I want to follow up on my article titled "Is Natural Gas Displacing U.S. Coal Demand" and continue the debate with Paulo Santos on the big question every coal and natural gas investor wants to ask: Did the coal to natural gas (NG) switch happen in the electricity power sector?
Santos believes the power companies are actively switching from coal to natural gas. He has the remarkable year-over-year percentage increase of NG, as shown in EIA's weekly updates (see the chart here). He has many witnesses on his side. Even the CEO of Southern Company (SO), an electricity power company, claimed it was actively switching from coal to NG. The problem is that Santos does not have EIA data to support his view. The EIA data still supports my view that in the last few months in the power sector, reduced coal consumption as well as increased natural gas consumption were both due to exceptional weather conditions, not due to NG price incentive. Thus, as the weather returns to normal, the perceived coal to NG switch should disappear soon.
EIA just released its Electricity Power Monthly and monthly natural gas data on Monday, April 30. So I looked at the new data and decided to write this update when I saw a few surprises in the latest numbers. I clearly saw the quick disappearing of the coal to NG switch just as winter thawed. It's right in the EIA data.
But first let me address what Southern Company said during its earnings conference call. Santos quoted the company in claiming that utilities are moving away from coal toward NG. I just want to point out the following facts:
- The company had a 16% mix in NG and 70% coal mix in 2007, but by Q1 2012 had a 40% NG and 40% coal mix. Obviously, its move toward more NG was a long-term strategic shift that started way before recently depressed NG prices. Thus the company's strategic move was not driven by cheaper NG prices. As I discussed previously, coal is for base load while NG is for dynamic peak load. Southern Company may have a good reason to switch to more NG capacity. The electricity supplied at peak hours can fetch top dollar, while the base load power is much cheaper.
- The company claimed that it ran the NG units up to a 70% capacity factor. Obviously, it is maximizing its NG capacity to burn more NG amid lower NG prices. But the same cannot be said for other utilities in the U.S. Nationwide NG capacity factor is only 29.8%. (91.262K GWH electricity was generated from NG in February. The average power is 91262/29/24 = 131 GW. Dividing it by 439W installed NG capacity gives 29.8%.)
- This low 29.8% national average NG capacity factor tells us that most power companies are choosing to wait and see, instead of following Southern Company in boosting NG usage rate. The 70% NG capacity factor was shown to be possible at this season, but there were few followers.
- Southern Company also said it can promptly switch back to coal if it sees the NG price incentive disappear.
Now, let's look at what the latest EIA Electricity Power Monthly data can tell us. This is a 130-page document full of numbers. I've summarized the most important data in the spreadsheet below:
Click to enlarge image.
In the table, column B and C are coal and NG generated electricity in GWH (giga-watt-hour), respectively. Columns H through M are my calculated numbers that reveal something very interesting. For coal: Column H is the MWH of electricity generated per ton of coal; J is the amount of energy contained in one gram of coal; and L is the generation efficiency (the percentage of energy that can be converted into electricity). For NG, the corresponding columns are I, K, and M, respectively.
These six columns of data are important. Columns J and K tell us the quality of the fuels -- i.e., the energy content of the fuel. Column K is almost constant for NG, which is no surprise. All NG contains mostly the same methane and thus has about the same energy content.
But column J, indicator of coal quality, deteriorated quite a bit over the last 10-plus years. It went from 20.48 in 1998 to 19.535 in 2011. In recent months it quickly worsened to 19.24 in December 2011 and 19.21 in January 2012, before recovering a bit to 19.41 in February 2012.
The long-term gradual deterioration of coal quality could indicate that peak coal is occurring in the U.S. What about the short-term rapid deterioration starting from September 2012 until today? Does it mean coal companies are producing inferior coal just because the price is undesirable at the time? I have no explanation so far. But suffice it to say that inferior coal quality means utilities have to burn more coal in order to generate the same amount of electricity.
As shown in column L, the energy efficiency of coal generation units is pretty steady over the years. But column M shows the energy efficiency of NG generation has steadily improved over the years, probably due to the adoption of super-critical working temperature. Notice also that during hot summertime, the NG energy efficiency is lower, while during wintertime it is higher. If you know about the hypothetical Carnot Engine, you know that a bigger temperature gap maintained between the high and low means higher energy efficiency. In winter, lower room temperature leads to a bigger temperature gap and higher energy efficiency.
