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In the U.S. coal and natural gas sector, it is frequently claimed natural gas ((NYSEMKT:NG)) supply is so abundant and cheap that it competes with coal and displaces U.S. coal demand. With the NG spot price drop to only $1.85 per mmBtu, it seems to make sense. So few people would bother to spend time to scrutinize actual data to see if coal demand was indeed displaced by NG, and if so by how much.

Let the Data Speak

Never taking anything for granted, I want to dig out the data and scrutinize them to find the truth. My main data source is EIA and details of my data analysis can be found in a separate instablog post so as not to bloat the size of this article.

In the U.S., coal is used almost exclusively in electricity generation, thus utilities are the places where NG can displace coal demand. If the utilities see NG as the cheaper fuel, they may decide to run the NG units more often and idle the coal units more.

Surprisingly, EIA data show that neither is NG cheaper than coal, nor does it displace coal demand. Coal's usage drop in Q1, 2012 was almost entirely due to an unusually warm winter. The same is responsible for the fluctuation in NG demand as well.

I should not be surprised. There is an unprecedented "glut" of NG. The current NG storage level is 900 BCF higher than where it should be. Had NG displaced coal demand, more NG would have been consumed, resulting in more NG storage draw down and lower storage level, not higher. The record high storage level shows the demand of NG was weak so there wasn't much coal demand displacement.

Long term NG Expansion Did Not Displace Coal

The data table below shows long-term gradual NG capacity expansion that did not seem to displace coal usage in the U.S. electricity industry:

(click to enlarge)

In the long term, there was a gradual expansion of NG-based electricity capacity, and a gradual growth of NG demand commensurate with NG capacity expansion. But coal demand remained flat. NG did not displace coal. NG simply lifts the U.S. electricity total. Read my instablog post for detailed discussions of the data.

Coal generated electricity remained flat from 1999 to 2010, going from 1881G KWH to 1847G KWH, losing only 1.8%, even as NG-generated electricity almost doubled. There were two recent drops in coal electricity. The drop in 2009 was due to economic recession and less electricity demand. The drop in 2011 was widely rumored to be due to NG displacing coal demand, as total electricity did not drop much.

Coal Usage Dropped in 2011 Due to Weather

Was the coal drop in 2011 really due to NG displacement? Based on EIA data, coal generated electricity dropped from 1847.090 to 1734.265 (in units of giga-KWH), a net drop of 112.825, or 6.1% in a year.

The U.S. coal electricity drop of 112.825G KWH in 2011 was attributed to (read my instablog post for details):

  • 17.13% or 19.326G KWH was due to less electricity consumed, thanks to mild weather.
  • 57.5% or 64.871G KWH was due to higher hydroelectricity generated, thanks to abundant rainfall.
  • 24.66% or 27.82G KWH was due to higher wind electricity, thanks to good wind condition.

The total comes to 99.3% of coal's drop, which came from the three weather-related factors.

NG electricity was up by 28.898. That's 25.6% of coal's drop. As NG usage changes drastically depending on the weather condition, the NG displacement of coal is probably yet another contribution from the weather factor, not from prices.

Exceptional weather alone, explains the entire drop of coal's usage in 2011! Fuel prices had little to do with it. That's the conclusion.

NG Was Not Cheaper, Nor Did Utilities Switch to NG

To summarize other conclusions drawn from the EIA data:

  1. Natural gas price is NOT yet cheap enough to compete against coal. The Henry Hub spot price was misleading. Utilities pay much higher delivered price for NG. In January 2012, average fuel cost was $2.41/mmBtu for coal and $3.73/mmBtu for NG. Even though NG units are 50% more energy efficient than coal units, coal is still 14% cheaper than NG. So utilities have no price incentive to switch from coal to NG yet.
  2. NG usage for electricity generation fluctuates drastically during the year, depending on weather and seasonality, on any given day, the NG units usage factor could go as low as only 19%, or as high as 40% of the hours.
  3. In January 2012, the NG units usage factor were 28%, which is moderate. It indicates that utilities have not dispatched the NG units ahead of coal units. In comparison the coal based units were running at 54% usage factor during the same period.

Some basics of how utilities run the power grid. All the generators nationwide are connected into one giant power grid. To connect to the grid, the generators must spin at precisely the same frequency, and synchronize exactly in phase. This required careful monitoring of the load and prompt adjustment of power supply to meet the changing demand. Such adjustment requires split-second response time and employs quick firing NG turbines that can sprint into action to quickly boost power when needed.

