AI Fuels Utility Stocks: A New Era of Energy Investment

This spring, an unexpected star has emerged in the stock market, standing out even in a year full of surprises on Wall Street. Utility stocks —the usually unremarkable sector—are outperforming the competition.

Discover how utility stocks are surging amid the AI-driven market boom, transforming from defensive investments to growth opportunities with electricity demand.

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A Rebound and a New Hope for Utility Stocks

The recent rise in utility stocks is partly a rebound from a challenging 2023. However, it also signals increasing confidence that the U.S. economy can withstand higher interest rates and turn the potential of artificial intelligence (AI) into a reality.

Recent data has shown a cooling in job growth and a gradual slowdown in inflation, without significant economic decline. This has positioned power generators, who are expected to supply the energy for AI-driven data centers, as a strategic investment linked to the anticipated tech boom.

Utility Stocks: The Steady Sector on the Rise

The typically steady utility stocks of the S&P 500 have risen by 18% over the past three months, outpacing the energy industry, which climbed 11%. Notably, three of the top five performers in the index this year are power producers. Texas-based Vistra’s impressive 138% surge in 2024 even overshadows Nvidia’s celebrated 91% increase.

Despite this performance, few investors believe that utility stocks, known for their steady dividends, will reach the high price/earnings ratios of chip makers and large tech companies focused on AI. However, on Wall Street, there is a growing belief that the sector will benefit from new data centers driving a significant increase in U.S. electricity demand for the first time in decades.

“That’s where the puck is going,” said John Bartlett, president of Reaves Asset Management. A long-time utility investor, Bartlett now closely monitors the development plans of cloud-computing giants like Alphabet, Amazon, and Microsoft, which are investing billions in AI.

“Those are the people that you really need to pay attention to regarding electricity demand,” he added.

The Future of Utility Stocks and AI-Driven Demand

According to Citi analysts, data centers could account for 10.9% of U.S. electricity demand by 2030, up from 4.5% today. If power needs grow as expected, it will mean more plants, transmission lines, and infrastructure—translating to higher returns for the companies building them.

The rise in utility stocks represents a reversal from last year when the Federal Reserve’s interest-rate hikes made high-yield investments like Treasurys more attractive, pulling investors away from utilities and their reliable dividends.

Although this dynamic persists—utility dividends still offer less income than government debt—more traders are now turning to the sector. This shift follows optimistic projections from tech analysts and power providers about increasing electricity demand in the future, transforming power companies from defensive stocks into a surprising growth investment.

The rally began with independent power producers selling electricity in wholesale markets and has since spread to regulated utilities. However, analysts caution that companies less involved with data centers or those manufacturing grid equipment may not benefit as much. There’s also a risk that the U.S. economy might slow down or AI enthusiasm might fade before utilities can capitalize on the expected growth in demand.

Challenges and Risks

“Nothing in the world of electric power is a sprint,” said Pavel Molchanov, an analyst at Raymond James.

Long-term, higher electricity prices or dirtier power generation could provoke regulatory backlash. In states like Georgia, utility plans to build new fossil-fuel plants have faced opposition from consumer groups and climate advocates. If the projected growth in power demand doesn’t materialize, critics warn that rate payers could end up with higher costs for decades.

“The risk is always that this build-out is very inflationary,” said Jim Lydotes, deputy chief investment officer of equities at Newton Investment Management. “It’s going to have to come on the backs of consumer bills.”

As more utilities propose new construction, the tension between ratepayer concerns and shareholder returns could increase. Regulators might limit utility returns, diminishing the investment appeal of companies that will need to issue stock to fund projects.

Balancing Growth and Regulation in Utility Stocks

“The utilities are going to have to self-fund this growth,” Lydotes said. “The regulators have to keep returns acceptable.” This balance will be crucial as utility stocks navigate the complexities of increased demand driven by AI and the necessary infrastructure investments.

Utility companies that can successfully manage this growth while maintaining favorable relationships with regulators stand to benefit significantly. Those involved in building and operating data centers, and the transmission networks supporting them, will likely see the most substantial returns.

Strategic Moves by Utility Companies

Several utility companies are already making strategic moves to capitalize on the expected increase in electricity demand. For instance, Duke Energy and NextEra Energy are investing heavily in renewable energy projects and grid modernization. These investments not only address environmental concerns but also position them well to meet the future energy needs of AI-driven technologies.

Meanwhile, Southern Company is exploring advanced nuclear projects, and Dominion Energy is expanding its portfolio of natural gas and renewable energy sources. These diversified approaches reflect a broader industry trend toward balancing immediate energy needs with long-term sustainability goals.

The Broader Implications for Utility Stocks

The rise in utility stocks also has broader implications for the overall market. Traditionally viewed as a defensive investment, utility stocks are becoming more attractive to growth-oriented investors. This shift could lead to increased volatility in the sector, as well as higher valuations.

Investors need to be aware of the inherent risks, including regulatory challenges and the potential for slower-than-expected growth in electricity demand. However, the long-term outlook remains positive, especially for utility companies that can adapt to the changing energy landscape.

The Future of Utility Stocks in an AI-Driven World

Utility stocks are experiencing a remarkable transformation, driven by the rising demand for electricity to power AI technologies. As data centers proliferate and cloud-computing giants invest billions in AI infrastructure, utility companies are poised to benefit significantly.

This sector, traditionally known for its stability and reliable dividends, is now seen as a promising growth investment. However, the path forward will require careful navigation of regulatory landscapes and strategic investments in new energy sources and infrastructure.

For investors, utility stocks represent a unique opportunity to capitalize on the AI revolution while maintaining a position in a historically stable sector. As the demand for electricity grows, driven by AI and other technological advancements, utility stocks are set to play a pivotal role in the future of energy and the broader market.

By balancing growth and regulation, and strategically investing in infrastructure and renewable energy, utility companies can secure their place at the forefront of this new era. The surprising rise of utility stocks underscores the dynamic nature of the market and the potential for traditional sectors to reinvent themselves in response to technological innovation.