⚡️ What's up with your Electric Bill?
Why Utility companies have been a winner so far during the inflation recession market
Monday, September 12th, 2022:
The Market rose for the fourth day in five as investors staged a mini-rally ahead of tomorrow’s CPI inflation numbers. All Major indexes rose:
The S&P 500 rose by +1.06%
The DOW edged up by +0.71%
The NASDAQ climbed by +1.27%
The Russell 2000 jumped by +1.23%
The Market rose by more than 5% this past week after a period of despair following remarks from Federal Reserve Chairman Jerome Powell that the US economy would likely slow due to monetary tightening policy. Investors are looking ahead to tomorrow’s August Consumer Price Index report, which will hopefully show that inflation is cooling, much like it did in July.
Yet despite the past week’s optimism, the Market is still muddling through high uncertainty on the other side of tomorrow’s inflation report and what it will mean for the interest rate hike in ten days’ time. If inflation numbers don’t slow more than expected tomorrow, expect more volatility for the total US stock market, which is still down close to -15% since the start of the year.
But, do you know what's not down this year, and is the leading sector after energy producers?
Utilities. Yes—the dull old electric bill you need to bring to the DMV by March of 2023. Whereas the S&P 500 is down a painful 14% year to date, Utilities as a sector are up by more than +10% in 2022.
Why? There's the classical thinking that as the US enters a recession, consumers cut back on spending to the bare essentials. People will cancel a vacation but can't afford to turn off the gas and electricity. And sure, this stickiness, plus the recent Inflation Reduction Act, which carves out funding for energy infrastructure investments, definitely play roles in utilities' ascent.
But other drivers are also fueling the case for making utilities sexy again—namely, a supply and demand imbalance caused by war and climate change. And we have these two in spades in 2022, severely disrupting the supply and demand for utilities, much to utility companies' benefit.
Before diving into these drivers, let's understand utilities better and why they haven't been popular for most investors.
Unbeloved in boom times
For many, utility companies, such as water, electric, and gas suppliers, hardly come to mind when thinking about stock investing. It's a complicated industry to follow due to state-by-state regulations. And for retail investors, it's hard to distinguish their municipal supplier from giant for-profit corporations.
Make no mistake, though. The US utility market is enormous--to the tune of more than $600 billion in revenue annually. In 2021, the US consumed 3.93 trillion kilowatt hours, slightly down from a peak of 4 trillion in 2018.
And while this level of consumption is 13 times greater than in 1950, the industry is dependent on population growth and under pressure from more energy-efficient consumer technology. Thus, over the past couple of decades, utility companies' revenue growth has slowed drastically over the past decades to a compound annual growth rate of 2.3% with tight profit margins.
And low growth, competition, and strict regulation make utilities a Wall Street ugly duckling during growth boom times. Nowhere has this been so starkly evident as in the composition of the S&P500 over time.
In 1990, utility companies made up more than 6% of the S&P500 index by market capitalization. Frankly, almost every sector has been eclipsed by the rise of big tech. But currently, they make up less than 2.5%. Public relations disasters, such as the USA's largest utility Pacific Gas & Electric's culpability in the California Camp Fire and subsequent bankruptcy in 2018, have not helped the industry's attractiveness.
Thus, utility companies rarely eclipse $100 billion in market cap, and the industry's annualized returns since 2007 have trailed the S&P 500 by more than 2%. But in 2022, with armed conflict disrupting supply and the environment warms, things are trending up for utilities.
War is Disrupting Energy Supplies
As Russia's War in Ukraine enters its seventh month, it has turned the global natural gas supply upside down. In retaliation for Europe's proposal to cap the price of Russian energy imports, Russia has indefinitely shut off the flow of natural gas into Germany via the Nordbank 1 gas pipeline.
Resultantly, Germany is facing a shortage of natural gas to generate electricity and is increasingly looking to replace Russian supplies with sources from Netherlands and Norway. However, this change in suppliers isn't as simple as swapping toothpaste.
Since Germany is now desperate to replenish its natural gas supplies, it is willing to pay more, pushing up prices across the globe, including in the US. Since the start of the year, UNG, an ETF that tracks changes in the price of natural gas delivered to the Henry Hub in Louisiana, has increased by more than 127%.
These price increases get passed through to consumers through higher electricity bills. While prices have risen just 14% nationally, some states, such as Oklahoma, which are heavily dependent on fossil fuels for power generation, have seen their prices rise by more than 49% over the past year.
And while their supply input costs are higher, utility companies benefit from higher revenues. But this means higher prices for consumers, which lends to inflationary pressures.
Climate Change is affecting both Supply and Demand
The natural world is full of feedback loops, meaning that if a factor causes a situation, that situation can, in turn, either positively or negatively enhance that factor. For example, when a drought occurs, less moisture is in the soil, and thus less water enters the atmosphere, thus leading to more drought.
So when climate change occurs, it can make certain weather events even worse. And these natural disasters affect utility providers, which get their energy supply from a handful of sources, such as wind, gas, coal, nuclear and solar.
Recently, an extended drought in California has drastically decreased the state's hydroelectric power output. But at the same time, as things heat up, people use more air conditioning which requires more electricity during peak demand periods. As a result, higher demand and lower supply threatened the state with blackouts during the recent heat wave.
Due to more scarcity, electricity prices will rise unless more supply comes into the system. This situation benefits utility companies through revenue growth but ultimately makes life more expensive for consumers. And while the recent Inflation Reduction Act targets bringing on more renewable energy sources, such as solar and wind, additional supply will take a while to come online.
So, high energy prices may be the norm for a while, making it more challenging to bring down inflation. As the saying goes, when it rains, it pours.
Stay frosty,
Alex with TAI