Among our biggest concerns about the recent global market turmoil is that it could lead to further declines in stocks, a deepening in the commodities crash and a cycle of currency devaluations lead by China’s yuan. These are deflationary trends that could export overseas pain to the U.S. economy.

Deflation has been a worry of ours for a while.  More than two years ago, as the Fed announced its intent to begin tightening, I wrote that the central bank’s “removal of stimulus could set the stage for another deflationary spiral.”

And we noted last September, economist Carmen Reinhart’s paper found “the risk of the world economy is actually tilted toward deflation for the 23 advanced economies … even eight years after the onset of the global financial crisis.”  

Up until now, improvements in U.S. growth, consumer spending and employment have been offsetting global weakness.

But it’s hard to ignore the fact that the Fed is pretty much the only major central bank that isn’t currently in easing mode. Clearly, its peers are already worried about disinflation, if not outright deflation.

What much of the media seem to ignore when talking about China and other countries that devalue their currencies is the deflationary impact that such actions have on U.S. businesses. These moves can force U.S. firms to lower their prices to stay competitive with overseas products, and that erodes earnings and stifles growth.

That’s mainly why even as we have a Buy American theme, it’s only domestically-focused companies as multinationals are being hurt by a strong dollar. And we insist the domestic businesses have pricing power, such as electric utilities. 

If continued global weakness leads to deflation in the U.S., then utilities will be the best investment in such an environment.

A deflationary spiral is a vicious cycle where price declines lead to lower production, which in turn leads to lower wages and demand, which leads to further price declines.

Amid deflation, capital preservation is king, and utilities offer relative security and stable income. That doesn’t mean share prices of utilities won’t dip during a downturn, but it does mean that they do a far better job of holding their value, while continuing to offer a steady payout.

Even when consumers cut back on discretionary spending, they’ll still pay for to keep the lights on, the water running, and the media streaming.

Portfolio Update

Conservative Portfolio Holding Sempra Energy (NYSE: SRE) was recently placed on Hold by Global Income Edge and our sister publication, Utility Forecaster, where I am a senior analyst, as a result of a gas leak situation in its service territory that the utility is dealing with.   

My colleague Ari Charney, chief investment strategist at Utility Forecaster, in a guest column, provides an overview of the situation that has led both publications to put SRE on Hold.

Hold on Sempra

By Ari Charney

There’s nothing like a state of emergency to turn a local news story into a national one. That’s what happened this week to Sempra Energy (NYSE: SRE), when California Governor Jerry Brown declared an emergency in response to a gas leak at an underground storage site owned by Sempra subsidiary Southern California Gas Company (SoCalGas).

While such a proclamation garners headlines, seven state agencies have been working alongside Sempra and SoCalGas to fix the situation since the leak was first discovered during a routine check on Oct. 23.

Below the headline drama, such a declaration enables the state to allocate further resources to the situation, while giving it additional regulatory power. It also puts significant pressure on Sempra and SoCalGas to plug and kill the leak as quickly as possible.

Nevertheless, this is indeed a serious situation. The gas field is adjacent to an outlying suburb of Los Angeles, and so far about 2,500 families have been relocated and another 1,460 have pending requests for relocation. The leaking well is about a mile away from the closest homes.

Naturally, plaintiff’s attorneys are already circling, making dramatic statements to the media, and filing suits.

The irony is that the odorant added to natural gas to help humans detect a leak is making homes in proximity to the leak temporarily uninhabitable. Exposure to the putrid mercaptan can cause headaches, nausea and rashes, among other ailments, though thankfully it is not believed to cause any long-term health effects.

Since the leak was first discovered, SoCalGas tried to plug the well on seven separate occasions by pumping fluids down the well shaft. About two weeks after the leak was found, the firm began making preparations to drill a relief well, and that operation commenced on Dec. 4.