This quick on/off duty cannot be carried out by coal-fired units. It takes a full day for coal units to be turned on and running normally. So coal units are kept running 24 hours a day providing for the base load, while NG units should sit in waiting most of the time, be started only when they are needed to meet the dynamic load during peak hours.

Can utilities run the NG units to provide base load power supply, thus displace coal consumption? They can, but they are unlikely to do it. Maintaining the grid stability is very important, because a power grid collapse is extremely expensive. They must leave the NG units sit in stand by, ready to be turned on at any time. If the NG units are running constantly, there will be nothing left to be turned on when you need a power boost promptly.

Moreover, the NG turbines are not designed to run at full capacity continuously. They are meant to run a few hours and then shut down for maintenance and recovery. Running continuously increases the wearing and results in higher cost to utilities. It is penny wise and pound foolish to run the NG turbines in a way not intended by design.

For these reasons, even though NG electricity capacity expanded over the decade, the utilization rate of NG units remains at roughly 30%.

Cheap NG Is An Illusion That Will Not Last For Long

Will the exceptional cheap natural gas price last? Is it long-term trend that NG will replace coal demand? The answer to both questions is NO.

The cheap natural gas price is an illusion created by the shale gas boom and burst. The natural gas industry was too eager to jump both feet in, fighting each other to lock land leases and drill shale gas wells with high hopes, but disappointing results. They collapsed the natural gas price while chasing the shale gas dream.

I predict that in the next few years, many shale gas players will go bankrupt, as they are unable to recoup the high debts they incurred in the development of shale gas wells. Wall Street and the industry conspired to cover things up while they try to fleece the investors for as long as they can, before it all blows up.

Rolling Stone made a long report called: "The Big Fracking Bubble: The Scam Behind the Gas Boom." Calling an entire industry a Ponzi Scam is rather heavy. Geologist Arthur Berman, though unwilling to join the accusation game, nevertheless confirms that typical shale wells have much faster decline rate than expected, and much lower amount of ultimate recoverable gas. See the chart below courtesy from his blog:

(click to enlarge)

A typical shale well costs roughly $15M from start to end. If it can yield 5 BCF of gas, as the industry hoped for, then $4 or $5 per mmBtu gas price (one mmBtu is about one thousand cubic feet) might be marginally profitable. But the chart above shows that the ultimate recovery is only 1 BCF, not 5 BCF. The gas price has to go as high as $15 to $20 per mmBtu to keep these shale gas producers alive.

Is 1 BCF the likely typical volume of ultimate recoverable gas? The above chart was a survey of hundreds of actual shale wells, some produced for 56 months or more. I think the sample size is big enough to be conclusive that 1 BCF is very likely the best these wells can do.

Where Do We Go From Here?

Will natural gas price ever recover? Definitely! Probably very soon.

Will gas price ever go up to $15 to $20 per mmBtu, which is needed for shale gas companies to be profitable? Unlikely! The demand destruction will occur as such high price is prohibitive to some end users. I think many of the shale gas producers that have incurred a mountain of debt from banks and gambled good return on the shale gas boom, will never be able to recoup the cost and pay back the debts. They are doomed and so are the banks that lend the money. They've got to keep the illusion of cheap and abundant shale gas a little bit longer so hopefully they can unload the craps to the last fool standing.

Arthur Berman said: what people thought was a 100 years worth of North American natural gas reserve, was more likely good for 6 years.

Shale gas was a beautiful dream. Do not count on it. Do not count on it to displace coal demand. The shale gas boom will burst soon. U.S. coal will stay relevant for our foreseeable energy future.

I advise people to avoid ETFs like UNG and KOLD. They are short-term gambles but not long-term investments. I advise people to be cautious and skeptical in natural gas companies like Chesapeake Energy Corp. (NYSE:CHK), ConocoPhillips (NYSE:COP), Anadarko Petroleum Corp. (NYSE:APC), EOG Resources Inc (NYSE:EOG), Devon Energy Corp. (NYSE:DVN), and Baker Hughes Inc. (NYSE:BHI).

The real values are in U.S. coal mining companies like James River Coal Co. (JRCC), Patriot Coal Corp. (PCX), Arch Coal Inc. (NYSE:ACI), Alpha Natural Resources Inc. (NYSE:ANR), Alliance Resource Partners (NASDAQ:ARLP), Cliffs Natural Resources Inc. (NYSE:CLF), Peabody Energy Corp. (NYSE:BTU), and Walter Energy Inc. (NYSE:WLT). They have been deeply discounted to ridiculous levels. As Peabody Energy's earnings result released yesterday show, US coal is not that pessimistic after all. Please read my other articles on US coal and natural gas industry.

Source: Is Natural Gas Displacing U.S. Coal Demand?