, "Nationwide, I think we're going to be consuming over 50% more gas going forward than we currently do, or at least there's a good potential for that." He acknowledges that increased production due to more wells and the use of hydraulic fracturing technology has contributed to increased supply and low gas prices. But he offers, "Gas has traditionally been way more volatile certainly than coal and nuclear. So you're buying a more volatile product. You're creating a higher-Beta energy policy." (Beta is the measure of the volatility of the price of an asset in relation to the overall market.)
What Mr. Fanning is concerned about is that as coal, a low-Beta fuel, is eliminated from the market, power customers will be forced to rely on less productive and more expensive energy sources. While that would appear to target renewables, Mr. Fanning says he is excited about renewables, but warns they are really a niche fuel. He is also concerned about the political risk for natural gas supply from concerns about the wide-scale use of hydraulic fracturing.
Looking to the future, Mr. Fanning sees natural gas prices normalizing globally, meaning America's current low prices will disappear. As a result, he sees the dividend our economy is getting now from low energy prices is something that will not last. As a result, his strategy is best summed up in the following statement. "Believe me. I think gas will be the dominant resource going forward. But I am not willing to subject my customers to the risk of betting it all on gas."
As a result, Mr. Fanning focuses much more on the risks in managing his business, and in particular the long-term risks. He believes the vertically integrated, regulated utility model "should be the dominant solution" in the power industry. What he worries about are those companies that are set up to focus on maximizing the next quarter's returns at the expense of long-term profitability. In his view, "Risk is as important as return. And I think so often given the herd mentality we see in the markets, people forget that."
Those are excellent thoughts to keep in mind as we contemplate the future of the natural gas industry.
G. Allen Brooks is Managing Director of Houston-based investment banking firm Parks Paton Hoepfl & Brown. This article originally appeared in the June 19, 2012, issue of PPHB's newsletter "Musings from the Oil Patch."