Published on August 14, 2020

Following decades of investment and cost reduction, electricity from renewable energy should be cheaper than most existing fossil- and nuclear-fueled electricity within the next three-to-five years. We believe selectively investing in operators with scale and cost advantages in this sector should be rewarding given the increasing demand for clean energy.

For years, renewable energy companies have been considered risky investments that were too dependent on federal tax credits. However, we believe that renewables are entering a new phase that will fundamentally change energy markets.

Well-placed concerns about the environmental impacts of both fossil fuels and nuclear energy have increased demand for renewables. Meanwhile, a material reduction in production costs over the past several years has made renewables a highly cost-effective fuel source, even without federal tax credits.

While not all renewable energy producers will be profitable businesses, particularly in the near term, the combination of falling prices and growing demand bodes well for the industry (and for investors). As a rule, we favor companies that operate in markets with strong secular tailwinds, so we are very encouraged by the positive developments in the renewables sector.

Electricity Production: The Basics

According to the Energy Information Administration (EIA), 4.1 trillion kWh of electricity were generated in 2019 at utility-scale generation facilities in the U.S. Roughly 63% of this electricity was sourced from fossil fuels, including coal, natural gas, and petroleum, and another 20% came from nuclear energy. Renewables and other accounted for the remaining 18%, which was twice their contribution in 2000 (9% of the total).

This 4.1 trillion kWh of electricity generation has held steady since 2010, and we expect it to remain roughly flat for the foreseeable future as energy efficiency continues to improve, modestly offsetting rising demand over the long term. However, we expect the underlying composition of fuel sources to change dramatically.

Historically, coal and natural gas were the biggest sources of electricity generation in the U.S. because of the cost advantages and wide availability of both fuels. Nuclear accounted for most of the balance, with costs roughly in line with coal.

However, society increasingly has recognized the externalities related to fossil fuels—namely carbon emissions that lead to severe pollution and climate change—as well as the risks inherent to handling and disposing of nuclear material. This recognition, in addition to various regulatory frameworks imposed on the coal, natural gas, and nuclear sectors to manage the related costs and risks, have in turn led to demand for cleaner and safer sources of electricity, creating an opening for renewable energy.

Renewable energy sources consist primarily of wind, hydropower, and solar fuels. A key challenge over time has been producing renewable energy at a reasonable cost. From manufacturing solar panels and wind turbines, to building effective battery storage, the costs were often prohibitive and made the prospect of displacing fossil fuels seem unlikely.

Current State of the Industry

The cost dynamics of various fuel sources have changed dramatically over the past 10 years. In 2010, the EIA projected the unsubsidized levelized cost – the average cost over the life of a project – of electricity generation in 2016 to be roughly $100/MWh for coal, $80 for natural gas, $120 for nuclear, $170 for wind, and anywhere from $250-400 for solar. In other words, wind and solar were prohibitively expensive without tax credits.

Today, the EIA projects wind and solar unsubsidized levelized costs to clock in at $30-35 by 2025, below even natural gas. Multiple factors—including improved product design, innovative manufacturing techniques, and economies of scale in production—have driven the rapid cost declines.

When considering the cost advantages of renewable energy, combined with the substantial and invaluable benefits to the environment, it is evident that renewables will comprise a much greater portion of the grid’s fuel source in the future.

The EIA now projects that renewables will comprise almost 40% of electricity generation in the next 30 years vs. just 18% currently. Given the constantly declining costs to produce renewable energy, this estimate may significantly understate the future contribution of renewables to the electrical grid.

Furthermore, new technologies continue to emerge that could create added opportunity for renewables to displace fossil fuels and nuclear. For example, hydrogen-powered fuel cells and electrolyzers that produce renewable hydrogen could start replacing natural gas. While still early stage, this technology is gaining traction, and industry participants are pointing to potential commercialization by 2030 as costs decrease.

Promising Future, Limited Present

Renewables have been expanding rapidly, underpinned by the seismic shifts discussed above, and we are confident the sector has a very bright future. However, thus far few companies have been able to translate the growing demand into highly profitable financial results. We are carefully monitoring the space for attractive opportunities.

Case Study: NextEra Energy, Inc. (NEE)

One renewables firm that has been consistently delivering strong performance is NextEra Energy, Inc., the largest electric utility in the U.S. and the world’s largest generator of solar and wind powered electricity.

NextEra’s regulated electric utility business operates under the Florida Power and Light (FPL) and Gulf Power banners. FPL is the largest electric utility in the U.S., creating a scale advantage that no other domestic peer enjoys. Because of its scale, FPL procures inputs—from renewable energy to equipment—at structurally lower costs than its peers. FPL also drives costs out of its operations in a way smaller players cannot, which allows the utility to offer among the lowest utility bills in the U.S. Highly efficient operations enable FPL to consistently earn returns on equity at the high end of the range allowed by regulators.

Importantly, capital spend should grow at 9-10% annually for the foreseeable future due to undergrounding and hardening projects. The company is able to reinvest in the business at incrementally lower cost, creating a flywheel effect, as the business gains further scale and reduces costs more, ensuring continued attractive returns for reinvestment.

NextEra periodically acquires other regulated utilities, like Gulf Power, which it will fully merge with FPL in 2022. FPL should be able to meaningfully improve operations at Gulf Power, while ultimately gaining increased scale and further bolstering its already considerable scale advantage.

