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Lower natural gas prices last week positive for coal-to-gas switching

2013.02.18 - Nat Gas US Power GenerationEnlarge GraphCoal-to-gas switching is a term used for when power plants decide to use natural gas in place of coal as fuel. Given sustained low natural gas prices, and the fact that natural gas burns more cleanly than coal, coal-to-gas switching has been rising. This trend increases natural gas demand and provides some support to natural gas prices, therefore helping upstream energy producers with significant natural gas production. Power producers are incentivized to use more natural gas and less coal when natural gas prices fall relative to coal prices.

Last week, coal futures prices for Central Appalachian coal moved down 2% from $59.75/ton to $58.43/ton, while natural gas prices fell 4% from $3.27/MMBtu (millions of British thermal units) to $3.15/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 below graph displays natural gas as a percentage of US power generation over the past five years. As seen above, 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 than 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.

2013.02.18 - Nat Gas vs CoalEnlarge 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 be cautious of natural gas prices becoming 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.

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