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Utilities, Continued Disbelief

04/10/2013

The utilities sector continues to outperform all major U.S. equity indices, as well as the majority of its sector peers except health care and consumer staples. Yet, as I read the sector view from multiple investment banking analysts, continued disbelief that utilities can appreciate further prevails. The usual conditions for a reversal to sector underperformance are cited:

•  Elevated PE’s
•  Interest rate risk
•  Natural gas prices below $4

In reality, however, utilities looks, first and foremost, exactly like what investors desire, a sector that “appears bond-like yet isn’t actually a bond.” While it’s popular to believe that interest rates will spike higher, the evidence is simple: the yield on a U.S. 10-year Treasury (Figure 1.1) is unchanged year to date at 1.757%. That makes the average utilities’ dividend yield of roughly 4.25% look rather compelling.

Additionally, spot natural gas prices are very quietly creeping higher and maintaining the advance above $4. Technically, it appears the spot price of natural gas (Figure 1.2) is headed toward a challenge of the early 2011 breakdown levels between $4.50 and $5.00, favorably for utilities.

Fundamentally, while recent headlines are focusing on the 2.384 trillion cubic feet of recoverable domestic gas and its ability to fuel the U.S. for 100 years, recent inventory data showed inventories were 2.1% below the 5-year average (Figure 1.3), the first occurrence in 18 months. Commercial and residential demand for electricity motivated the Department of Energy to raise its electricity consumption estimate by 0.6% for 2013. Electricity generation will average 11.19 billion kilowatt-hours a day this year versus 11.14 billion in 2012. Combine these conditions with a very tight supply/demand Texas power market and the independent power producers should maintain their current tailwind.

I expect that some of the fund flows into utilities is more of a secular story. I would assert it to be a correct one. Over the next few years, pipelines will become critical for transporting shale oil and gas. Given the challenging U.S. current deficit and our abundant shale supply, common sense suggests that the U.S will become a major player in the exportation of oil and gas. Infrastructure is needed, and it is from within the utilities sector that infrastructure pipeline provider opportunities will be found. 

For those doubting my expectations and the continued outperformance of the utilities sector, I urge you to do the homework on this past Monday’s $3.3 billion purchase of Lufkin Industries by General Electric. GE obviously recognizes the opportunity in U.S. shale oil and gas. GE’s oil and gas segment has witnessed the fastest growth over the past three years. So much so that GE is investing in a $100 million-plus Oklahoma research lab to improve upon hydraulic fracturing and horizontal drilling.  

Figure 1.1 U.S. 10-Year Treasury Prior 365 Days


Source: Bloomberg

Figure 1.2 Spot Natural Gas Prices, Prior 3 Years


Source: Bloomberg

Figure 1.3 U.S. Natural Gas Inventories Relative to 5-Year Average


Source: Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.