April 2018 Utility Review

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About: Utilities Select Sector SPDR ETF (XLU), Includes: AES, AWK, EIX, NRG
by: Robert Howard, CFA
Summary

The XLU underperformed the S&P 500 in April by over 300 bps.

The XLU hit a new record in April, and the ETF's P/E and dividend yield are at historical extremes.

Power prices were weak across most of the country except for Texas, and this hurt IPPs like NRG.

Sector Stock Performance

April did not give utility investors much to be excited about, with the Utility Select Sector SPDR ETF (XLU) eking out less than a 1% gain. The performance was well behind the S&P 500’s 4% gain, and only beat two sectors for the month.

EXHIBIT 1

Source: FactSet and Garnet Research

Interest rates were a bit of a headwind for utilities in April, with the ten-year Treasury gaining eight basis points during the month. However, rates had been as much as 17 bps higher in the middle of the month, and as rates fell slightly toward month-end, utilities performed very well.

EXHIBIT 2

Source: FactSet and Garnet Research

XLU's assets under management dropped from March’s record level to just over $9.0B. This is still $1.8B above the level of a year ago, and is still a historically high number for the ETF.

EXHIBIT 3

Source: FactSet and Garnet Research

The increase in the XLU for the month means the ETF closed the month at a new record level. As discussed last month (see here), investors could be looking at utilities for their defensive characteristics as the stock market reaches new heights, but there are dangers with the group at record levels.

EXHIBIT 4

Source: FactSet and Garnet Research

The P/E ratio of the XLU ended April slightly higher than the end of March.

EXHIBIT 5

Source: FactSet and Garnet Research

The dividend yield of the XLU is also near historical lows, implying that valuations are stretched, and if there is any increase in interest rates, people could move from utility stocks to more fixed income investments.

EXHIBIT 6

Source: FactSet and Garnet Research

With valuations at historically rich levels, it is a difficult time to get excited about investing in utility stocks. As I said last month, if there is a downturn in the near future, XLU investors will be happy they moved to utilities, but if the economy just meanders along or the market enters a "risk off" mode, XLU investors would likely fall well behind the broader market.

Nine of the XLU components were down in April.

EXHIBIT 7

Source: FactSet and Garnet Research

AES Corp. (NYSE:AES) lost 5.3% for the month, its biggest decline since a 6.7% drop back in December. Of course, back in December, lots of utilities had big declines so AES was moving with the crowd. This time AES’ performance was over 200 bps worse than the next closest XLU component. AES started the month with a slight decline that was really in line with the XLU. Then, on April 23, the company announced the sale of six different assets in the UK and Jordan for $211M. The market seemed to be disappointed in the proceeds, and the stock’s descent increased rapidly for the remainder of the month.

NRG Energy (NRG) was the second worst decliner for the month, down 3.1%. Like AES, NRG started the month down slightly, basically in line with the XLU. Then on April 15, the supreme court announced it would not hear appeals related to lower court rulings that upheld the legality of some zero emission credit laws in Illinois and New York. Eliminating these laws would have helped the company’s generation assets in these states.

Another headwind for NRG were generally weaker power prices throughout the country. The weak spot prices led to weak forward prices as well, and Exhibit 8 shows how 2019 PJM West forward prices continued a trend from earlier in the year and declined further in April.

EXHIBIT 8

Source: SNL and Garnet Research

Water utility American Water Works (AWK) was the leading XLU component in April, rising 3.8%. During the month, the company announced a 9.9% dividend increase.

California based Edison International (EIX) was the second leading XLU performer in April, gaining 3.0%. The big up move for the stock came on April 12th, when the California governor’s “wildfire strike force” presented its report on the California wildfire situation. (You can find the report here.) The report's recommendations included the creation of a catastrophic wildfire fund and changes in how these costs are spread between different groups in the state. The stock market took a positive view of the report, with EIX shares gaining $5 that day. But the initial enthusiasm soon faded and the stock gradually gave back much of that day's gains.

Wholesale Power Markets

Of the prices tracked below, only Houston peak hour prices showed any improvement versus the past. Also note that California's infamous duck curve was back in force for the second month in a row, as average power prices in peak hours were again lower than the average price across all hours in that region of the country.

EXHIBIT 9

Source: SNL and Garnet Research

There is reason to hope that the lower prices were just due to lower power demand during the month. April tends to have relatively mild weather, but it was even milder than usual across most of the country and much milder than last year.

EXHIBIT 10

Cooling demand was basically insignificant throughout the country with the exception of Houston, which had substantially more cooling degree days than last year.

EXHIBIT 11

When you look at the amount of electricity used across the country, Texas (ERCOT) was the only area to show an increase, which occurred both versus last month and versus April 2018. There were a couple of regions that also showed higher peak loads relative to other periods, but they still had lower total energy usage.

EXHIBIT 12

Source: SNL and Garnet Research

A long-run positive for Texas power markets can be seen in the curves for forward power. The price spread between 2020 power and the next two years had been widening earlier this year. However, the spread between these three years really narrowed in April. The view has been that 2019 would be a tight year for the power market in Texas, but then over the next few years, new projects would come online that would reduce prices in the future. A narrowing spread implies that the market could have doubts about some of the new projects coming online, and it could be a bullish sign for the long run.

EXHIBIT 13

Source: SNL and Garnet Research

Natural Gas Markets

The US has now officially survived the 18-19 winter without major supply problems. And with the end of winter, the Henry Hub price continued to fall, ending April at $2.58/mmbtu.

EXHIBIT 14

Source: FactSet and Garnet Research

Gas in storage in the beginning of April was about 180BCF less gas in storage than in the beginning of April 2018, but in the beginning of May, there was about 110BCF more in storage than the previous year.

EXHIBIT 15

The move from a storage deficit to a storage surplus compared to last year has also had an impact on the futures curve. Back in December (see here), I discussed how low storage levels had taken away the margin of safety in the gas market and led to much higher prices. Now with the YoY surplus and lots of time before the winter, the margin of safety has been restored. As a result, the spot price dropped as shown above, and futures prices fell along most of the curve, especially in the near months.

EXHIBIT 16

Source: FactSet and Garnet Research

Lastly, I wanted to take a quick look at gas prices at the Waha Hub in Texas. Last month I mentioned that they had some days in negative territory in March. April started out the same way, with the price falling below $0 on multiple days, including a whopping -$4.28 on April 4th. After that, the price didn’t go negative again, but it also never got above $0.83/mmbtu either. Bottlenecks in the Permian Basin are probably going to keep these gas prices low for a while, but it looks like these low gas prices haven’t had too much impact on the Texas electricity market because Texas power prices have remained relatively strong. There are obviously some power generation constraints that limit the amount of power that can come from this super low cost gas.

EXHIBIT 17

Source: SNL and Garnet Research

Disclosure: I am/we are long NRG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.