The company’s renewables division, known as NextEra Energy Resources, is the world’s largest generator of wind and solar energy. The division’s unmatched scale has enabled 15% annual reductions in wind and solar costs and 18% annual reductions in battery storage costs since 2010. With the wind and solar market growing roughly 15% annually, NextEra has the opportunity to drive attractive growth as the global renewables leader with an unmatched cost advantage.

Given NextEra’s scale advantages across both its utilities segment and its renewables segment, we believe it holds a durable competitive advantage that is extremely difficult to replicate. The utilities segment should continue generating significant profit growth given its scale advantage and attractive returns profile. Meanwhile, the secular growth of renewables should provide an added multi-decade tailwind to growth. The net result should be earnings growth approaching 10% annually for the foreseeable future, with dividends growing modestly faster in the medium-term and in-line with earnings over the long-term.

Looking Ahead

We are extremely bullish on the future of renewable energy – market demand is increasing at the same time it is falling for fossil fuels. Energy markets are in the midst of a structural shift, and the trends are well established and accelerating. Through this transformation, we are confident that other attractive investment opportunities will present themselves. The challenge is identifying the strongest companies that are most likely to deliver consistent and attractive financial results.

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Core Equity Composite (as of 3/31/24)

In our Core Equity accounts Osterweis has the discretion to decrease or increase equity exposure in an effort to reduce risk.

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
(1/1/1993)
Core Equity Composite (gross) 9.85% 9.85% 27.09% 6.83% 12.83% 11.58% 9.40% 12.56% 9.54% 11.49%
Core Equity Composite (net) 9.59 9.59 25.85 5.80 11.74 10.49 8.32 11.46 8.44 10.34
S&P 500 Index 10.56 10.56 29.88 11.49 15.05 14.09 12.96 15.63 10.15 10.42
Swipe Table for Full Data

Past performance does not guarantee future results.

Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees, which may vary between accounts due to portfolio size, client type, or other factors. From 1/1/2021 onward, net returns also reflect mutual fund fee waivers in certain periods.

The Standard & Poor’s 500 Index (S&P 500) is an unmanaged index and is widely regarded as the standard for measuring U.S. stock market performance. This index does not incur expenses and is not available for investment. Index returns reflect the reinvestment of dividends. The S&P 500 Index data are provided for comparison of the composite’s performance to the performance of the stock market in general. The S&P 500 Index performance is not, however, directly comparable to the composites’ performance because accounts in the composites generally invest by using a portfolio of 30-40 stocks and the S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring U.S. stock market performance.

The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.

Clients invested in separately managed core equity accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk and default risk. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.

The Core Equity Composite includes all fee-paying separately managed accounts that are predominantly invested in equity securities, and for which OCM has the discretion to increase and decrease equity exposure in an effort to reduce risk. The non-equity portion of the account may be invested in cash equivalents, fixed income securities, or mutual funds. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

Holdings and sector allocations may change at any time due to ongoing portfolio management. You can view complete holdings for a representative account for the Osterweis Core Equity strategy as of the most recent quarter end here.

Flexible Balanced Composite (as of 3/31/24)

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR INCEP
(10/1/2010)
Flexible Balanced Composite (gross) 7.66% 7.66% 21.20% 5.77% 9.79% 8.99% 7.62% 9.52%
Flexible Balanced Composite (net) 7.45 7.45 20.27 4.98 8.94 8.11 6.72 8.59
60% S&P 500 Index/40% Bloomberg U.S. Aggregate Bond Index 5.94 5.94 17.97 5.94 9.30 9.01 8.52 9.36
Swipe Table for Full Data

Past performance does not guarantee future results.

Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees. Net return calculation:
- Prior to 1/1/2020, the composite net return is calculated using actual advisory fees with the following exception: one member of the composite was a mutual fund portfolio whose fee was partially waived at some point due to an expense limitation agreement. The composite net return shown during this period does not reflect this waiver and is therefore lower than the actual return.
- From 1/1/2020 onward, the composite net return is calculated using actual advisory fees.
- Our fees may vary between accounts due to portfolio size, client type, or other factors.

The 60/40 blend is composed of 60% Standard & Poor’s 500 Index (S&P 500) and 40% Bloomberg U.S. Aggregate Bond Index (Agg) and assumes monthly rebalancing. The S&P 500 is an unmanaged index that is widely regarded as the standard for measuring large cap U.S. stock market performance. The Agg is an unmanaged index that is widely regarded as a standard for measuring U.S. investment grade bond market performance. These indices do not incur expenses and are not available for investment. These indices include reinvestment of dividends and/or interest.

Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.

Clients invested in flexible balanced separately managed accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk, default risk, interest rate risk, inflation risk and liquidity risk. Additionally, there is a risk that we do not manage the asset allocation strategy successfully. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.

The Flexible Balanced Composite includes all fee-paying separately managed accounts and mutual funds that are invested in a dynamic allocation of equity and fixed income securities as well as mutual funds and cash equivalents. OCM has discretion over individual investments as well as the discretion to increase and decrease equity exposure within the range of 25% to 75%. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.

Dividend payments are not guaranteed.

Return on equity is the amount of net income returned as a percentage of shareholders equity.