Coal has been a hot and surprisingly fun topic on SA in the last four months. There are countless well-written articles, with thorough and in-depth analyses of what transpired in natural gas and coal industries, why and how it happened, and speculation as to what's next.
This is my attempt at doing some of that through a two-part article. In Part One, I will mostly be focused on coal's emerging strength domestically and globally, short term and long term, then continuing with why reasons why I see coal as a stronger and wiser investment over natural gas, followed by a brief summary.
The World Wide Web of Coal
It's hard to fathom exactly how dependent the world is on coal. From 2001 to 2010, global coal consumption increased by 47 percent, or put another way, global coal consumption increased by about the same amount as the growth in oil, natural gas, and nuclear combined.
The impact continues: Globally, coal consumption grew by 5.4 percent in 2011, and it's share of in global primary energy consumption increased to 30.3 percent (highest share since 1969) - generating 42 percent of the world's electricity, according to BP (BP). Also in 2011, it was the only fossil fuel to record above average growth and the fastest-growing form of energy outside renewables.
The EIA estimates that the international demand for coal will continue to increase and account for 47 percent of the world's electricity production by 2035 with a 28 percent dominant market share. While a 17.5 percent increase in demand over 23 years doesn't seem that impressive, it does show constant and steady growth, also, we are talking about worldwide growth, which is a pretty big deal.
Consumption in Organisation for Economic Co-Operation and Development (OECD) countries declined by 1.1 percent. The decline can largely be attributed to U.S. and Japan, which offset most of the growth in Europe. Consumption might continue to decline some from the U.S. and Japan, but the economic woes in the EU have only increased coal production and consumption. Germany, the EU's biggest power market, is expected to produce as much as 130 terawatt-hours (TWh) of electricity from coal this year - a 13.5 percent increase from the 114.5 TWh last year, says Reuters.
The increase in production and consumption is due to the decreased price of the carbon allowance per ton (which has dropped 60 percent in the last year) and the decreased price of coal. The carbon allowance initiative has been the EU's solution for fighting global warming, but seems largely ineffective since Reuters data shows that the price for a ton of CO2 would have to rise to almost 40 Euros, up from under 8 Euros currently to make gas generation cost competitive.
Meanwhile, in the non-OECD, coal consumption rose by 8.4 percent. Leading the pack as usual was China with consumption growth of 9.7 percent. Global production grew by 6.1 percent, non-OECD countries accounting for virtually all of the growth. China's 8.8 percent growth accounted for 69 percent of global growth. If that number seems staggering, it's because it is. I had to double-check it. Let's take a closer look at China.
China is one of the largest importers of coal, because it is far cheaper to import than produce domestically. Chinese energy companies rely heavily on South Africa, Australia and the U.S. for cheap coal. According to the data provided by SA author Andrew W. Dai, China imported a total of 140 million tons of coal in first half of 2012 alone - meaning a 66 percent year-over-year growth. The growth can be attributed to a drastic increase in met coal demand. Met coal imports grew over 175 percent. Crazy.
To put into perspective with oil - China's share in global coal production is almost four times that of Saudi Arabia's production of oil (world's largest oil producer). China's consumption is more than double the U.S.'s demand for oil. In total, the Chinese domestic coal market is more than three times that of the entire coal trade world wide, says the International Energy Agency.
India is also a significant coal importer. From 2012 to 2013, India is projected to import 80 million tons of thermal coal. Combine the two countries and you get a 300 million ton coal order for the year. This demand presents a golden opportunity for U.S. coal companies to make up for the lackluster domestic demand. From what I understand, the U.S. does not currently have the export facilities available to export coal at these volumes. In the next two to three years while those facilities and terminals are being built, the companies with the best logistics will be able to profit the most from this opportunity.
Coal has been a staple in this country for over 300 years. It fueled the Industrial Revolution, and led to inventions such as the steam engine, locomotive, and electricity. And though the overarching theme is that U.S. coal demand is decreasing, we still heavily rely and depend on it for energy.
