Energy Fuels Gas Utilities' Gains
For utility investors, the natural-gas group has been the place to be.
The S&P 1500 Gas Utilities Industry Index has risen 23% over the last five years, versus 9% for the sector index. Some of that strength can be traced to natural-gas prices, which rose 80% from July 2006 through July 2008.
Natural-gas prices have averaged $6.45 per thousand cubic feet over the last five years. Since setting a record with a monthly average price of $10.82 in June 2008, prices have trended lower. The average price of $2.99 in September marked a seven-year low. Prices have rebounded over the last eight weeks but remain 32% below the five-year average.
Regulated gas utilities are resellers of natural gas purchased at wholesale prices, and most take steps to hedge against changes in natural-gas prices. But the industry’s profits tend to be high when natural-gas prices are high, largely because of four gas-utility companies with operations in exploration and production.
Of the 16 components of the S&P 1500 Gas Utilities Industry Index, four are utility-energy hybrids. Energen ($44; EGN), National Fuel Gas ($46; NFG), EQT ($42; EQT), and Questar ($40; STR) each generate less than 38% of revenue from regulated utilities in the last fiscal year. All four operate substantial energy businesses, producing natural gas and oil. Together, the four stocks represent 46% of the total stock-market value of the S&P 1500 Gas Utilities Industry Index, and as such they have a huge effect on the performance of the capitalization-weighted index. Hybrids make up less than 5% of the broader S&P 1500 Utility Sector Index.
Over the last five years, the four hybrids averaged a share-price increase of 62%, versus 18% for the 12 other current components of the index. None of the hybrids rose less than 50%. Over the last year, the hybrids are up an average of 29%, versus 41% decline for all S&P 1500 utilities.
What does all this mean for utility investors?
• While the natural-gas utility group has outperformed the broader sector over the last one, three, and five years, much of the outperformance has been concentrated in four stocks. Excluding hybrids, gas-utility stocks’ prices have fallen more than those of the average utility over the last year.
• Most utilities are expected to post profit declines next year. Hybrids are no exception, with consensus estimates projecting an average per-share-profit decline of 7% in 2010, versus a 9% dip for the average utility. However, some of the hybrids seem capable of exceeding the consensus, particularly if production volumes or natural-gas prices rise more than expected.
• Investors interested in owning traditional utilities should check out our Top 15 Utilities portfolio. Rather than purchase just one or two companies, we recommend investors buy smaller amounts of all 15 stocks.
• The two most attractive hybrids, Energen and Questar, are rated Long-Term Buy and represent the only utilities on the Forecasts’ buy lists. Questar is reviewed in Income Spotlight, and Energen is reviewed in the following paragraphs.
Energen ($44; EGN) operates a natural-gas utility (44% of 12-month sales) and produces energy (56%). Natural gas accounts for 65% of Energen’s production volume and 57% of production revenue in the past year. Natural-gas production has surged in recent years, as new drilling techniques allow the extraction of deposits locked inside of shale, a type of sedimentary rock. A surplus has driven down prices, but drilling costs have also fallen.
To shelter itself from the full force of volatile energy prices, Energen hedged more than 70% of September-quarter production at above-market prices. Without the hedging strategy, Energen’s average realized sale price would have fallen 56% in the September quarter, far steeper than the actual 23% decline. Energen has also hedged 63% of estimated 2010 natural-gas production at prices 96% above market rates. Trading at 12 times trailing earnings, Energen is a Long-Term Buy.