Coal Faces Tremendous Long-Term Problems

|
 |  Includes: ACIIQ, KOL, UNG
by: Paulo Santos

It's no secret that I believe coal's short-term cycle will turn -- indeed, has turned - upwards. I even bought into Arch Coal (ACI), and I believe coal stocks in general will probably see a good performance in the months ahead.

The main reason why I believe there's a good chance of the coal cycle turning upwards has to do with the behavior I expect for coal prices. Coal prices were deeply depressed since late 2011 due to a combination of warm winter weather and large natural gas production coming from the shale revolution. These made for very low natural gas prices, which in turn led to natural gas-fired generators jumping ahead of coal-fired power plants in the dispatch order. Coal consumption suffered, stocks increased, prices fell and naturally profits for coal producers imploded. The stocks, in turn, were slaughtered.

This dynamic, however, made for a bottom in natural gas prices. Back in April 2012 and due to the increased usage for power generation, as well as the following scorching summer, natural gas prices bottomed below $2.00/Mcf and have been going up ever since, more than doubling in the last year. This, in turn, finally took the pressure off coal. The dispatch order again started favoring coal-fired power plants, consumption increased and now coal prices are again bottoming out. Although coal producers see losses as far as the eye can see, such a bottoming process usually establishes the right timing to buy into cyclical equities.

These short-term dynamics should be enough to override any other fundamental considerations, and thus I am positive on coal at this point. However …

The long-term

Coal, when we set aside the short-term cycle and the impact of the shale revolution, faces at least three tremendous problems to its long-term prospects:

  • Renewable energy;
  • China's over-reliance on coal and its pollution problems;
  • The drive towards limiting CO2 emissions.

Let's go over each of these problems.

Renewable energy

The problem with renewable energy such as wind energy or solar energy is not just tied to the generating capacity that it might replace. Obviously, these sources are expected to increase their contribution in the future, as can be seen in the following EIA chart (Source: EIA):

Click to enlarge

The real problem is that as these sources represent an higher share of the installed generation, they imply much larger and uncontrollable fluctuations in what energy is generated. And this has severe implications for the electric grids and the kind of other generating assets present in them.

In short, the presence of a larger share of intermittent renewables such as solar and wind makes it highly desirable to then have natural gas-fired generation assets complementing them. This is because these generators are faster to start up and to change their production levels, and thus can cope much better with the wind and sun's variability. These assets also imply lower investment and are thus easier to justify when run at lower utilization rates.

China's over-reliance on coal and pollution

China is by far the greatest user of coal (Source: Europe's Energy Portal, chart below), and depends on it massively to generate electricity, with close to 80% of its generation capacity being coal-fired.

Click to enlarge

At the same time, China is facing a serious, well-known, pollution problem in its cities. This has led to politicians trying to break the heavy reliance on coal, by stimulating other generating assets such as nuclear or solar. Additionally, much tighter regulation is being applied to coal generating plants, leading on one hand to modernization, but on the other making the fuel less competitive.

An example of these moves can be seen in how Beijing is trying to close the last of the coal-fired generators close to the city.

Any smaller reliance on coal by China is bound to affect the entire worldwide market for coal, given China's position as the largest consumer by far. In this regard it's a situation similar to what is happening on steel, where China is the largest consumer and producer by far, as well. This smaller reliance seems certain to happen gradually.

The drive towards limiting CO2 emissions

Finally, we have global warming. Whether one believes in it or not, increasingly measures will be taken to limit CO2 emissions. And naturally burning coal is a major contributor to those emissions. Through programs such as carbon credits, burning coal will be punished cost-wise.

The impact on coal in places more open to the global warming view, such as Europe, can already be seen in the stagnation or deep contraction of coal use (Source: Eurostat).

Click to enlarge

It's likely that this view will slowly gather further adherents both in the U.S. and in China, leading to policy measures which will hasten the long-term decreased usage of coal.

Conclusion

There's reason to believe coal, on account of several structural problems, faces tremendous pressure towards lower usage in the future. Although it will continue to be used, especially in clean coal applications, the very fact that it might be used less might lead to depressed economics over the long term, as installed mining capacity is forced offline. This means that beyond the positive short-term cycle now expected, it might be hard to justify holding coal stocks over the long-term.

You'll notice that I didn't mention the shale revolution as a problem over the long-term. I actually expect that the worst of natural gas pricing pressure is gone and over the long-term coal's problems will be mostly self-generated by the need to take capacity offline, and not from seeing its prices being pressured downwards by a plunging natural gas price.

Disclosure: I am long ACI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.