Wall Street Has A New Favorite Energy Niche

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By Alex Kimani

For many years, investors have been willing to pay significantly more for shares of natural gas utilities compared to electric utilities. In more recent times, natural gas is also increasingly being viewed favorably as a bridge to climate breakdown, even as coal power generation gives way to its cleaner counterpart.

However, the warm glow has not stopped investors from fleeing natural gas utilities as the fossil fuel sector has come under increased scrutiny for its role in climate change.

In a rare occurrence, electric utility valuations have blown past those for gas, an ominous sign that investor confidence in the future of fossil fuels is approaching a nadir.

Natural gas discount

For the first time in a decade, shares of local gas distributors are cheaper than those by electric utilities based on projected earnings. The S&P Gas Utilities Index is now trading at an average P/E ratio of 16.7 times vs. 17.1 for the S&P’s electric utilities index is trading at 17.1, according to Bloomberg data. In sharp contrast, NextEra Energy Inc. (NYSE:NEE), the world’s largest publicly listed developer of wind and solar, is trading at a staggering 30.5x fwd earnings. The huge discount is a clear reflection of the dimming prospects of fossil fuels in general. It’s also a reflection of the poor state of the industry, with natural gas prices currently hovering at multi-year lows.

The near-and mid-term prospects for natural gas, however, still appear bright. Hydraulic fracturing has made the fuel plentiful and cheap making it hard to find a suitable substitute. In fact, natural gas consumption has accelerated in recent years, with the IEA predicting it will increase another 40 percent to nearly 200 quadrillion Btu by 2050 as the global transition from coal gains momentum–natural gas produces about 50% less CO2 emissions than coal for the same amount of energy. Natural gas is also able to keep the grid stable as solar and wind power fluctuate.

And climate advocates might have a harder time kicking it out compared with coal.

Climate advocates in dozens of cities in liberal-leaning states such as Washington, California and Massachusetts have been pushing for natural gas to be banned from homes and businesses with lawmakers in New York to California taking a stand against greenhouse gas emissions.

But all that is easier said than done, if California is any indication.

California is regarded as one of the greenest states in the United States. Although its millions of vehicles still produce tons of smog that pollute the air, the state has been very vocal and proactive than most at keeping greenhouse emissions low. For instance, the Golden Bear State produces more renewable energy than any other state in the nation and has even set an ambitious goal to generate 100% clean power by 2045.California  has also become the first state to vanquish coal for power generation.

But unlike the state’s successful push to ditch coal, early efforts to phase out natural gas have been facing heavy pushback. Pushing out coal was relatively painless for California residents and businesses because it mostly affected out-of-state mines and power plants. It’s a different story though with natural gas, with the state’s powerful homegrown company, Southern California Gas Co.(OTCMKTS: SOCGP)– a natural gas utility that serves nearly 22 million people from the Central Valley to the U.S.-Mexico border–determined to stay put. SoCalGas–a subsidiary of San Diego-based Sempra Energy (NYSE:SRE)–has launched a sweeping campaign to preserve the role of its pipelines in powering society and convincing local officials that policies aimed at replacing gas with electricity would be wildly unpopular. Natural gas is California’s largest electricity source.

Obviously, SoCalGas is fighting for self-preservation with revenue from residential gas sales clocking in at nearly $2.3 billion in 2017. But it also appears to have a much better clean energy value proposition than your average fossil fuel company.

The Los Angeles-based company plans to produce biomethane using waste from dairy farms, landfills and sewage treatment plants. It contends that doing this can kill two birds with one stone: replacing some of the natural gas in its system with renewable gas as well as limiting heat-trapping methane emissions. The company has already injected small amounts of renewable gas into its pipelines with plans to add more.

It appears investors have not lost faith in the natural gas utility, having bid its shares up 11.7% in the year-to-date.

Utilities as defensive plays

Natural gas defenders such as BlackRock Inc. contend that the fuel should have a long life as a bridge to clean energy with constraints imposed on development “few and far between.”

At the same time, the value of utilities in general as an investment vehicle is not likely to fade any time soon.

Utility companies tend to be slow-growing, but high-yielding and inexpensive relative to earnings. They are generally viewed as good defensive plays because of their relatively steady and safe cash flows both in both good and poor economic cycles. Utilities are more recession-proof than most sectors, as evidenced by their positive returns during the last recession when the rest of the market tanked wildly. Indeed they are still living up to their billing, with the 4% YTD return by the S&P 500 Utilities Sector Index trumping the -6.4% yield by the S&P 500.

By the same token, utilities can be a drag on your portfolio during the good times. The S&P 500 Utilities Index has yielded a 8.5% annualized return over the past decade compared to 10.6% return by the S&P 500 over the timeframe. For perspective, putting $10,000 in the Utilities SPDR ETF (XLU) over the last 10 years would have resulted in a nearly $5,000 lower profit before fees compared to the same amount invested in the S&P 500 ETF Trust (SPY).

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