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Must-know critical factors that affect coal substitutability

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Substitutes

Like any commodity, coal prices are driven by supply and demand. Because substitutability makes it possible for power generators to switch from one fuel to another, thermal coal suppliers such as Arch Coal (ACI), Alpha Natural Resource (ANR), Peabody Energy (BTU), Cloud Peak (CLD), and Consol Energy (CNX) must compete against alternative fuels, which makes the industry competitive. Successful investment in coal requires understanding of the degree of substitutability and beyond.

Shifts in share of fossil-fired electric power generation

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Historically, coal’s biggest competitors have been petroleum and natural gas. When prices of alternative fuels fall because of increased supply (or lower demand for the particular fuel in other areas), demand for coal is negatively affected–which is what happened in 1960s and in recent years. Conversely, if prices of substitute fuel sources rise, then coal prices and coal demand rise. The strong relationship between commodity prices can also work in reverse. For example, if coal prices rise, prices of alternative energy fuels will also rise. In today’s market, where natural gas power plants’ capacity is underutilized and natural gas boom in the U.S. has driven production up and prices down, competition has intensified.

Critical factors

However, there are some factors that could inhibit power generators’ ability to switch fuels, which in turn will affect the pricing dynamics of coal and supply. As pointed out by the EIA (Energy Information Administration), these include:

  • Proximity to fuel sources (which affects transportation cost),
  • Fuel inventory levels,
  • Availability of transportation and storage infrastructure (which affects fuels’ local prices),
  • Supply economics of competing fuels; excess capacity to utilize competing fuel,
  • New plant development time horizons,
  • Reliability requirements,
  • Economics of power plants in the region, and
  • Long-term supply agreements with coal suppliers or transportation companies—whether at a specified price, volume, or time.
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