The relief well is being drilled by Halliburton subsidiary Boots & Coots, which is well known for its expertise in this area. The relief well is already about 5,500 feet below ground, but work will have to proceed more slowly at this stage to get the angle and proximity exactly right, while avoiding hitting the existing well and making the situation worse.

The relief well will intercept the existing well at about 8,500 feet below ground, at which point it will be plugged and killed. SoCalGas has estimated that will occur sometime between the end of February and the end of March. The firm will also commence drilling a second relief well this month in case the first one fails.

At this point, the good news is that a bad situation is getting less bad: The leak has significantly declined in part because about 33 billion cubic feet of gas, or 42.9% of the total gas stored in the field, has been withdrawn for distribution to customers or transported to a different storage site. And the company is withdrawing gas from the field at double its usual daily rate. That decreases the pressure in the field, slowing the pace of the leak.

Even so, it will still take at least another six weeks to contain the situation, and there are safety risks for workers at the site. Fortunately, the customarily cautious SoCalGas is proceeding with the motto “work slow to work fast” to avoid the sort of rushed work that can lead to accidents.

Assuming the company can sustain this cautious approach amid state pressure to stop the leak as soon as possible, then that should limit the headline risk. Also limiting the headline risk is the fact that, absent something horrible such as an explosion, there isn’t all that much to see visually, in contrast to an oil spill, which is often accompanied by snapshots of volunteers gently scraping crude from seagulls with a toothbrush.

As investors, of course, we have the distasteful task of quantifying a disaster’s effect on our fellow human beings.

Thus far, Sempra has spent $50 million through the end of the year on stopping the leak, as well as leak-related efforts such as relocating residents and monitoring the environmental impact.

An analyst with Bloomberg estimates that this will cost Sempra about $900 million, not including fines and penalties. That amount is derived from an estimate “based on a worst-case scenario that assumes maximum injuries and includes relocation, response, litigation and the loss of natural gas expenses.”

PG&E’s gas pipeline explosion in 2010, which killed eight people and injured 58, resulted in fines and penalties of around $1.6 billion. The fact that there haven’t been any deaths or long-term injuries associated with this leak should mean lower fines and penalties for Sempra.

Meanwhile, other analysts are starting to weigh in with their own estimates.

Barclays projects about $610 million in costs, and about $60 million in total fines and penalties.

And Morgan Stanley believes the drop in Sempra’s market cap more than prices in any potential liability from the leak.

Sempra notes that it has more than $1 billion in insurance coverage across at least several policies, and it intends to collect.

But the example of Duke Energy Corp.’s (NYSE: DUK) experience with its coal-ash spill may be instructive. The clean-up costs, fines and penalties associated with that disaster were minimal compared to the expense of shutting down its other coal-ash ponds to comply with regulators’ demands.

The aging SoCalGas well lacked a safety valve because it was removed back in 1979 after it broke. Apparently, state regulations on gas storage are so lax that this isn’t even a violation. But we expect that lenient approach to change.

Similar to the situation with Duke, regulators will likely impose significant new rules to ensure that old wells are brought up to modern standards. Sempra owns four gas storage fields in Southern California. And more than half of the 229 wells connected to these fields are at least 57 years old.

Another irony is that the state public utilities commission is considering a rate case filed by SoCalGas back in 2014 that proposed a rate increase to cover the inspection of all wells for corrosion and any associated fixes. Regulators are expected to rule on the rate increase by April.

Fortunately for Sempra, the odds are that any such spending on upgrading infrastructure will be rate-based, just as Duke apparently hopes to do with the clean-up of its coal-ash ponds.

So with insurance and higher rates covering a significant portion of any expenses associated with the gas leak that means shareholders should be on the hook for only a portion of the cost. And again, that does seem to be more than priced into the stock at this point.

Although Morgan Stanley sees this as a buying opportunity, prudence dictates caution. We’re temporarily downgrading Sempra to a Hold until the leak is fixed and we get greater clarity on the financial impact of the situation.