In 2007, coal accounted for 49 percent of the U.S.'s total electricity generation, and 42 percent in 2011. Though U.S. coal demand has been decreasing, the EIA estimates that coal will continue retain the largest share of the electricity generation mix through 2035 - somewhere averaged out to 38 percent (depending on economic conditions). If my math serves me correct, coal's share in the energy generation mix is only expected to drop 9.5 percent over the next 24 years? When you look at the graph - it appears as if the 45 percent figure over 2010 is about equal to the next column over's 38 percent bar. This may be going out on a limb, but is that to say that in 2035, the amount of electricity generation by coal will be close-to or similar to the 2010 figures? I would hardly say this is the "death of coal" based on those numbers - if anything, it just means that it should make sure to get a flu shot every year and take calcium supplements to protect against osteoporosis.
Whether or not those estimates will be anything close to the actual numbers 23 years from now is anyone's guess; however, I think it is important to note that government agencies have impeccable accuracy and are rarely wrong.
Though 2020 is still three presidential elections away, it's a bit easier to put in perspective when compared to 2035. Using coal's electricity generation figure of 42 percent from 2011, coal should still account for roughly 39 percent of electricity generation - a 7.2 percent decrease over the next eight years.
Why the EIA used 2020 and 2035 is because by 2020, growth is expected to plateau. Coal's growth is only expected to decline 2.6 percent from 2020 to 2035.
Long time foe of coal, the EPA, has passed legislation requiring that by 2015, all coal plants must comply with new environmental standards and have either a "Flue Gas Desulfurization (FGD) system" or "Direct Sorbent Injection system" installed in order to stay operational. Currently, over half of the nation's coal plants have FGD systems. EPA regulations will always be a problem for coal, especially with Obama in office, however, the coal bull is an animal that can't be stopped easily and it will continue to prosper against all odds.
Above, I took some of the highlights from the EIA's monthly Short-Term Energy Outlook and put them into an excel document. Based on the August 7, 2012 report, things are improving quicker and better than expected. The corrections from the July report reflect all positive changes, with the exception of "U.S. Total Energy Consumption" for Q2. Key take-aways from this chart are the "U.S. Secondary Stocks" (stockpiles), "U.S. coal production" and "U.S. Electrical Demand" for coal.
Stockpile estimates decreased by roughly 3 percent from July's estimates - the lower the stockpile goes, the more bullish coal will become, especially when it gets around 175mm I believe. Combined with production and demand increases, this report brings nothing but good news. Look for the next report on Sept. 11, 2012. It is also important to note that the changes for NG from July to August were for the most part negative.
Natural gas and renewables have a very bright future for energy production in the U.S., but they will not be wiping out coal anytime soon.
Sean Williams recently noted that according to the Aspen Environmental Group, it would cost $743 billion to convert all of the country's coal power plants into natural gas capable plants - about 15 times more cash than most of the publicly traded electric utilities in the U.S. have combined.
At the end of the day, it's all about the Benjamins. And right now, energy production companies simply cannot afford to make the switch. Not only is NG more expensive than coal, the capital equipment investment is rather substantial, especially in this economy.
There was this notion that six months ago, energy companies were all beginning to switch from coal to NG, and some believed this to be the "death of coal." However, these companies were merely just burning more NG than coal because four months ago when NG was only $1.902 per mmBtu (decade low) NG was cheaper to produce than coal.
Gas futures reached a seven-month settlement high last week of $3.214, though today, NG settled at $2.933. The 55 percent price has completely eliminated NG's price advantage over coal. No surprisingly, companies like NRG Energy (NRG) that switched from coal to NG are now back to coal.
"Particularly in Texas, with the combination of that and some heat-rate recovery, we have seen the reversal of that coal- to-gas switching that we experienced in January," Chief Operating Officer Mauricio Gutierrez of NRG said on a conference call with analysts.
Increasing gas prices have made use of Powder River Basin coal more economic, and it's "starting to get closer" to costs for eastern U.S. coal, Gutierrez said. The trend of switching back to coal from gas is expected to continue for the balance of the year, given the increase in gas prices and heat rates, Gutierrez said in an e-mailed statement after the call. NG prices will continue to rise and are expected to hit $4.00 six months from now.
