What Does Hazelwood Closure Mean For AGL?

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French owner ENGIE has announced Victoria's Hazelwood power station will close in March and higher wholesale electricity prices are expected as a result.

-AGL Energy a beneficiary as it is highly leveraged to Victorian wholesale electricity prices
-Closure of Alcoa's Portland aluminium smelter now considered more likely
-Questions raised over which other power stations may be facing closure
 

By Eva Brocklehurst

French owner ENGIE will close Victoria's Hazelwood power station and associated brown coal mine in March 2017. This is consistent with the company's strategy to exit coal activities. Hazelwood recently supplied around 20% of Victoria's electricity generation. As a result, the upcoming closure is expected to substantially tighten the supply/demand balance in the wholesale electricity market in Victoria from 2017, and make prices more volatile and higher on average.

What does this herald for AGL Energy ((AGL)), Victoria's largest base load power station operator? With substantial upside risks to wholesale electricity prices AGL would be the main beneficiary, as it is highly leveraged to Victorian wholesale electricity prices because of its ownership of the Loy Yang A coal-fired power station. Deutsche Bank calculates that every $15/MWh move in the Victorian wholesale electricity curve represents around $150m of incremental net profit for AGL, once legacy hedges have rolled off.

Brokers also believe the closure of Alcoa's Portland aluminium smelter is now probable, given the associated change in the Victorian wholesale electricity forward curve from the exit of Hazelwood. Given its high consumption of electricity closure of Portland would help mitigate the tightness in the Victorian wholesale electricity market.

Macquarie believes scope exists for the simultaneous closure of Hazelwood and Portland. This would bring stability and balance to the Victorian base load market. AGL is the biggest winner in this scenario.

The broker expects there to be some negative response to the Hazelwood closure and subsequent price rises, in terms of demand, which is likely to be more prominent at the retail level. Yet broadly the fundamentals are unchanged, as forward curves continue to signal a strong, and now more balanced, wholesale base load market. The uplift to AGL earnings should underpin continued cash generation from re-pricing across the company's books, in the broker's view.

Citi upgraded earnings estimates for AGL substantially back in September, when the closure of Hazelwood loomed likely. The broker suspects higher electricity prices may start to be incorporated in consensus estimates but the near-term prospect of Portland's closure, and Loy Yang industrial action, may mean that upgrades are slower to eventuate.

AGL's share price has recently disconnected from wholesale electricity prices, which the broker attributes to the company's conservative commentary at the FY16 result. Citi envisages material upside to the share price as investors regain confidence in the earnings outlook.

The broker notes reduced flexibility in gas markets also limits the ability to cheaply support peak electricity demand, and with ENGIE leaving the market it reduces the liquidity in electricity contract markets, creating price pressure for non-integrated retailers. The broker agrees the closure of Hazelwood is constructive for AGL as electricity prices are the company's biggest driver of earnings, and this more than offsets the risks from closing Portland.

On the subject of Portland, Citi believes closure is very likely and already factored into wholesale prices. The size of the subsidy required to keep it open would make it incredibly difficult for the Victorian government to justify protecting an estimated 500 jobs and 200 contractors. At Loy Yang A, AGL is currently negotiating with the union on a new enterprise bargaining agreement.

Citi also suspects that the closure of Hazelwood will provide an opportunity for coal generation in NSW and Queensland to run harder where spare capacity exists. Origin Energy's ((ORG)) Eraring power station in NSW has the greatest potential to increase generation above its current capacity of 50-60%, because of its location close to the Newcastle coal export terminal.

AGL's MacGen in NSW is already at close to its age-limited capacity and Mt Piper is limited because of its inland location. The broker highlights the fact that the age of the Australian coal-generated power station fleet limits the ability to run them consistently at maximum production without risking breakage.

Outside of Hazelwood (50 years old) and Liddell (NSW) (40 years old), the broker surmises that a further seven power stations that are over 30 years old are less likely to close for now. The wild card in the mix is any government carbon/renewable policy changes, which further incentivise renewables and accelerate coal closures.

Further to speculation regarding other power station closures, Ord Minnett suggests old power stations in Victoria, such as Yallourn, could be targeted next by activists. ENGIE will appoint an advisor for the sale of its 1,000MW brown coal-fired Loy Yang B and the 123MW gas-fired Kwinana co-generation operation in Western Australia. The broker finds it hard to envisage a local buyer for Loy Yang B, as competition obstacles are likely to rule out AGL and Energy Australia and a focus on de-leveraging rules out Origin.

Being mindful that two brokers are yet to update on the implications of the Hazelwood closure, FNArena's database has five Buy ratings and one Sell (Morgan Stanley) for AGL. The consensus target is $21.18, suggesting 8.3% upside to the last share price. This compares with $20.22 ahead of the announcement. Targets range from $18.80 (Morgan Stanley) to $23.00 (Ord Minnett).
 

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