Utilities Sector Surges Amid AI Boom And Rate Cut Expectations

In an unexpected turn of events, the utilities sector has emerged as a dark horse in the stock market race, with some players outpacing even the high-flying tech giants. This surge is driven by a perfect storm of factors: the artificial intelligence boom, interest rate cuts, and a renaissance in nuclear power.

The Utilities Select Sector SPDR Fund (XLU
Utilities Select Sector SPDR Fund
), which tracks the utilities sector of the S&P 500, has had a year of two distinct halves. The first half was characterized by mediocre performance, with most of the upside driven by just five stocks:

1. Vistra Corp (VST)
2. Constellation Energy (CEG)
3. NRG Energy (NRG)
4. Public Service Enterprise Group (PSEG)
5. NextEra Energy (NEE)

These companies, particularly the independent power producers, have leveraged their overall scale and nuclear assets to capitalize on the growing demand from data centers, AI infrastructure, and electric vehicle charging stations.

The third quarter saw a more even distribution of returns among XLU constituents, with an average gain of 20%. This broad-based rally kicked off after the first negative month-over-month Consumer Price Index report of -0.1% in early July and continued unabated into September, when the Federal Reserve kicked off its widely-anticipated rate cutting cycle.

Vistra Corp’s Shift From Underdog To Overachiever

Vistra Corp has emerged as the poster child for the sector’s transformation. As one of the largest independent power producers based in Texas, Vistra operates in deregulated markets like Texas and PJM, where it generates and sells electricity at market prices. This business model differs significantly from regulated utilities, where allowable returns on equity are set by public utility commissions.

Historically, Vistra, formerly TXU, was valued at a discount compared to other utilities due in part to stagnant domestic electricity demand, an oversupply of natural gas that kept U.S. electricity prices among the lowest globally, and the growth of subsidized renewable generation. These conditions led to price volatility and contributed to many bankruptcies in the sector, including Vistra’s former parent company TXU in 2014.

However, Vistra has engineered a remarkable turnaround through a series of strategic moves, including shutting down unprofitable coal plants, repurchasing 33% of its shares from 2018 to 2023, and acquiring 4,048MW of nuclear generation assets from Energy Harbor in March 2023, as reported by Utility Dive.

This last move was particularly significant, making Vistra the largest unregulated power generator with 6,400 MW of nuclear capacity. As such, Vistra’s current business model is well-positioned for the future energy landscape. It balances intermittent generation from renewables with the growing power demands driven by AI, data centers, and electric vehicles.

Constellation Energy Now A Phoenix Rising

Constellation Energy’s journey is equally compelling. After struggling with Lehman Brothers exposure in 2008, it was acquired by Exelon in 2011. In 2022, Constellation regained its independence when Exelon split its regulated utilities and unregulated power generation businesses. Now, as the largest nuclear producer in the U.S., Constellation is well-positioned to meet the growing demand for reliable, clean energy.

In fact, one of the most significant developments in the sector came on September 20, 2024, when Constellation Energy and Microsoft announced a groundbreaking power deal. The agreement aims to resurrect a unit of the Three Mile Island nuclear plant in Pennsylvania, marking the first-ever restart of its kind.

According to Reuters, the deal states that Microsoft will purchase energy from the restarted plant for a 20 year period. The Three Mile Island unit will produce 835 megawatts of electricity, or “enough to power about 700,000 homes.”

Utilities With AI-Like Multiples

Interestingly, the two big winners in the sector, Vistra and Constellation, now sport valuations more commonly associated with high-growth tech stocks. They boast the highest price-to-earnings ratios and lowest dividend yields in the XLU, save for the troubled California utility PG&E.

While the utilities sector has enjoyed a remarkable run, challenges remain. The rest of the XLU index has only recently recovered losses from the 2022 highs, as interest rate hikes took their toll on capital expenditures, debt service, dividends, and cash flows.

However, the sector’s future looks bright, buoyed by several key factors:

1. Strong demand, as evidenced by record PJM capacity payouts in August 2024
2. The potential for further interest rate cuts
3. Ongoing investments in grid modernization and renewable energy integration
4. The critical role of reliable power in supporting AI and data center growth

As the lines between traditional utilities and tech-enabled energy providers continue to blur, investors would do well to keep a close eye on this evolving sector. The utilities of tomorrow may look very different from those of yesterday, but one thing is clear: they will play a crucial role in powering our AI-driven future.