The coal sector is one that stirs a lot of passion. Identified as producing a commodity that can somehow be associated with crude, many traders expect it to outperform given the monetary debauchery undertaken by both the Federal Reserve and the European Central Bank. It also helps that coal had a few glory moments where the stocks (as well as the product) traded much higher than they are today. Stocks such as Peabody Energy (BTU), Alpha Natural Resources (ANR), Arch Coal (ACI), CONSOL Energy (CNX) or even Patriot Coal Corporation (PCX) have taken large beating and seen their estimates drop precipitously, yet still command a large following of faithful investors, expecting coal to once again rise from the proverbial ashes.
However, coal has a huge problem. The problem with coal is that its main usage by far in the U.S. is for producing electrical power. And in this usage, the fuel it competes with is mostly natural gas (source: EIA):
As a result, the share of U.S. power generation fueled by natural gas is projected to rise from 24.8% in 2011 to 27.1% this year. Conversely, the share of electricity generation from coal is projected to drop from 42.2% to 40.4%.
The power sector consumes about 92% of U.S. coal production. Other large users of coal are coking plants involved in the steelmaking process and industrial users such as cement and paper manufacturers.
Now, we all know just how badly natural gas has performed, both due to increased shale gas extraction, and lately also due to an incredibly mild winter. This has led to a plunge in natural gas prices, and this plunge made electrical generation using natural gas extremely competitive with coal-fired generation. As a result, coal-fired assets saw lower allocations, coal saw lower consumption, and even Warren Buffett suffered as a result.
But just how bad is this phenomenon for coal? As a matter of fact, we can try to visualize it. Natural gas is quoted in the CME with its price corresponding precisely to 1 MMBTU. If we just convert coal to equivalent units, we can then plot both on the same chart and have a feel for how coal has historically related to natural gas.
The price series for coal that I managed to obtain was for Australian thermal coal, in $ (USD) per metric ton, with 6,667 kcal/kg. At 3.968 BTU per kcal, this gives us 26,455 BTU/kg, or 26,454,656 BTU per metric ton. We'll thus have to divide the quoted prices on coal by 26,454,656 and then multiply per 1,000,000 to arrive at a price per 1 MMBTU as we already have for natural gas. This is what we get (Source for conversions: Platts; source for coal prices: ycharts):
This is not truly representative of what's happening in the U.S., because coal is more of a local market, and coal is cheaper in the U.S. In the U.S. CAPP coal could be had for $58.50 per short ton. CAPP is betuminous coal and carries a 12,500 BTU/lb energy value; this translates to 27,557,750 BTU per metric ton. Doing the math, we arrive at $2.34 per MMBTU, still more expensive than natural gas (and the modern natural-gas fired power plants are less expensive to build and maintain, easier to permit, less polluting and more efficient). Historically coal has always been a lot cheaper, so having natural gas so cheap naturally pressures its prices lower.
Thus, the relationship still holds -- natural gas became cheap enough to displace coal in power generation. In the U.S. as we've shown the price differentials are not as large as in the chart (in the chart, coal is 100% more expensive for the energy content), but they still pressure coal prices downwards, as EIA itself acknowledges. The average delivered coal price for 2011 was $2.40 per MMBtu, so almost 20% above where natural is trading today.
Light at the end of the tunnel
Is there a light at the end of the tunnel for coal? There are two hopes:
- One is that natural gas will stop plunging. This is not realistic on the short term; natural gas is now entering the filling season with record inventories. It's even likely that there won't be enough storage to hold all the natural gas that'll be produced and stocked during 2012 - wells will have to be shuttered, under these conditions prices can go to unimaginable lows. Although rigs and exploration are already down, it's still too early to say there's any kind of control on the oversupply;
- Another is that China demand for thermal coal is not predicted to fall and might continue to expand even in the face of an investment slowdown. Met coal, however, can easily be a victim of less Chinese steel demand and production, especially once residential construction sees reduced activity (a practical inevitability). As we've seen, U.S. coal prices are competitive and exports might well increase substantially over time (the same thing might happen to natural gas, once LNG export facilities are up to speed).
It is likely that coal companies will continue to be pressured in the months ahead, due to the continued pressure from natural gas as a substitute fuel for power generation. Over the longer term, increased usage of natural gas in transportation, and increased exports of natural gas and coal, together with less natural gas exploration, might alleviate the situation. But the next few months can be brutal if natural gas inventories grow to the point of exhausting existing storage -- as they seem likely to.