Alternative Energy Vexes Autos and Utilities

High prices for oil and natural gas are leading automakers and utilities to seek alternative energy solutions, but it's going to take years

by Robert McNatt

The recent high prices for oil and natural gas have been particularly hard on hydrocarbon-reliant industries with no easily available substitute. Airlines, for instance, still need aviation fuel made from petroleum, chemical companies need fossil fuels for plastics, and truckers can't make their runs without diesel fuel. Many companies in these industries have been hard-hit and face endangered ratings, squeezed profits, or the task of trying to pass along the higher costs to their customers—sometimes successfully, sometimes not.

Still, other industries are trying to switch to alternative technologies or energy sources. In theory, based on past estimates of the point at which the higher-cost alternative fuels become competitive with traditional ones, the recent rapid increase in oil and natural gas prices should boost the pace of this conversion—especially considering that many experts view recent energy price increases as permanent, rather than as the temporary spikes of the past.

Two of the most voracious energy-consuming industries—autos and utilities—illustrate the obstacles to rapid conversion. Car companies are suddenly (and at last) deadly serious about lessening the dependence of their products on oil, now that it's north of $130 per barrel. And utilities are just as eager to burn less natural gas, now that it's at around $12 per million Btu (mmBtu), or roughly two and one-half times the pre-Katrina price.

Toyota and Honda's Head Start

Natural gas prices can and do vary enormously because of the weather. Still, the total cost of electricity from wind compared to natural gas was already fairly close in 2007, when gas was at only $7 per mmBtu. That means wind should be a decidedly more affordable option now. But while a wider use of alternative energy sources seems almost certain to occur, it's also clear that it will take time—years, in fact—before alternative energy generates more than its current tiny 2% share (not including hydroelectric or nuclear power) of U.S. electricity.

The problem both automakers and utilities face is time. Though Toyota (TM) and Honda (HMC) have a head start, most automakers have a long way to go to perfect energy-efficient technologies, not to mention convert existing production capacity. And with more hybrid models coming out, each auto company is also facing an increasingly competitive field.

Utilities, once they have the technologies, must also negotiate the minefield of government and regulatory policy and approvals. The bottom line is that while conversion efforts will bear fruit over the long term—perhaps five or 10 years from now—we don't believe that they'll lead to meaningful improvement in the credit quality of carmakers or utilities any time soon.

Automakers Look Beyond Gasoline

Probably no industry would like to convert more quickly than U.S. automakers, which until recently pinned their business strategies on gas-guzzling pickup trucks and SUVs. Buyers are now shunning these vehicles and buying smaller cars and crossover utility vehicles. Hybrid cars, while still a niche segment—they have a single-digit U.S. market share—continue to grow in popularity despite their price, which might be several thousand dollars above that of a comparable conventionally powered vehicle.

Automakers are responding the best way they can on short notice. "It's causing them to sharply cut production of trucks and SUVs and increase the production of cars," says Standard & Poor's Ratings Services credit analyst Robert Schulz. General Motors (GM), Ford (F), and Chrysler (each carries an S&P credit rating of B) are all going through the painful process of idling truck plants while trying to boost production of conventional cars and hybrids.

This difficult transition and its effect on the companies' cash flows and prospective liquidity was the major factor in Standard & Poor's recent placement of GM, Ford, and Chrysler's ratings on CreditWatch with negative implications. "Even higher-rated automakers are cutting SUV and light-truck production in light of prospective market conditions," said credit analyst Gregg Lemos Stein.