The Changing Landscape of Energy

Gas Utility Fund Portfolio Manager Ryan Kelley describes the Fund's composition and factors that influence earnings growth. He also discusses natural gas stocks' mergers and acquisitions, key demand drivers for natural gas and how the growth of renewable energy sources may impact the industry.

 

June 2018

  • Ryan C. Kelley
    Ryan C. Kelley, CFA
    Portfolio Manager

Would you describe the types of companies in the Hennessy Gas Utility Fund and the factors that influence their earnings growth?

About 55% of the Fund’s assets are invested in diversified utilities, companies primarily engaged in both the distribution of natural gas and the production and distribution of electricity. Earnings growth for these companies is driven principally by growth in energy consumption. Another 20% of the Fund’s assets are invested in regulated gas distribution companies. The earnings growth of these companies has been tied principally to the growth in the consumption of natural gas. Thus, roughly 75% of the Fund is invested in utility-type companies whose profits are not significantly affected by commodity price fluctuations.

Approximately a quarter of the Fund’s assets are invested in interstate pipeline companies and liquefied natural gas (LNG) exporting companies. The profitability of these companies tends to be at least partially correlated with the prices of crude oil and natural gas. As a result, their stock prices can fluctuate in line with movements in commodity prices.

What has been driving recent performance?

Over the last year, both diversified utilities and local gas distribution companies have been reporting higher earnings. However, stock price performance has lagged as higher interest rates have pressured the prices of higher-yielding assets. Both earnings growth and price performance for pipeline companies were mildly negative.

Which market factors are impacting natural gas stocks?

We believe there are two main trends affecting natural gas stocks that investors should be paying attention to merger and acquisition activity (M&A) and dividend increases.

Many diversified energy companies view the natural gas industry as an attractive growth sector. There is an abundance of natural gas supply under U.S. political control, natural gas prices are competitive and demand is growing. As a result, diversified energy companies have been increasingly seeking access to natural gas assets through M&A to help fuel their dividend and revenue growth. In the last twelve months ended June 30, 2018, two holdings in the Fund were purchased by larger rivals. The Fund’s performance has benefited nicely from such activity as the acquiring companies have generally been paying a premium over current market prices.

Natural gas companies have been raising their dividends at a healthy rate, with some companies boosting dividends as much as 10%-15% in the last twelve months. We expect this trend to continue since we expect earnings growth in the industry to remain robust. Within the Gas Utility Fund, 48 of the 52 holdings paid a dividend and the vast majority of them increased their dividend in the last twelve months.

How might the move to renewable energy sources in the U.S. impact the Fund?

The growth of energy supplied from renewable sources in the U.S. has certainly been increasing over the last decade. In 2017, renewable energy sources accounted for about 11% of total energy consumption and about 17% of electricity generation (including hydropower). This growth has been driven by federal regulations mandating the reduction of use of fossil fuels in addition to market forces. The costs of producing renewable energy have been falling faster than expected.  According to the International Renewable Energy Agency, the cost of generating power from onshore wind has fallen by around 23% since 2010 while the cost of solar-powered energy has fallen by 73%. Since January 2017, the price of solar panels/watt has fallen by a third. We believe that renewable energy sources will become a larger proportion of the energy supply in the U.S. over time and that the Fund will participate in this growth through its holdings of diversified utilities.

Many diversified utilities in the Fund are investing in renewable energy sources. For example in 2017, one-third of the electricity sold by PG&E came from renewable sources, with wind and solar together accounting for 21%. Xcel Corp. is committed to retiring its portfolio of aging coal plants and increasing the use of wind and solar power. From 2005 to 2017, renewables jumped from only 9% of Xcel’s total electricity output to 27%. By 2022, the company estimates that wind alone should produce 40% of their power deliveries. Dominion Energy is forecasting that it will increase electricity produced from renewables from 5% of the total in 2017 to 10% by 2033.

What is your outlook for growth in demand for natural gas from the electricity generation industry?

The electricity generation industry is the largest consumer of natural gas, accounting for just over 32% of total consumption in 2017. Demand for natural gas from the power sector has been growing rapidly, and is up over 35% over the last decade, as power plants have switched to using cleaner-burning, competitively-priced natural gas in place of coal. Coal used to be the principal source of fuel for the electricity generation industry and accounted for about half the electricity generated in the U.S. in 2001. However, the use of coal has fallen steadily and coal accounted for just 30% of the electricity generated in 2017. As electricity generation economics have become more favorable for natural gas, coal plants have been closing or converting to natural gas. Since 2010, nearly 40% of the nation’s coal-fired power plants have either been shut down or designated for closure. We believe natural gas will continue to take share from coal as a fuel for the power industry and, as a result, we believe demand for natural gas from electricity producers will continue to grow at a healthy pace.