Electric Utilities: Good Bye Coal, Hello Natural Gas

by: George Fisher

For electric generating utility owners, the ongoing seismic shift in fuels used for power generation will alter the utility investment landscape. In short: Coal is out, Natural Gas is in. Not only is the government and media pushing this addenda, but so is simple current economics.

As most electric utility investors already know, the EPA has proposed higher restrictions on coal-fired plant emissions. When implemented by 2016, upwards of 20% of electric generation by coal could be shuttered as uneconomical for emission upgrades. In 2010, coal-fired plants produced 340,000 megawatts (MW) of electricity, or 45 percent of total U.S. electricity production. At-risk plants that may be uneconomical to upgrade represent about 70,000 megawatts of generating capacity. These at-risk plants provide about 9.3% of total US electric power generation. On the positive side, about 17,000 MW of new coal-fired capacity is due to come on-stream by 2017.

In 2009, the Energy Information Administration (EIA) listed 594 coal-fired power plants in the U.S., down from 645 coal-fired power plants in 2001. Of these plants, 341 are operated by electric utilities, 100 by independent power producers, and the remainder by industrial and commercial producers.

Who owns the most coal-fired plants? According to a table offered on the MIT website, listed below is the combined largest coal-fired power plant capacity operated by the largest coal-based electric utilities:

  • Southern Company (NYSE:SO) - 13, 802 MW
  • American Electric Power (NYSE:AEP) - 11,904 MW
  • Tennessee Valley Authority (U.S Gov’t) – 10,636 MW
  • Duke Energy (NYSE:DUK) - 10,300 MW
  • MidAmerican Energy HC - 7,328 MW
  • Ameren (NYSE:AEE) - 7,065 MW

The complete table by coal-fired plant is here.

Regardless of one’s political posturing, the reality of electric generation is the road ahead for coal is fraught with higher regulations and higher costs. This will energize a conversion to the next easiest, abundant, and currently cost effective fuel source – natural gas.

Exelon (NYSE:EXC) has been expanding its merchant power generating capacity by buying natural gas plants. Recently, the company purchased five natural gas plants to add to is assets of nuclear power plants and regulated utilities. In comments concerning Exelon’s purchase in May of a natural gas plant in Texas for $305 million, John W. Rowe, Exelon Chairman and CEO said, “Forthcoming EPA clean air rules will make Exelon’s natural gas-fired power plants even more valuable and increase our role in the nation’s transition to a clean energy future.”

In a March 8th speech before the American Enterprise Institute, a conservative Washington think tank, Rowe also gave a bit of insight into his belief that the only cost-effective clean energy sources that exist today are existing nuclear (not new plants) and natural gas:

“U.S. energy policy has been driven by a mess of mandates and power subsidies for nuclear, cleaner coal, gas, wind, solar and other renewables – a constant urge to pick winners and losers.

Congress needs to slow down.

Energy efficiency and uprates at existing nuclear plants are economic at today’s prices. New gas plants and coal to gas switching are the next cheapest options at a cost of $69 per MWh and $82 per MWh respectively, and those sources of cleaner energy are only needed as demand returns or supply is tightened by EPA regulations.

New wind, new nuclear, solar and clean coal all cost over $100 per MWh when you take into account the capacity factors, supply back up and so forth. Federal subsidies shift a portion of the costs from electric ratepayers to taxpayers, but do not change the overall economics.”

His speech can be found here.

Coal-fired generation has historically been utilized for “base-load” requirements – consistent electrical production 24 hr a day, 7 days a week, 52 weeks a year. With the pending reduction of total base-load electric generating capacity, the slack will be made up through a fuel source that also has base-load characteristics. The dilemma with current solar and wind generation is the variables of power output make them not as reliable for base-load needs. Natural gas, however, fits the bill.

Last spring, Mr. Bill Powers, Editor of Powers Energy Investor, offered an in-depth comparison between the economics of coal versus natural gas for electric power generation, citing a report from last fall authored by Credit Suisse. In that report, CS calculated that at a current price of $74 per ton for Central Appalachian coal, the price of natural gas would have to rise to $6.30 per mcf for the two fuels to reach parity for electric power generation.

A graph presented by Mr. Powers indicates the belief that pricing parity coal to natural gas will not be reached until well after 2014:

(Click to enlarge)

Current futures pricing indicate this disparity could last for some time. The highest futures contract pricing quoted on NYMEX is Dec 2015 at $6.20 per mcf.

These factors have led to a slow but consistent upswing in the amount of natural gas used in power generation. According to the EIA, natural gas consumption by electric power producers increased 7.3% in 2010, based on volume. This trend should continue to accelerate as more coal-fired plants are converted to natural gas in order to meet higher EPA emission standards.

With the power generation business moving away from coal and towards natural gas, how might a utility investor benefit from this trend? Usually characterized as a more conservative bunch, with many seeking income, utility investors may want to review natural gas MLP companies such as natural gas storage firm PAA Natural Gas Storage (NYSE:PNG), Enterprise Products Partners (NYSE:EPD), and Dorchester Minerals (NASDAQ:DMLP). All three should be handsomely rewarded over time with a continuing uptick in natural gas consumption by electric power utilities.

PAA Natural Gas Storage is a spin-off of Plains All American Pipeline (NYSE:PAA). Utilities need a consistent supply of gas and will contract to storage companies to provide fuel matching their needs. PNG is expanding its storage capacity in the Southeast, partially to take advantage of this utility trend. During the current market malaise, share prices for PNG have dropped to $17.20 and currently yield 8.0%. With a fee-based business model, PNG is depended more on volumes and seasonal price spreads than commodity market pricing. A previous article can be found here.

Enterprise Products Partners is also a MLP and is one of the largest pipeline operators in the country. In addition, the firm provides mid-stream processing of natural gas. Like PNG, EPD is dependent on a fee-based business model focused on providing services to the natural gas industry. As volumes increase from utilities, so does the need for transportation and processing services. EPD share prices are 7.3% below its 52-week high and yields 5.9%

Unlike the other two suggestions, DMLP is a MLP that owns mainly natural gas production acreage and receives a royalty or net profit interest on wells. DMLP’s fortunes are directly tied to both demand and pricing, and their override position becomes an unhedged exposure to the price of natural gas. DMLP trades at $23.50 and yields 7.1%. More information on DMLP can be found here from a previous article.

While there are many good quality natural gas exploration and production companies that should benefit from a turn-around in natural gas demand and pricing supported in part by the utility industry, these three companies are a bit more conservative and provide sustainable income. PNG, EPD, and DMLP are also priced below where they were just a few short months ago, effectively goosing up future yield on invested capital for new investors.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I am long EXC, EPD, DMLP, AEP.