By Avi Salzman

The emergence of Chinese artificial-intelligence company DeepSeek raises a simple question that has clobbered energy stocks tied to the AI boom: What if AI can run sophisticated models without using so much energy?

DeepSeek hasn't fully answered that question. There is still too much about the company's model that is unknown, and some of the claims made about it look overdone. But simply raising the question has poked a hole in an investment thesis that had been viewed as a sure thing.

Wall Street's consensus view has been that AI will consume ever-growing amounts of electricity because the chips involved are becoming increasingly powerful. Those projections have led to surges in the stocks of a variety of companies, from power-plant owners to natural-gas producers to manufacturers of transmission wires. But all those trades unwound this past Monday when investors first started to grapple with the implications of DeepSeek. The hardest-hit included independent power producers Constellation Energy, Vistra, and Talen Energy. All three dropped more than 20% on Monday, and had only regained about half those losses by Thursday morning.

"The bull thesis on independent power producers and most integrated utilities is entirely dependent on data centers," writes Jefferies analyst Julien Dumoulin-Smith. In fact, 75% of electricity demand growth between 2030 and 2035 is premised on data-center growth, he estimates. "The DeepSeek model is more energy- and capital-efficient, which calls into question the significant electric demand projections for the U.S.," he adds.

At first blush, the selloff looks like a buying opportunity. There's been no sign so far that tech companies are considering reducing their spending on AI data centers since DeepSeek appeared. Quite the contrary. Meta Platforms CEO Mark Zuckerberg said his company is building a data center "that is so large it would cover a significant part of Manhattan." Morgan Stanley estimates tech companies are still planning $650 billion in capital expenditures over the next two years, much of that for data centers.

But even after the week's price drops, most of the power stocks aren't obvious bargains. On a longer time horizon, they have hardly dropped at all -- they're all still up year to date and have doubled over the past year. Constellation trades at 20 times its expected 2025 earnings before interest, taxes, depreciation, and amortization, or Ebitda, the preferred valuation method for capital-intensive businesses like this. That's a significant premium to the broader market, which is trading around 16 times its expected Ebitda, and an even larger premium to energy stocks, which trade at seven times. Vistra and Talen trade at 13 and 11 times respectively. Constellation is considered more valuable than its peers because it owns more nuclear power plants than they do, and nuclear power is priced at a premium because it's considered clean and reliable.

The power companies have made a few special deals to supply electricity to tech companies at above-market rates. Constellation is even bringing back a nuclear reactor at Three Mile Island in a deal with Microsoft that analysts say was priced at a significant premium. Their valuations presume that they will be able to sell much more of their power at these kinds of above-market rates. Dumoulin-Smith's price target for Constellation, which is just below the current stock price, is premised on the likelihood that the company signs above-market deals for 75% of its nuclear power.

The company and its peers may sign more of those deals, but they're facing increasing competition from other power suppliers that want in on this gravy train. Chevron, GE Vernova, and investment firm Engine No. 1 said last week that they're planning to roll out custom-built power plants around the country starting in 2027 that will be designed to plug directly into data centers. Their plans call for building four gigawatts worth of natural-gas plants, more electricity capacity than is used by the city of Philadelphia. And regulated utilities around the country are signing special deals with tech companies too -- Meta's Manhattan-size data center will be powered by Louisiana utility Entergy, for instance.

Some of the energy stocks that fell on the DeepSeek news may be more likely to rebound in the near term. Natural gas producers like EQT and Expand Energy and pipeline companies such as Williams Companies and Kinder Morgan fell in reaction to the DeepSeek news, because they had been expected to benefit from data-center demand. There's reason to believe they can bounce back, however.

Jefferies analyst Lloyd Byrne projects that 14% of the incremental demand for natural gas between 2025 and 2030 is tied to data centers. But natural gas has other major drivers that should keep the group's results strong even if the data-center theme fades. Exporting liquefied natural gas accounts for 61% of the increased demand, Byrne calculates. "We believe the medium-term macro fundamentals for the natgas sector are generally unaffected," he writes.

Natural gas pipelines also should see more demand in the years ahead from several factors. CFRA analyst Stewart Glickman wrote that the DeepSeek selloff was "a bit of an overreaction," particularly given that the data-center demand lift wasn't expected to come in 2025 and 2026 anyway. He thinks Williams could rise to $62 from a recent $56, and Kinder Morgan could advance to $34 from a recent $28.

Write to Avi Salzman at avi.salzman@barrons.com

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January 30, 2025 14:09 ET (19:09 GMT)

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