Coal-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 up 3% from $58.43/ton to $60.32ton, while natural gas prices moved up 4% from $3.15/MMBtu (millions of British thermal units) to $3.29/MMBtu. The relative increase of natural gas prices compared to coal prices last week is a short-term economic incentive for power plants to use less natural gas in place of coal for electricity generation. Less natural gas demand is a negative for domestic natural gas producers such as such as Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), and EXCO Resources (XCO).
Despite last week’s negative short-term data point, natural gas has gained significant market share from coal for use in US power generation given sustained low natural gas prices. The above graph displays natural gas as a percentage of US power generation over the past five years. As seen below, in 2012 natural gas made up a significantly larger share of power generation as compared to recent years.
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.
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 (XLE), an ETF that includes a variety of energy companies.