Higher coal prices on the week positive indicator for coal-to-gas switching

2013.02.11 - Coal to GasEnlarge GraphRecently many power plants have opted to use relatively more natural gas as a fuel as compared to coal in a trend called coal-to-gas switching. Two major factors have spurred this: (1) natural gas prices have fallen relative to coal prices, making it cheaper to burn natural gas and (2) natural gas burns more cleanly than coal, and concerns about emissions have incentivized power plants to use more natural gas. This trend, also called coal-to-gas switching, increases natural gas demand and provides some support to natural gas prices, therefore helping natural gas producers.

Last week, coal futures prices for Central Appalachian coal moved up 3% from $58.25/ton to $59.18/ton, while natural gas prices fell from $3.30/MMBtu (millions of British thermal units) to $3.28/MMBtu. The relative decrease of natural gas prices compared to coal prices is an economic incentive for power plants to use more natural gas in place of coal for electricity generation. More natural gas demand is a positive for domestic natural gas producers such as such as Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), and EXCO Resources (XCO).

The graph below displays natural gas as a percentage of US power generation over the past five years. As seen in the above graph, in 2012, natural gas made up a significantly larger share of power generation as compared to recent years.

One reason for this is that natural gas prices have moved lower compared to coal prices as seen in the graph below. The lower price of natural gas is an economic incentive for power plants to switch from coal to natural gas.

Enlarge Graph

Many expect that coal-to-gas switching is a trend that’s here to stay, not just for economic reasons but for environmental reasons. For example, the government agency known as the Energy Information Administration (EIA), noted in a report from December 2012 that in its forecast, coal remains the largest energy source for energy generation, but “its share of total generation declines from 42 percent in 2011 to 35 percent in 2040”. The agency also states that market concerns about GHG emissions continue to dampen the expansion of coal-fired capacity in its forecasts.

Coal-to-gas switching results in increased natural gas demand, which is ultimately a positive for natural gas prices. However, investors should caution that if natural gas prices become too high relative to coal, it incentivizes power producers to switch from natural gas back to coal. Because of the coal-to-gas switching trend, the relative movements of natural gas and coal prices are an indicator to watch for those holding domestic natural gas producer names such as Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), and EXCO Resources (XCO). Additionally, many natural gas producers are in the Energy Select Sector SPDR Fund, an ETF that includes a variety of energy companies.