Rasi Bhadramani
By Reed Cassady, CFA, Albert Grosman & Sam Peters, CFA
AI Solutions Require Solving Power Problems
Market Update
The market is focused on the transformative potential of artificial intelligence (‘AI’) but, in our view, has not come fully to grips with the real-world bottlenecks attached to this emerging technology. While markets appear to be increasing the supply of leading-edge graphics processing units to meet accelerating demand, new pinch points have emerged as the AI arms race gains pace. These include sourcing data center sites, lining up connections to the electrical grid, obtaining cooling equipment, and so forth. While we believe markets will eventually find a solution to most of these impediments, the lifeblood of this AI infrastructure is electricity, and access to the electrical grid and power generation capacity will likely prove to be more durable headwinds.
Innovations like cloud computing have been steadily increasing power demand from data centers, but current high-end estimates for electricity needed for AI computing is on the order of 30x more per server. Given the multitude of servers in a rack, racks in a data center, and the growing number of data centers across the country, it is easy to see why the aggregate increase in power demand proves a headwind not only for the AI ecosystem but also for other users of electricity. As a result, current estimates conclude that the U.S. is poised to inflect to growth in power demand for the first time in decades at a pace of more than 3% over the next decade on the back of growing AI demand (Exhibit 1). While meeting this increased demand would be difficult under normal circumstances, given that we are also undergoing and accelerating a global energy transition will make this even more difficult.
Exhibit 1: AI Driving a Sharp Increase in Power Demand
As of March 21, 2024. Source: Wells Fargo Securities, LLC.
This shift, from abundant yet polluting fossil fuels to renewables in the form of wind and solar, further complicates things. Namely, that the intermittent variability of day-to-day and seasonal swings in energy production make renewables poorly suited to flex up with current demand estimates. Furthermore, the buildout of these renewables also entails a monumental investment in electrical transmission infrastructure since the best places for wind and solar farms are often far from areas of high electricity demand. Ultimately, this will entail figuring out how to accelerate the connection of new resources to the grid, transmission buildouts and, we suspect, investment in “lesser evil” fossil fuels like natural gas to manage the intermittency risks to grid reliability.
Major AI infrastructure players Amazon (AMZN), Google (GOOG, GOOGL), Microsoft (MSFT), META, and even increasingly Oracle (ORCL), are not waiting, and appear poised to put existing systems to the test. Unsurprisingly, given these difficulties, power is rapidly emerging as the number-one bottleneck to more substantial AI data center buildouts. Even if these companies can get all the permits and requisite equipment in place, lead times are rapidly lengthening for getting power hooked up. As such, many of these companies are circumventing the grid altogether by going directly to merchant power companies to purchase electricity via long-term contracts, often at a significant premium to prevailing power prices. We suspect that these deals will become more prevalent as these companies focus on speed, and that more deals are coming that will benefit power producers. While new renewable energy will have an important role to play, going directly to established power sources will both get data centers online faster and involve a rising pull on existing resources.
But what is good for large AI players does not necessarily translate into good for the rest of society. Take the recent deal with nuclear power producer Talen Energy (OTCQX:TLNE) and Amazon, in which Amazon has contracted to purchase upwards of 1 Gigawatt (GW) of power at a 50% premium to prevailing power prices. This is a massive amount of electricity that instead of supporting grid reliability and keeping power prices low will instead serve Amazon alone. A well-functioning market would have new additions offset this power draw from Amazon, but grid connection bottlenecks for this new power means that local grid operators have gone so far as to completely stop accepting applications due to the size of their backlog. Accelerating demand growth with insufficient offsetting supply means higher bills for consumers and businesses who will be asked to implicitly subsidize Amazon’s AI ambitions.
“In a worst-case scenario, power blackouts are not out of the realm of possibility.”
To make matters worse, the price required to match supply curve for power — like any commodity — is not remotely linear (Exhibit 2). Once less expensive power generation resources are exhausted, the price required to bring a certain amount of power generation to bear starts to skyrocket around 130 GW as more costly “peaking” assets are asked to produce electricity during periods of peak demand – typically very hot or cold days. While Amazon’s 1 GW deal might not seem like that much in comparison to that 130 GW, removing it from the system can have an inordinate impact on power pricing across the entire market given this non-linearity, impacting tens of millions of people as grid operators anticipate peak winter load of ~135 GW. If demand in this market is 100 GW, removing 1 GW from supply has only a fractional impact on total power prices. However, at 135 GW, where the curve below starts to hitch meaningfully higher, it’s not hard to see a much more meaningful impact to market power prices. Considering all of Amazon’s competitors have certainly taken note of its ability to accelerate its AI strategy with the Talen transaction, it’s quite likely that others follow suit in this market, further tightening supply-demand. As a result, a parabolic increase in power prices is a real possibility over the next few years as this plays out. Lastly, pulling that baseload off the grid will force utilities to lean more on renewables to support peak demand, creating the risk that they simply cannot support it, given their inability to substantially flex up production, unlike gas and coal plants. In a worst-case scenario, power blackouts are not out of the realm of possibility.
