Some power plants can switch between coal and natural gas for fuel
“Coal-to-gas switching” refers to power plants deciding to use natural gas in place of coal as fuel. For most of 2012, due to low natural gas prices and the fact that natural gas burns more cleanly than coal, coal-to-gas switching rose rapidly. The primary short-term determinant for natural gas demand from the power sector is price. As natural gas becomes cheaper than coal, the economic incentive for coal-to-gas switching becomes greater. The inverse is also true. If natural gas becomes more expensive than coal, the economic incentive for coal-to-gas switching diminishes.
Electricity producers are incentivized to use more natural gas and less coal when natural gas prices fall relative to coal prices, and therefore benefit from coal-to-gas shifts.
However, since 2013 and continuing into 2014, natural gas prices have risen relative to coal, causing natural gas to lose some market share in the power generation sector.
This was largely attributable to a colder-than-normal winter, causing residential sectors (the largest consumer group of natural gas) to withdraw huge amounts of gas from inventories, pressuring gas prices.
Coal-to-gas switching in 2013
As we discussed above, coal-to-gas switching occurs when natural gas is relatively cheaper than coal. However in 2013, the price of natural gas saw an upward trend. Through most of 2013, prices remained in the vicinity of $3.5 to $4 per mmBtu compared to coal, which was ~$2 per mmBtu.
The above graph represents the momentum of coal-to-gas switching trends in 2013. Note that at a lower price, consumers demand greater bcf/d of natural gas. For example, when the price of natural gas is $3, the quantity demanded is approximately 2 bcf/d, compared to a situation when the price is $4 and the quantity demanded would be 0.
Natural gas trends in 2014
Henry Hub natural gas spot prices were volatile over the past few months, increasing from $3.95 per MMBtu on January 10 to a high of $8.15 per MMBtu on February 10, before falling back to $4.61 per MMBtu on February 27, and then bouncing back up to $7.98 per MMBtu on March 4 . The EIA expects that the Henry Hub natural gas spot price, which averaged $3.73 per MMBtu in 2013, will average $4.44 per MMBtu in 2014 and $4.11 per MMBtu in 2015—well above the EIA estimate for coal prices of ~$2 per MMBtu.
Rising natural gas prices may reverse coal-to-gas switching. As demand for coal increases, coal inventories would fall, driving prices up, which is again a positive for coal producers. Coal-fired electricity generation is expected to increase by approximately 1.9% year-over-year in 2014. However, total coal consumption is projected to decline by 2.4% in 2015 as retirements of coal power plants rise in response to the implementation of stringent employment regulations.
Investors track coal and gas prices
Because of the coal-to-gas switching trend, the relative movements of natural gas and coal prices are an indicator to watch for investors holding domestic natural gas producer names such as Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), and EXCO Resources (XCO). These companies are also investable through ETFs such as the U.S. Natural Gas Fund (UNG)
To read about the latest trends in natural gas, please read the Market Realist series Must-know takeaways from the latest oil and gas inventory reports.