Editor’s Note: Utilities fell more than 12% last quarter while energy stocks rose more than 16%, and Jim Pearce explains why in the article below. Our colleague Robert Rapier looks at the other side of the ledger: America’s utilities expect to spend about $1.4 trillion building over the next five years, more than in the ten years before. See what they’re building →

Last week, my colleague Robert Rapier explained why “Energy Roared Back in Q3 as Utilities Fell to Last Place.” As he noted, “Energy is inherently cyclical, and sentiment can shift very quickly when crude prices, geopolitical risk, or expectations for supply change.”

This year, all three of those factors have experienced extreme vacillations. The price of crude oil began the year below $58 a barrel, then more than doubled to above $117 in April after the onset of the war in Iran. It dropped below $68 in July, only to rise above $106 two months later.

Along the way, geopolitical risk intensified as the three countries that produce the most crude oil – the United States, Russia, and Saudi Arabia – carefully weighed the financial benefit of higher crude oil prices against the burden that higher fuel prices impose on the global economy.

All those factors worked in favor of oil producers over the past three months, which is why energy stocks were the best-performing sector of the S&P 500 Index during the third quarter. However, if President Trump makes good on his promise to end the war in Iran immediately after the midterm elections in November, then energy stocks would most likely reverse direction as crude oil prices gradually decline.

From Worst to First?

That is why I am more intrigued by the worst-performing group of stocks during the third quarter, which is utilities. Fuel prices are an input cost for power generation, so higher oil prices mean smaller operating margins for most utilities. That largely explains why the utilities sector declined by more than 12 percent during the third quarter, while energy stocks rose more than 16 percent.

Another macroeconomic factor working against utilities is rising interest rates. Since utilities borrow a lot of money to expand their power generation portfolios, higher borrowing costs impinge on their operating margins. Also, higher bond yields make the dividends paid by utility stocks less attractive on a relative basis.

Last month, the Fed raised its policy rate by a quarter-point and indicated that it would probably do so one more time before this year is over. Contributing to that upward bias are high fuel costs, which in turn push up the price inflation that the Fed is determined to drive down.

However, those two factors may be close to peaking. Once the war in Iran is over, the Fed may feel less pressure to use monetary policy to combat rising inflation. The combined effect of falling oil prices and stable borrowing costs should encourage more investment in utilities on Wall Street.

Past is Not Prologue

If you are looking for an easy way to play a turnaround in utility stocks, consider the iShares U.S. Utilities ETF (NYSE: IDU). According to the fund’s sponsor, IDU “seeks to track the investment results of the Russell 1000 Utilities RIC 22.5/45 Capped Index, which measures the performance of the utilities sector of the U.S. equity market.”

The fund’s top five holdings – NextEra Energy (NYSE: NEE), The Southern Company (NYSE: SO), Constellation Energy (NSDQ: CEG), Duke Energy (NYSE: DUK), and Waste Management (NYSE: WM) – account for approximately 35 percent of its net assets.

For the reasons cited above, the fund’s recent performance has not been good. Over the first nine months of this year, IDU lost 12.2 percent. However, it has shown signs of renewed life since then, recovering nearly a third of that loss over the first six trading days of October, as shown in the circled area of the chart below.

Option Play

This month’s resurgence in utility stocks could mean that Wall Street isn’t waiting for an end to the war in Iran to get back into that sector. Once that becomes official, a lot of money will start moving around in anticipation of lower fuel prices and a corresponding decrease in inflation.

What we haven’t seen yet is much action in the options market on utilities. For that reason, the spread between bid and ask prices for IDU call options was extremely wide (a call option increases in value when the price of the underlying security goes up).

Last week, while IDU was trading near $105, the call option that expires on March 19 at that strike price was trading at a bid/ask of $0.80/$7.30. The midpoint of that spread, $4.05, requires a rise of roughly 4 percent in IDU’s share price within the next five months for this trade to become profitable.

That isn’t much of a move, but utilities tend to be less volatile than the overall stock market. However, an end to the war in Iran could trigger a buying spree in utility stocks, in which case the trade outlined above could be a big winner.

Jim’s idea here is about timing: a sector that sold off on fuel costs and interest rates, and may recover when both ease. Our colleague Robert Rapier comes at the same sector from a different direction. Utilities are in the middle of the largest build-out since the country was electrified, about $1.4 trillion over the next five years, and the companies doing the building pay a dividend while they do it. In Utility Forecaster, Robert shows which ones he owns. See Robert’s case →