This may mean that when summer kicks in, utility companies have to burn more NG just to generate the same electricity. The variation is quite significant. The energy efficiency can be as high as 45.3% in the winter or as low as 41.5% in the summer. That's a 9.16% difference. If the utilities burn 9.16% more natural gas in the summer, there will be a lot of additional demand.
Finally, let's observe the year-over year changes of coal-generated electricity in each of the recent months:
- November 2010-2011: 135.185 to 121.197, dropped 13.988G KWH
- December 2010-2011: 167.258 to 132.706, dropped 34.552G KWH
- January 2011-2012: 170.983 to 129.064, dropped 41.919G KWH
- February 2011-2012: 138.295 to 113.831, dropped 24.461G KWH
Notice how the year-over-year drop changed? The situation for coal was looking worse by the month, but it changed with the new EIA data release. Suddenly, the year-over-year figure is not dropping more, but is reversing for the better. If the reversal continues, by March or April, we may see coal demand higher than last year.
What happened? It was the weather. The coal demand in the past few months did not vary much since it was a mild winter. But a year a go, the winter was cold and demand surged in December and January. It created the illusion that we had weaker coal demand.
The demand for coal this year is perfectly normal given the weather conditions. The dramatic drop from last year was also expected given the different seasonality conditions. There was very little coal to NG demand switch after all. As I said, the weather is the explanation.
This conclusion is good news for coal bulls, but not necessarily bad news for natural gas bulls. As the latest EIA natural gas monthly data show, the natural gas production cut has already taken hold. No NG demand increase is needed to bring the price back to a fair level.
The real bad news for natural gas investors is not the price. Natural gas prices already surged 19% in one week since touching the decade low. I am pretty comfortable we have seen the worst of the NG price drop. The prices of both natural gas and coal are going higher.
The danger for natural gas investors is the bursting of the shale gas "fracking bubble." Shale gas production using hydraulic fracturing has not been proven economical in the long term. As Arthur Berman and many others have pointed out, shale gas wells decline fast, with an ultimate production volume far lower than expected. Natural gas price would have to go to an unsustainably high level for shale gas plays to be profitable.
Not willing to take anyone's word for granted, I decided to do my own research. I came up with a math model that is neutral. I was able to show that it fits the actual production data of the Barnett Shale perfectly, and it insisted on locking on to a set of parameters that predicts low ultimate yields of shale gas wells. I will discuss my discovery in detail in an upcoming article. Stay tuned.
I want to caution people to only use the following ETFs as short-term trade vehicles, not long-term investments: United Stated Natural Gas (UNG), ProShares Ultra DJ-UBS Natural Gas (BOIL), and ProShares UltraShort DJ-UBS Natural Gas (KOLD). I have no opinion on Market Vectors Coal ETF (KOL), though. You should be aware of the danger in shale gas boom and burst if you own these U.S. oil and gas stocks: Chesapeake Energy (CHK), Constellation Energy (CEP), Cabot Oil & Gas (COG), ConocoPhillips (COP), Anadarko Petroleum (APC), EOG Resources (EOG), Devon Energy (DVN), Baker Hughes (BHI), Southwestern Energy (SWN), Pioneer Natural Resources (PXD), Magnum Hunter Resources (MHR), Kinder Morgan Energy Partners (KMP), Enerplus Resource Fund (ERF), Carrizo Oil & Gas (CRZO), Callon Petroleum (CPE), Enterprise Products Partners LP (EPD), Goodrich Petroleum (GDP), GMX Resources (GMXR), IDT Corp. (IDT), Lucas Energy (LEI), Rex Energy (REXX), Approach Resources (AREX), Natural Gas Services Group (NGS), Breitburn Energy Partners (BBEP), National Fuel Gas (NFG), Range Energy Resources (RRC), Petroquest Energy (PQ), Unit Corp. (UNT), Transocean (RIG), BP (BP), and Exxon Mobil (XOM).
An excellent opportunity to make huge investment return within a relative short period of time is in the US coal mining sector now. I recommend these US coal mining stocks: James River Coal (JRCC), Patriot Coal (PCX), Arch Coal (ACI), Alpha Natural Resources (ANR), Peabody Energy (BTU), Alliance Resource Partners (ARLP), Cloud Peak Energy (CLD), Cliffs Natural Resources (CLF), Consol Energy (CNX), Natural Resource Partners (NRP), Penn Virginia Resource Partners (PVR), and -- last but not least -- Walter Energy (WLT). Although I own a lot of James River Coal and Patriot Coal, I would not dwell on the specifics of individual stocks. The U.S. coal sector is so bullish that all coal stocks are good buys.