By LIAM DENNING;Wall Street Journal

With fear rippling through the markets, utility stocks should be natural beneficiaries. Unfortunately, power providers face a few head winds of their own.

Greater risk appetite has persisted for most of this year. Even if that implies less defensiveness, though, electricity companies ought to be doing better than the slight drop registered so far. As the economy recovers from recession, power demand should rise along with it. Electricity sales fell 5% between 2007 and 2009, led by a 14% in demand from industrial users. On a 12-month trailing basis, however, demand has now turned positive.

If power producers now represent an option on economic recovery, however, many remain unconvinced by its strength. Duke Energy, reporting decent first-quarter earnings earlier this month, sounded a cautious note on industrial-power demand in the second half.

Perhaps the best indicator of uncertainty is a pair of large deals. In February, FirstEnergy pounced on Allegheny Energy, paying $8.5 billion, including assumed debt, to expand its unregulated generation portfolio. In essence, it was a bet on recovery. Late last month, on the other hand, PPL Corp. said it would pay $7.6 billion for E.On's largely regulated U.S. assets, reducing PPL's leverage to any recovery.

 Bloomberg News Duke Energy, reporting decent first-quarter earnings earlier this month, sounded a cautious note on industrial-power demand in the second half. Above, a Duke employee works on power lines.

Compounding this uncertainty is the collapse in natural-gas prices. Since gas-fired generation is the marginal price-setter in many regional U.S. power markets, low gas prices also weigh on electricity prices. Futures prices for the period of 2010 to 2013 in the regional PJM electricity market in the eastern U.S. have dropped by between 8% and 13% since the start of the year, according to Morgan Stanley.

All this should prompt a switch toward regulated utilities, which are less leveraged to power prices and usually carry a high dividend yield. But there is uncertainty on this side of the sector, too.

Tax cuts on dividends enacted under President George W. Bush are set to expire at the end of this year, potentially raising the top rate to almost 40% from 15%. While there is little doubt the rate will rise, how far remains unknown. Since 1974, dividends have accounted for 69% of total returns from owning utility stocks, against 42% for the S&P 500, according to Sanford C. Bernstein, so this is a big unknown. Bernstein reckons that, based on the historical relationship between the yields on utility stocks and 10-year Treasurys, the sector is already discounting an expected increase in taxes.

But uncertainty will likely continue to weigh on these stocks. In addition, that close relationship with Treasurys presents a wild card. Flight to safety from risks like the Greek debacle has kept U.S. government debt yields surprisingly low, despite the ballooning deficit.

But any crack in the market's confidence about Uncle Sam's ability to keep issuing paper, or an inflation scare, could cause yields to rise. Utility stocks would likely fall to keep their dividend yields competitive. In the wake of the latest recession, even utilities don't necessarily offer the safest haven.

Write to Liam Denning at This e-mail address is being protected from spambots. You need JavaScript enabled to view it

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