Coal Substitution Is Temporary

by: Paulo Santos

There is some confusion in the market regarding coal (Market Vectors Coal ETF: KOL) substitution for natural gas (The United States Natural Gas ETF, LP: UNG). Since the public is not very aware of how power plants are selected to produce power, there seems to be an illusion that there's a lot of coal substitution that's being done on purpose and that going back to coal won't happen easily.

This isn't so. The process by which coal is being substituted - dispatch switching - is basically a decision that's done daily. Every day there's a given stack of power generators that present the prices at which they're available to produce electricity the next day, and from those - taking into account other operational constraints - the lowest cost producers are selected to produce electricity the next day ordered by the presented prices (with all being compensated at the price that's necessary to meet demand at any given time).

What this means is that as natural gas got cheaper, natural gas fired plants went up in this merit order, and got to run more often than in the past. And coal plants, which usually dominated baseload power generation, got to run less often. That's what made for an increase in natural gas usage for power generation, and a decrease in coal usage.

However - and this is what is at stake here - as soon as natural gas goes up again, the inverse process takes place, with coal-fired generation getting to run more often, and natural gas, again, getting to run less often. This happens within days of natural gas going up!

So the switch from coal to natural gas was thus temporary and will be gone once natural gas goes up. Maybe not exactly to the 2010-2011 usage levels, because a few coal generators were put out of service, but very close. Since during 2012 coal will see a 15% or so reduction in usage, this will show up as an increase in usage during 2013 (where I expect natural gas to go up enough for the inverse switch to completely take place - might start happening during late 2012).

It might be early (hard to say) to put money into coal stocks such as Arch Coal (ACI), Alpha Natural Resources (ANR) or Peabody Energy (BTU), but at least knowing this dynamic allows one to keep the faith that coal is still cyclic. There has been no definite movement away from it.

Also, due to the way power is priced, low natural gas prices make for low power prices - because as we have seen above the power price is set by the marginal producer, which is usually a natural gas-fired generator. This means that as natural gas goes up, power prices will also go up, benefiting generators that use fuels other than natural gas. Namely, the nuke operators such as Exelon (NYSE:EXC) or Public Service Enterprise Group (NYSE:PEG). These might be safer dividend-paying alternatives to play this emerging trend.

Disclosure: I am long ACI, ANR, BTU, EXC.