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Natural gas (NYSEARCA:UNG) bottomed one month ago. Stagnated production (though still up year-on-year), together with much higher demand for power generation, have meant the former fear that natural gas could fill up all available storage is receding. EIA's weekly updates continue to confirm this bullish thesis, which I first put forward on my April 24th article, "Natural Gas In 2012: Electric Generation Switch Implications".

So now, with natural gas up more than 40% in a single month, the time has come to ask: what obstacles does natural gas face next, in its upward motion? Two such obstacles stand out:

  • The natural gas to coal switch and;
  • The natural gas rigs start coming back.

This article will deal with each of those obstacles, to see what they represent and at what prices they should become more evident.

The Natural Gas To Coal Switch

The main force behind natural gas new found strength was the large increase in natural gas demand for power generation. This increase in demand happened because natural gas got so cheap that many gas-fired generators jumped ahead of coal-fired generators in the dispatch merit order. In many places it simply became cheaper to burn natural gas than coal (NYSEARCA:KOL) - something historically very rare, even with the combined cycle turbines being considerably more efficient than coal generators usually are.

So this switch was entirely dependent on the relative pricing of natural gas and coal. And the same way that this trend emerged when natural gas went down, it will disappear as natural gas goes up.

We can estimate at what point this obstacle will appear, even though in reality this is a continuous process, as each generator has its own heat rates, costs for coal/natural gas including transport, access to different grades of coal, etc.

Estimating through an arbitrage with CAPP coal

Front month CAPP coal on CME trades at $55.42 per metric ton, with an energy content of 12000 BTU/lb. This comes to 26.4552 mmBTU/ton, which translates CAPP coal's price to around $2.09/mmBTU. Given natural gas combined cycle turbines can be anywhere from 33-50% more efficient than coal-fired units, that translates into an effective price of $2.79 to $3.14 when compared to natural gas.

From this perspective, natural gas is already approaching a broad zone where we can start seeing switching back to coal. Also important, there are cheaper coal grades that trade at a discount to CAPP coal on a per-BTU basis, such as PRB coal. This also means that theoretically coal shouldn't suffer much more downside pressure at these levels, especially if natural gas manages to surpass this barrier - which isn't easy because as it goes higher, it will lose some of its higher consumption due to the switch back into coal.

The Rigs Come Back

If natural gas manages to overcome the natural gas to coal switch, it will have to face another obstacle a bit higher. That would be the price at which we see increased drilling for natural gas. Presently natural gas rigs have been plunging hard, as natural gas fell to prices where it simply made no sense to drill for it, especially when one could drill for much higher margin liquids.

Here, too, the well economics can vary wildly from well to well and play to play. As a proxy to establishing where rigs might start coming back, we'll use the empirical observation of where they started going away.

As per EIA's data on the number of operating natural gas rigs, there have been 2 recent tops. One during August 2010 and another during November 2011. Both these months included a slump in natural gas prices, with August 2010 seeing a front month range between $3.76 and $4.96, and November 2011 seeing a range from $3.27 to $3.93. In between August 2010 and November 2011 there was only a mild recovery in natural gas drilling rigs, and natural gas prices mostly held below $4.81.

What we can conclude from these observations is that prices below $4-4.50 or so don't show much of an incentive for drilling rigs to increase. So that will probably represent the second barrier natural gas will face in its upward trek. I'd expect this barrier to be more relevant during 2013, when we should be observing falling natural gas production.

Conclusion

Natural gas has continued its 2012 rally predicted by us one month ago. It now faces the first of its two large price barriers, in this case because at prices slightly higher than it trades for now, we should start seeing the natural gas to coal switch. This should mean two things:

  • The rally will become more volatile;
  • Coal finally starts getting some price support.

This event calls for a stabilization in the deeply punished coal sector, and in stocks such as Peabody Energy (NYSE:BTU), Alpha Natural Resources (NYSE:ANR), CONSOL Energy (NYSE:CNX), Arch Coal (NYSE:ACI), Cloud Peak Energy (NYSE:CLD), Walter Energy (NYSE:WLT) and others. Since I expect natural gas to continue to see increased pricing into 2013, I also expect the present situation in the coal sector to be a buying opportunity.

With natural gas prices rising power prices will be rising too. This means that power producing companies that generate electricity using nukes are also favored. Exelon (NYSE:EXC) and Public Service Enterprise Group (NYSE:PEG) are two such companies.

I don't favor natural gas producers because many haven't discounted the deep natural gas plunge, or are exposed to shale gas - I am not entirely sure of the economics of shale gas until prices exceed the barrier at which the natural gas rigs come back.

Source: The Barriers Natural Gas Faces