AGL Energy remains Ord Minnett's preferred stock in the utilities sector, despite its recent strong rise, due mainly to the company’s earnings leverage to increasing wholesale forward electricity prices.
The company sells the majority of its generation via forward contracts, prices for which have more than doubled in all states over the last 12–18 months. The increase has been driven by increasingly volatile spot prices and baseload capacity closures which reduce supply of forward contracts.
At circa $120 per megawatt hour (MWh), the question now is how sustainable prices are at current levels. Forward prices are now around the level required to induce new gas-fired generation capacity, but Ord Minnett has taken a somewhat conservative view and forecasts prices to decline to around $80/MWh by 2021. We have moved our earnings estimates significantly higher to consider the impact of elevated electricity prices, and believe market estimates will continue to rise, driving the stock price higher.
The first of two key risks to our view is the growing pressure on policy makers to implement changes to alleviate cost pressures on the industrial sector, which could negatively impact electricity prices. Policy change has usually been directed at reducing carbon emissions rather than addressing higher energy costs.
Secondly, there is the chance of delays in AGL getting the benefit to earnings, particularly noting the lag in realising higher wholesale forward prices. AGL stock has risen circa 32% from January 2016 to 24 March 2017, versus the S&P/ASX 200 Index's rise of around 15% over the same period, so there is some risk to these gains if earnings fail to meet expectations. We have attempted to address this by assuming a two-to-three year trailing weighted average of forward prices in our modelling. This sees realised prices increasing from $45/MWh today to $93/MWh by 2020.