Sharp Turn In Demand Jolts Electricity Market

This story features AGL ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: AGL

How will Australia's electricity providers fare during the coming recession?

-Electricity demand in several states now approaching the lowest on record
-Lower gas prices could also have a material impact on wholesale power prices
-Volatility in the oil market adds another layer of complexity for Origin Energy
 

By Eva Brocklehurst

What does sharply reduced economic activity mean for Australia's electricity market? After a summer of high demand and fears of shortages, the outlook has turned around quickly. Usually, Morgans assesses, electricity retailers would be good defensive assets but in this instance the sector is not facing typical problems.

Demand is down by -6.3% in March in south-east Queensland, the lowest level since March 2014 – when electricity demand from the resources industry started increasing.

Meanwhile, demand in NSW is down -6.6%, the lowest March in the history of the National Electricity Market (NEM), and Victoria is down -6.8%, the lowest since 1999. Again, South Australia demand is down -11.1%, the lowest on record.

Morgans suggests larger falls in demand could happen if Australia's grid-connected heavy industry, normally running 24/7, reduces activity. What does this mean from a company perspective?

While there is likely to be higher demand from consumers during this period of the crisis, because more are working from home, margin gains from the consumer segment could be offset by higher bad debt provisions (businesses & households).

While household demand for electricity should be resilient, bad debts are still likely to increase, as a number of households struggle to pay their bills when jobs are lost. The increased customer investment by both companies is positive, nevertheless, Morgan Stanley believes, as both have scale advantage compared with their competitors.

The broker envisages the losses will be reflected more in the lower-margin commercial and industrial segments for both AGL Energy ((AGL)) and Origin Energy ((ORG)).

A similar pattern is expected for gas. Gas prices are falling, contributing to the weakness in electricity emanating from softer demand, but as books are principally contracted forward, the effects will be felt in FY21, Macquarie assesses. Hence, the main impact in the short term for energy retailers, in the broker's view, will be the bad debt provisioning that reflects the oncoming recession.

Wholesale

Still, gas supply is the marginal price-setter of electricity to the NEM and lower gas prices could have a material impact on wholesale power prices. And the key issue for investors is the wholesale price and its impact, Morgan Stanley asserts. FY21 baseload futures for Victoria and NSW have fallen below $60/megawatt-hour and large-scale generation certificate prices are below $30/megawatt-hour.

UBS calculates a -$10/MWh drop in wholesale electricity price forecasts could pass on a -20% reduction to FY21 net profit estimates for AGL Energy, which has the highest exposure across its utilities sector coverage to changes in wholesale electricity prices.

This stems from the nature of the generation base, as AGL Energy is net long generation, i.e. generating more energy than its own portfolio requires. The broker expects an NEM weighted average wholesale electricity price of $70/megawatt-hour by the end of 2021, supported by committed new renewable projects. However, this cannot occur with renewables alone and the other key contributing factor will be lower domestic gas prices.

UBS revises forecasts for AGL Energy, extending FY21-21 debtors working capital and bad debt provisions, and reducing segment demand for small-medium enterprises by -25%.

AGL Energy is considered over-exposed to falling wholesale electricity prices and securing value-accretive growth is challenging. Still, the broker acknowledges the share price could be supported by demand for defensive income stocks and upgrades to Neutral from Sell. Morgans disagrees and downgrades to Hold, concerned about the downside in demand and increasing bad debts from retail customers.

AGL Energy has a strong generation portfolio, with long-term cheap black coal contracts in NSW and a brown coal mine in Victoria. In this way, the company has a competitive advantage. Regardless, while acknowledging the defensive characteristics of the stock, Morgans assesses the rapid slowing of demand could intensify and there is not enough value in the stock.

Oil/Gas

Meanwhile, the volatility in the oil market, as prices probe multi-decade lows from supply/demand shocks, could cause significant difficulty for Origin Energy in FY21, so Morgans assesses the bottom for that stock could still be some way off.

Origin Energy only owns one major base-load generation plant, Eraring in NSW. These contracts are of shorter duration compared with AGL Energy's contracts. While there are a number of fast-start gas generators in the company's fleet  these are unlikely to be used heavily in the current market, despite cheap gas prices.

Moreover, a number of these have the type of turbines which are not very fuel efficient. The plants require price spikes to be economic and the volatility in spot electricity is expected to be subdued while demand is low.

There is some value in Infigen Energy ((IFN)) for the long term although Morgans does not believe this is enough of a catalyst to cause a re-rating in the future. The company's wind farms provide the bulk of earnings, hence there is a much lower share of retail sales versus the two major operators.

The company expects around 20% of its generation to be un-contracted and sold on the spot market but Morgans anticipates spot prices will fall over the remainder of FY20 and this will reduce revenue. Nevertheless, Infigen Energy should be able to handle significant disruption in the market, although may need additional capital should this be prolonged.

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