Coal's Long Sunset

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Includes: KOL, TONS
by: MassifCapital

Summary

Coal may be down but it is not out, global coal use is still expected to increase through 2040.

In the US coal is still used produce between 35% and 40% of electricity.

Natural gas switching in the US is occurring, but when the price rises above $2.50 mmBtu it becomes more cost effective to burn coal.

Although many know that oil consumption in the OECD has been declining for over ten years, what has gone largely unnoticed is that so too has oil's share of global energy consumption (that is oil as a source of the energy consumed globally). Chart A, below, shows the percentage of global energy consumption by source in terms of millions of tons of oil equivalent, Chart B focuses on the percentage of global energy consumption of oil, natural gas and coal over the last two decades of available information. What is worth noting about the charts is that despite the fact that oil has fallen in importance over the last 20 years' no one claims that the death of oil is imminent, yet coal, a commodity of increasing importance over the past two decades is frequently proclaimed as dead or dying. Looking at the market for coal globally, one can only conclude that the thesis that coal is dying is either premature or incorrect. (Both charts are based on information from the BP Statistical Review).

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Coal mining has been considered a dead industry for some time; some might even consider it to have been a dying industry since the 1950s. Nevertheless, it persists and has grown in importance globally over the last twenty years. It may be a sluggish, low-growth commodity, which lacks the sex appeal of tweets, snaps and selfies; it may struggle to maintain market share in the US and regions of Europe, but it is far from dead. Rather than dying, the coal industry, especially in the United States, is suffering a massive hangover. Like many commodities, the emerging market (principally China) call on coal between the late 2000s and 2013, which resulted in production growth globally of close to 70%, has created chaos throughout the coal supply chain.

The volatility in demand created by the "call on coal" has been enormous and continues to be disruptive, even in OECD countries. Evidence for this massive volatility in demand can be seen in the valuation shifts in the US coal sector, which in 2002 was valued at a rather minor $8 or $9 billion. The value of the sector shot to an astounding $40 billion in 2008 and has now collapsed to below 2002 levels. The Dow Jones U.S. Coal Index, which captures the largest listed U.S. coal companies, has fallen 94% in the last five years. This is not the only collapse of 90% or more that the industry has experienced in the last decade. (Price information in chart sourced from S&P CapitalIQ)

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At the same time as this volatility has occurred, coal's importance to global energy has not been as significant as it currently is since the 1970s, as Chart A highlights. The rapid expansion to accommodate its growing share of global energy consumption has come with a high cost, as coal has proven a commodity particularly sensitive to demand and supply issues at the margin. As soon as global demand flattened, the profit disappeared. Coal, despite its record demand, is barely economical to mine.

The industry persists and persists in importance though. As the IEA stated in their 2014 medium term coal market forecast:

"Despite the public image of a dying industry, coal is still the backbone of electricity generation worldwide - not to mention steel production - and produces more than 40% of power generated worldwide. Coal is abundant and affordable, it is easy to store and transport, and there are no geopolitical issues in the coal supply chain. Pulverized coal is a very well-known and reliable technology, and, with increasing flexibility in new designs, it can complement renewable generation as well as maintain its traditional role as base-load generation." (Source:IEA 2014 Medium Term Coal Report An executive summary of the report is available via the following link)

Coal does appear to be losing battles, especially in the US, but this too is a bit deceptive. The percentage of base load power in the United States, and globally, derived from coal remains significant. Perhaps, more importantly, the ability of natural gas or renewables to quickly and seamlessly supplant coal as the primary source of baseload power seems exaggerated. It is difficult to argue that it will not eventually happen, but it is not clear that it will be a short or simple transition either.

The speed of the transition is of great importance for investors; there is plenty of opportunity in a fading but evidently overlooked industry that still has 40 to 50 years of life in it. Furthermore, in the US at least, it is not clear that the current downward trend in coal-fired generation is necessarily as significant as it appears. The ongoing downtrend in the US only began in 2007, a similar trend has not begun outside of the OECD yet (in fact, the exact opposite trend remains underway, see Chart C), and the downward trend correlates with the sustained growth in natural gas production, fall in prices and oversupply of the coal market. Any one of these trends may reverse in the future, and in fact, the oversupply of the coal market is already beginning to change.

The primary area of concern for coal investors, especially in the US, is natural gas switching, which is neither new nor simple. In fact, the level of switching we are currently experiencing has occurred before. Look at Chart D from the EIA (Source: Electricity from natural gas surpasses coal for first time, but just for one month)

What is worth noting is that before this year, natural gas switching, resulting in a corresponding decline in net electricity generation from coal occurred as recently as 2012. At that time, April 2012, natural gas spot prices were near $2.00/mmBtu, the power generation shares for coal and natural gas diverged shortly after that as natural gas prices rose back to $3.50/mmBtu by the end of 2012.

