- Electricity demand is projected to fall by 5% this year in the wake of the coronavirus pandemic.
- Coronavirus has caused near-term volatility among utility stocks, but Morgan Stanley says investors should look through the noise.
- The bank recommends investing in utility stocks that are low-risk and undervalued or high-risk and “deeply undervalued.”
- It lays out four drivers of outperformance including a “second wave” of renewable energy that promises to wipe out many of the country’s coal plants.
- Visit Markets Insider to view the latest on oil prices.
Utilities have long been considered safe havens for investors. They provide essential products like electricity and gas — which people need even in a downturn — and typically they offer high dividends.
But what happens when demand for electricity drops off?
In the wake of a pandemic that closed large swaths of the country, US demand for electricity was down as much as 14% in some cities last month.
For the year, analysts at Morgan Stanley led by Stephen Byrd expect power demand to be down by about 5% overall. For the commercial sector, that number is closer to 11%.
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But that doesn’t mean investors should start ditching utility stocks, Byrd says.
“We believe the long-term earnings power, and growth potential, for US utilities is unchanged,” his team said in a note published Thursday. “We believe investors should ‘look through the noise’ of COVID-19.”
In the note, Byrd’s team laid out what they think will drive outperformance among energy utilities in the long term — and which ones will benefit most as a result.
A ‘second wave’ of renewable energy promises to give utilities a boost
Renewable energy has become so cheap that it’s putting coal power plants across the country at risk. In fact, as many as a third of the coal facilities across the US will become “economically at risk” over the next decade, Byrd’s team said.
That’s good news for the average customer, they added. Energy users across the country could save more than $3 billion collectively per year, the bank estimates, if utilities swap out coal power plants with cheaper renewable energy sources, such as solar.
It will also benefit the utilities themselves. A so-called “second wave” of renewable energy growth can create a triple benefit for utilities, which consists of higher earnings per share, lower customer bills, and “much lower carbon emissions,” Byrd’s team said.
Morgan Stanley says the biggest winners are NextEra Energy (NEE), AES Corp. (AES), American Electric Power Company (AEP), Xcel Energy (XEL), Pinnacle West Capital Corporation (PNW), Dominion Energy (D), Duke Energy (DUK), and Ameren (AEE).
The analysts also said they see “a surprisingly attractive opportunity” for retail electricity providers NRG Energy (NRG) and Vistra Energy (VST) “to substitute lower-cost renewables in Texas for their higher-cost fossil generation output, improving overall profitability.”
All utilities are benefitting from a ‘constructive regulatory environment,’ but a handful are out in front
The Federal Energy Regulatory Commission (FERC), which regulates the utility industry, has shown continued support for “transmission returns,” the analysts said.
The utilities that will benefit most from what they call a “constructive regulatory environment” include FirstEnergy (FE), Southern Co (SO), NextEra, Dominion, Entergy (ETR), CMS Energy (CMS), DTE Energy (DTE), Ameren, Xcel, and Atmos Energy (ATO).
Meanwhile, some states including California, New York, New Jersey, and Arizona have a tougher regulatory climate, they said. And that could present challenges for the following utilities: PG&E (PCG), Sempra Energy (SRE), Edison International (EIX), Consolidated Edison (ED), South Jersey Industries (SJI), Public Service Enterprise Group (PEG), and Pinnacle West.
Be wary of utilities with high-risk projects
“We remain cautious on utilities involved in major projects that could face risks of cost overruns, permitting delays/rejection risk, and risk of legal challenges,” the analysts said.
The New Jersey utility South Jersey Industries faces the greatest risk, due to its PennEast pipeline project, they said.
Byrd’s team also believes that the Atlantic Coast Pipeline — a Dominion Energy and Duke Energy project, which is set to run from West Virginia to North Carolina — “will not move forward due to legal challenges.”
However, the team notes that “little to no value for this project is embedded” in stocks for Dominion Energy and Duke Energy.
Finally, the analysts said there’s a risk of cost overruns and schedule delays for Southern Co.’s Vogtle nuclear project, but those risks are already reflected in the company’s stock.
Wildfire and hurricane seasons make some utilities less favorable
The analysts point to two major risks on the horizon: wildfire season in California and hurricane season in the southeast and Gulf region.
Legislation in California that provides for a wildfire fund will help reduce the risk to shareholders, they said, but they continue to “see such risk as very meaningful.” The potentially impacted utilities are PG&E, Sempra, and Edison International.
“One scenario we are concerned about: Additional fires cause the depletion of the utility-wide wildfire fund, followed by a requirement that the fund be replenished in part with shareholder capital,” the analysts said.
Recovery of hurricane costs in the south and southeast, on the other hand, is “highly likely,” they said — good news for Duke Energy, Southern Co., NextEra Energy, and Entergy.
“But we are concerned that, if hurricane costs rise, the impact to customer bills might ‘crowd out’ utility capex, which could reduce the [earnings per share] growth outlook for these utilities.”
Morgan Stanley’s top utility picks
In the note, Byrd’s team writes that the bank recommends a “barbell” approach to investing in utility stocks.
That means owning low-risk, undervalued utilities including American Electric Power Company and FirstEnergy and higher-risk, “deeply undervalued stocks with solid fundamentals including AES Corp., Exelon (EXC), and Public Service Enterprise Group.
Morgan Stanley also says the retail electricity providers NRG Energy and Vistra Energy also screen “highly attractive,” owing to “resilience to COVID-19 impacts, stability provided by large retail energy marketing businesses, low leverage, and very high free cash flow available to shareholders.”
The bank also favors a handful of stocks that are equal-weight — meaning, the analysts have a neutral outlook on the stock. Those are Algonquin Power & Utilities (AQN), Duke Energy, Edison International, DTE Energy, and Sempra Energy.
And finally, the bank lists a handful of stocks to avoid: Consolidated Edison, Southern Co., ONE Gas (OGS), Eversource Energy (ES), Xcel Energy, Spire (SR), and South Jersey Industries.
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