Utilities positioned to benefit from growing demand for natural gas
Utilities are in a position to benefit from an abundant and growing supply of natural gas in the United States, as well as growing demand for clean energy. During the past several years, innovative drilling technologies—including hydraulic fracturing (“fracking”)— have allowed energy companies to more effectively extract crude oil and natural gas from previously impenetrable shale rock formations below the earth’s surface. Recent discoveries of these commodities in fertile oil and natural gas field regions—such as the Eagle Ford (Texas), the Bakken (North Dakota), and the Marcellus (Appalachians)— resulted in an increased supply of domestic natural gas (see Exhibit 1, below right), followed by sharply lower prices for the commodity.1 Some industry analysts have even gone so far as to describe this era as a “U.S. Energy Renaissance,” and to predict the U.S. economy may reach a point in the future where it can meet 100% of its own demand for energy through domestically produced sources—a scenario that was hard to imagine only a few years ago.
The growing domestic supply and lower cost of natural gas relative to other fuels, such as home heating oil, have created higher demand for the commodity and the need for new infrastructure. Increased demand is coming from power plants that are looking to convert to lower-cost and cleaner power generation, industrial manufacturers that see lower fuel costs as a reason to repatriate facilities back to the U.S., and residential consumers looking to reduce their home heating bills.
To meet this increased demand for natural gas, new processing plants, storage facilities, and pipelines are needed. Processing plants are needed to refine raw natural gas liquids. Storage facilities are needed to maintain the processed natural gas. And pipelines are needed to transport newly discovered natural gas and natural gas liquids from shale drilling locations to underpenetrated regions, such as the Northeast.
Natural gas utilities are at the center of this natural gas infrastructure build-out. Natural gas utilities are constructing and expanding existing pipelines to transport the commodity from drilling wells in shale basins to highly populated demand centers in the U.S. In many neighborhoods in the Northeast—a region where a significant majority of homes are heated with home heating oil2—there is no existing infrastructure under the streets to transport natural gas to residential homes and businesses. In this region, demand has skyrocketed from consumers looking to convert heating systems from higher-cost home heating oil to lower-cost natural gas as a fuel for heating. Additionally, several utilities are now building natural gas liquefaction terminals to export the commodity, given the vast U.S. supply.
In my view, the capital investment being made by natural gas utilities to build out this new infrastructure is a positive longterm growth trend for investors that will continue to play out in 2014 and beyond. By building out new infrastructure to connect consumers to natural gas, utilities can quickly recover their capital investment, which can lead to faster earnings and dividend growth. Historically, utilities that have generated the highest dividend growth over time have tended to be the top performers in the sector.3 Today, I believe the stocks of utilities that are benefiting the most from the construction of natural gas infrastructure are poised to generate the fastest earnings and dividend growth, and are underappreciated by the broader investment community.
Risks: What to watch in 2014
Sharp increase in interest rates
One of the most significant risks for the stocks of utilities is an unexpected increase in interest rates. I believe there is still a significant percentage of income-seeking investors who had purchased utilities stocks during the past couple of years and remain invested, seeking to take advantage of their higher dividend yields relative to investment-grade bonds. If bond yields were to rise sharply in 2014, these investors may rotate out of utilities stocks and into bonds, which could put pressure on the stock prices of utilities.
A similar scenario played out beginning in the spring of 2013. When the yield on the 10-year U.S. Treasury bond nearly doubled over a short-term period,4 higher-dividend-paying stocks—such as utilities, real estate investment trusts, and consumer staples— fell sharply before recovering after several months when interest rates gradually declined to lower levels. Much of the outlook for interest rates will be determined by the trajectory of the U.S. economy and the Federal Reserve’s monetary policy in 2014. An unexpected acceleration of the domestic economy could lead to a dramatic increase in policy rates, and lead to lower valuations for utilities stocks. On the other hand, if U.S. economic growth continues to improve gradually and the Fed’s future policies lead to a slow, measured increase in policy rates, I believe utility stocks are likely to hold up fairly well. Longer term, I continue to believe utilities stocks can provide commensurate returns to the broader equity markets, and do so with less volatility.