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 had been rising for most of 2012. 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.
As stated, for most of 2012, natural gas gained significant market share (mostly against coal) for usage in power generation. However, in December 2012 natural gas took 25.2% of market share compared to 25.7% in December 2011. In January 2013, natural gas’s market share was 25.4% as compared to 26.8% in January 2012, an even steeper decline. For the last reported month, February 2013, natural gas’s share was 25.9% as compared to February 2012’s figure of 29.4%. In contrast, coal’s market share was 40.2% in December 2012 versus 39.5% in December 2011, 39.7% in January 2013 versus 37.9% in January 2012, and 40.0% in February 2013 versus 36.7% in February 2012.
A major factor in this was likely that natural gas prices were much lower relative to coal a year ago.
Additionally, given natural gas’s recent strong rally, it is likely that natural gas will continue to lose market share to coal in March and April.
Although the straight ratio of coal prices to natural gas is a simplistic way to view the amount that market share will change between natural gas and coal, it is an easy way to at least determine directionally where market share will go. Given that the ratio of coal prices over natural gas prices has declined year-over-year for both March and April, it is likely that natural gas could lose market share for these two months as well (on a year-over-year basis). This translates into less relative demand for natural gas, which is a negative indicator. However, note that the very reason that natural gas is losing market share is because natural gas prices have increased. Therefore, despite the fact that decreased natural gas demand is a negative indicator in that decreased demand translates into lower prices (all else equal), it is actually higher natural gas prices causing decreased demand in this case.
Additionally, despite the past three months’ decline in market share on a year-over-year basis, many expect that coal-to-gas switching will continue to be a long term trend. 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 as was seen for the prior three months which resulted in a medium-term negative for natural gas demand. 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, investors interested in investing in natural gas directly through an ETF, such as the U.S. Natural Gas Fund (UNG), may also want to monitor relative natural gas and coal prices.
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