Utilities Stocks: A Backdoor Play on Energy Prices

By STEVEN M. SEARS MORE ARTICLES BY AUTHOR Shares of electric-power stocks actually track oil and natural-gas prices more than commonly understood. Article New Comments Be the first to leave a comment on this article. WHEN INDIVIDUAL INVESTORS have an idea, they typically look for a stock that embodies their thesis. If they want to buy energy because of the belief that prices will rise, they buy energy stocks. It's that simple. But sophisticated institutional investors usually take a multidimensional approach to investing. When they have an idea, they look for the cheapest way to express it. If they want to buy energy, they might look at commodities, bonds, stocks, options or even credit-default swaps. Such are the benefits of having a powerful database, and the expertise to sift through complications like correlation and volatility. At Goldman Sachs, derivatives strategists are telling clients that diversified utilities offer a good way to gain exposure to energy prices. Recommending an options trade on utilities as a way to invest in commodities will strike most investors as odd, but the utility sector's business model has dramatically changed in the past decade. This means that utility stocks track commodities more so than is understood. Options on the Utilities Select Sector SPDR (XLU), and even its constituent stocks, offers a cost-effective way to position for an expected increase in natural-gas prices. Goldman's commodities team expects natural-gas prices will rise to $7.50/mm Btu next year from current prices of about $5.90. Utilities offer a backdoor way to participate in the price increase. Many utility companies have freed themselves from negotiating with states for a fixed profit margin, which often meant the stocks traded off interest rates. Now, utility companies evolved their businesses and increasingly use coal to generate power that is sold on the open market. Electricity prices are determined by customer demand and the supply of natural gas and coal prices, according to Goldman Sachs research. As business models evolve, so do relationships within the financial market. XLU, which is a primary proxy for the utility sector, is now increasingly tracking energy. This increased "correlation," is the linchpin to using XLU to cost-effectively gain exposure to rising energy prices. Don't be scared off by the mention of a $60 finance word like correlation. The mathematical formula might be complicated, but the concept is simple: Correlation essentially describes the price-movement relationships of stocks and indexes to each other. In good markets, correlation offers investors the chance to express investment and trade ideas for less money. Goldman's derivatives strategists tell clients that utility stocks are now 60% correlated with integrated oil and gas companies, and 34% correlated with oil/gas exploration and production companies. "In the past two years, the correlation of the Standard & Poor's Utilities sector returns with the Standard & Poor's Energy sector has been 76% higher than its correlation with any other sector," Goldman's derivatives strategists Stuart Kaiser and Maria Grant said in a recent report. Investors who buy calls on XLU, or sell puts, also stand to benefit from an expected rotation into the utility sector. Goldman's portfolio strategists note that large-capitalization stock managers are "underweight" utilities. If electricity demand increases, and if stock managers start buying more utility stocks, XLU and its components are likely to increase in price. Anyone who enters the energy sector through the backdoor of utilities will likely find an illuminating view.