The chart above is critical for thinking about the supply and demand of coal at the margins, and for understanding the sensitivity of coal to natural gas switching to price movements in either coal or natural gas. Electricity generation dispatch decisions, the decision between generating via coal or natural gas, are not simple decisions. The decision by a utility to generate via coal or natural gas reflects numerous variables including, but not limited to delivered costs, emissions costs (applicable in some places), heat rates, supply availability, and various other factors in fuel markets. Table A compares what is called the dark spread vs. the spark spread, in essence, the cost of generating via natural gas vs. coal at the margin.

Although the transition from coal to natural gas appears to have been deemed a fact going forward, it is likely a fact only in the very long run; and even that seems an oversimplification of a complex transition. As Table A suggests if natural gas prices are above about $2.50 it is more competitive and economical to burn coal, and depending on the location of the power plant, it remains more cost-effective to burn ILB and PRB coal than natural gas. There are additional costs: transport, pollution, etc., that are not included in the table and thus a slight discount to the real marginal cost of both generation via natural gas and coal, but the rough economics are clear. Switching also includes extra costs that are seldom included in the conversation , such as building additional natural gas generating facilities. The switch is not just about fuel but also infrastructure.

Often overlooked in the switching discussion is the fact that the coal to natural gas switch is a question of a new source of base-load power, not peak or cycling power. Coal-steam power plants generate baseload power. This is important to remember as it means any switch must include a switch from a power source running 24/7 to another source running 24/7. Natural gas facilities that can be used for peak power or even cycling cannot just be transitioned to baseload; they are neither as cost efficient or necessarily even capable of carrying the workload. If we look at just the east coast of the United States, the installed nameplate generating capacity of the 154 combined cycle generation turbine (CCGT) plants (the type of natural gas plant used for baseload power generation) is 84,177 megawatts. The installed nameplate generating capacity of the 109 coal plants is 69,828 megawatts; to switch to CCGT generation in entirety on just the east coast of the United States CCGT capacity needs to grow by 82%. If we look at five recent CCGT plant construction projects (Table B), we can get a very rough estimate of what the transition might cost, and it is not cheap. (Table Source: A Report on Combined Cycle Projects in North America)

The key takeaway: energy transitions are slow, complex and expensive. Although switching from coal to natural gas is occurring, there is a limit to how much can happen without significant, costly infrastructure investments. Valclav Smil, an academic who studies energy transitions, has found that they are often far slower and more ponderous than most people think. (Much of Smil's research can be found at his website Here, we suggest starting with "The Long Slow Rise of Solar and Wind").

Smil is worth quoting at length on the question of energy transitions:

The three successive changeovers have intriguing similarities [Smil is referring to the changeover from wood to coal, coal to oil and oil to natural gas]. Coal (replacing wood) reached 5 percent of the global market around 1840, 10 percent by 1855, 15 percent by 1865, 20 percent by 1870, 25 percent by 1875, 33 percent by 1885, 40 percent by 1895 and 50 percent by 1900. The sequence of years needed to reach these milestones was 15-25-30-35-45-55-60. The intervals for oil replacing coal, which began at the 5 percent level in 1915, were virtually identical. (Source: The Long Slow Rise of Solar and Wind)

In October of last year, the EIA estimated that natural gas was used to generate roughly 35% of US electricity, if Smil's research trend holds it will likely take another 25 or so years reach 50%. At the same time, for this trend to become a reality, natural gas has to remain cheap, and the infrastructure build out has to be significant. As Smil notes elsewhere, there are still numerous challenges ahead for this transition, and rarely do "complex changes…bring unalloyed benefits." (See: The Natural Gas Boom: Questions and Complications) The point of this is simply to demonstrate that despite the hype, coal is here, and it is (barring an unforeseen scientific advance, or departure from historical energy transition trends, both of which are possible) likely to remain a significant source of electricity for some time.

In absolute terms, global coal use is still expected to increase through 2040 in all but the most ambitious climate policy scenarios used by the International Energy Agency. Those projections will likely prove incorrect-they often have in the past. Nevertheless, they suggest coal has more strength than it is given credit for having. The prospect of cost reductions in clean energy technology is very real, and the pace of innovation in oil and natural gas development is working against coal. Natural gas growth in the US, largely the result of technological innovation by independent E&P's, is just one example. Short of further such technological surprises, investors should acknowledge the truth that coal may be down, but it is not yet out. As long as that is the case, there will be an opportunity for enterprising investors with strong stomachs to find opportunities.

Supporting data and excel charts available here

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Disclosure: I am/we are long CNXC.

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.