The examples of NG's price fluctuation from above hint at NG's volatility. It is the most volatile traded commodity out there, historically bearing twice the volatility price risk of oil. The main reason NG is so volatile is because it is an unregulated commodity. Coal, oil, corn - almost all other commodities are regulated and therefore don't have the exposure NG has to the natural market.
Additionally, the weather plays a rather unexpected, but significant, role in NG's volatility and production.
The Gulf of Mexico (GOM), both onshore and offshore, is one of the most important regions in the U.S. for energy resources and infrastructure. As of January 2012, refineries along GOM comprised about 44 percent of the U.S. petroleum refining capacity, and 30 percent of NG processing plant capacity, which is why investors will be keeping a close eye on the weather patterns as the most active period in the Atlantic hurricane season has arrived. The season begins June 1st and ends Nov. 1st each year.
Tropical Storm "Ernesto" continues to gain strength and is expected to make landfall 20 miles east-northeast of Ciudad Del Carmen, Mexico and forecast to continue east, steering clear of NG production infrastructure along the Texas and Louisiana coast. "Two other systems have formed in the Atlantic, the National Hurricane Center said, though both have only a small chance of forming into a tropical cyclone over the next 24 hours (8/8/12)"
This summer's drought has also had an impact on NG. Water became so scarce many farmers were unable to adequately water their crops. (Christopher Wallace actually wrote a fabulous article - with great comments on the drought's impact on NG production - which can be found here). To summarize in a sentence, fracking involves the use of highly pressurized water based fluid to fracture rocks. Shale gas wells require between 2.3 million and 3.8 million gallons of water each. Most shale wells are in relatively remote locations and NG producers will often times have to rely on a farmer's well in order to get the amount necessary for fracking, but when the farmer's well runs dry, then production comes to a halt.
I wouldn't be surprised if production starts to decrease as we begin to learn more about impact and health dangers from fracking. Recently, several more reports of contaminated drinking water have surfaced and all appear to share a common denominator: local fracking. I read one case of "flammable water." Several towns and environmentalist groups have called for a fracking ban, and it will only be a matter of time before things turn into a circus. EPA needs to do some more research and figure out how to avoid situations like contaminating drinking water and such. I don't doubt that the problem can't be solved, but I thinking it would be wise to take a second look to reassess the situation.
In addition to addressing the health and contamination concerns, other problems with NG, such as LNG, transportation, and overall efficiency are very likely to improve in the near future. NG technology is in the beginning stages and there are lots of opportunities for advancements to be made. However, one of the biggest advantages NG has over coal is political support from EPA and the current, and most-likely continuing administration. Coal will face additional pressure from the current administration as well as increased EPA standards and regulations.
To summarize why I like coal vs. NG:
- Coal is abundant, cheap and the infrastructure is already in place for easy transportation and exporting.
- NG prices will continue to rise, expected to hit $4.00 in 6-8 months
- Coal is significantly less volatile than NG, and it's exposed to way more variables
- NG prices move opposite to the market.
- Coal demand will increase short term as NG prices rise and companies that switched from coal to NG will continue to switch back
- EIA's short-term energy outlook shows production and demand increasing in the short term; decreasing in NG
- EIA's long-term outlook shows coal isn't going anywhere within the next 20 years (though I don't expect to hold my coal positions more than a few years max, it is comforting to know I am not under any sort of time constraint).
- Increased global demand will help set the stage to improve exporting and transportation logistics.
- I have faith in "cleaner" coal technology, but this could be a ways off.
It has been a rough past few months with coal. I've taken my fair share of beatings, but I feel pretty confident that the worst is over. All of the major coal companies have released their Q2 earnings and with the exception of PCX, everyone is still alive. In a positive light, this recovery came sooner than I expected. While I wouldn't say we are for sure in the clear, I do think now is the time to consider long positions in coal stocks.
In part two of my article, I will go analyze and share some of my perspectives on my three favorite coal stocks (Alliance Resource Partners (ARLP) does not count because of its MLP status): Arch Coal (ACI), Alpha Natural Resources (ANR) and Peabody Energy (BTU). Additionally, I will share my ultimate economic calendar, which has all the significant economic reports, conferences and meetings that are likely to have an impact on coal.