Any combination of meaningfully higher prices and decline in grid reliability likely drives meaningful political pushback to these AI builds. The AI aspirants will increasingly be told to pay their fair share rather than socializing the cost of data centers builds to consumers via higher prices, and could be put toward the back of the line for new grid connections given the lack of lasting localized economic development versus other alternatives like new factories. If so, at some point the accelerating growth trajectory embedded in many of those stocks could meet the more plodding and linear real-world reality, driving a major resetting of expectations. Given generational market concentration in these names, a substantial amount of market cap that has accrued to these stocks likely flows back into other parts of the market, flattering the ClearBridge All Cap Value Strategy given its value style and size tilt away from mega caps.
Exhibit 2: Price and Supply Is Not a Linear Relationship
Stylized PJM Dispatch Curve. As of April 11, 2024. Source: ClearBridge Investments
Portfolio Performance
Long-term expectations for a pricing power on the back of greater electricity demand from AI development and implementation were behind strong contributions from Vistra (VST) and Constellation Energy (CEG) in the first quarter as the Strategy outperformed its Russell 3000 Value benchmark. Investors also continue to reward these stocks based on their strong operational performance. Additionally, with large tech companies clamoring for greater renewable power sources, the company most levered to this from a developer perspective is AES. While the stock has not yet seen upward momentum on the back of this trend, we believe that project returns will increase, and growth could accelerate on renewables demand.
Stock selection in the information technology (‘IT’) sector also positively contributed to returns, led by electronic memory and storage manufacturer Micron Technology (MU). The company’s stock priced continued to benefit from investor enthusiasm for AI, as the current supply of electronic memory is dwarfed by the increasing anticipated demand by developers to roll out additional AI-related products and services. Industry data points that support the memory pricing cycle continue to mount as the major players lower both capital expenditures and factory utilization to better balance supply into growing demand, and the stock is following the improved fundamental outlook accordingly.
Our energy holdings weighed on relative performance in the first quarter, amid a decline in natural gas prices as a mild winter in both the U.S. and Europe met with higher production, which weighed on APA and EQT. We believe the currently low price of natural gas is a temporary phenomenon. Producers have already significantly cut production, while mounting demand growth from new liquified natural gas facilities and higher power demand should drive prices meaningfully higher.
Portfolio Positioning
We added a new position in ICON (ICLR), in the health care sector, which is a leading contract research organization (‘CRO’) serving biopharmaceutical and life science customers. We believe the company is an industry leader and an exceptionally positioned CRO with the capability to be a strong compounder in the portfolio due to steady revenue growth, margin expansion potential and financial leverage. While the market appears concerned with the prospect of tighter financial conditions on biotech R&D spending, we believe this underestimates the durability of the company’s growth and the capabilities of its skilled management team.
We exited a position in UnitedHealth (UNH), in the health care sector, a leading diversified health care company that offers health benefits through its UnitedHealthcare segment and health services through its Optum division. We have grown increasingly concerned about the rising competition within the Medicare advantage market, as well as a potentially mounting pattern of managed care companies underestimating the recent increase in health care utilization. We believe that the stock’s current valuation leaves less upside considering the growing risks and elected to exit the position in favor of other opportunities.
Outlook
The path of least resistance is one of higher power prices in markets with outsize AI infrastructure builds. Additionally, we believe the difficulty of getting large-scale data centers powered may not be fully appreciated by investors and presents a risk to AI growth and the long-term continued outperformance of many of these AI-mania stocks. Ultimately, while there is certainly a lot to be excited about with regards to AI’s impact, we believe investors should temper some of their enthusiasm given mounting risks to medium-term growth.
Portfolio Highlights
The ClearBridge All Cap Value Strategy outperformed its Russell 3000 Value Index during the first quarter. On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The leading contributors were the financials and utilities sectors.
On a relative basis, overall stock selection and sector allocation effects positively contributed to performance. Specifically, stock selection in the utilities, IT, financials, communication services and materials sectors, an underweight allocation to the real estate sector and overweight to the energy sector benefited performance. Conversely, stock selection in the energy and health care sectors weighed on returns.
On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vistra, Constellation Energy, Micron Technology, Meta Platforms and Fiserv (FI). The largest detractors from absolute returns were QuidelOrtho (QDEL), APA, Gilead Sciences (GILD), UnitedHealth and Biogen (BIIB).
In addition to the transactions listed above, we initiated new positions in United Parcel Service (UPS) in the industrials sector, ConocoPhillips (COP) in the energy sector, Goldman Sachs (GS) in the financials sector, CVS Health in the health care sector, Target (TGT) in the consumer staples sector and Skyworks Solutions (SWKS) in the IT sector. We exited positions in NCR Atleos (NATL) and Equitable (EQH) in the financials sector, SMART Global (SGH), Applied Materials (AMAT) and NCR Voyix (VYX) in the IT sector, Sensata Technologies (ST), Eaton (ETN) and Johnson Controls International (JCI) in the industrials sector, Pioneer Natural Resources (PXD) and APA in the energy sector and Bloomin’ Brands (BLMN) in the consumer discretionary sector.
Reed Cassady, CFA, Director, Portfolio Manager
Albert Grosman, Managing Director, Portfolio Manager
Sam Peters, CFA, Managing Director, Portfolio Manager
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Past performance is no guarantee of future results. Copyright © 2024 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
