Much has been written here on Seeking Alpha about a pending rise in coal stocks as the natural follow through to rising natural gas prices. But theory and practice have diverged over the last six months; that thesis has not played out. This article will attempt a brief examination of why.
The Bullish Coal Thesis
First, let's briefly examine why various articles here have espoused a bullish coal stock thesis and spawned some very spirited debate in the comments. The coal bulls have observed that natural gas has risen almost 50% since bottoming in April of this year. Both coal and natural gas are used as fuels in the generation of electricity and can be substituted, one for the other. Therefore, a rise in natural gas prices should result in a similar direction for coal prices and coal producers should benefit from improved economics through more favorable pricing.
What Has Actually Happened
Natural gas bottomed 5 months ago on April 19 at $1.90 per MMBtu. Let us look at the relevant statistics since that time:
- Natural Gas prices have risen 52% (from $1.90/MMBtu to $2.90/MMBtu)
- Natural gas producer stocks have risen 7.6% (using the First Trust ISE Revere Natural Gas ETF FCG, as a proxy for natural gas stocks)
- CAPP coal has fallen 14% (the October contract has fallen from $61 to $52.50)
- The KOL ETF has fallen 25% from $32 to $24.
The thesis that coal stocks would rally together with natural gas did not play out.
Reasons Why The Thesis Failed
The first reason is that not all coal investors fully appreciated the distinction between the two primary types of coal that are produced. Coal can be divided into two broad categories: thermal and metallurgical. Metallurgical coal (also referred to as "met coal" or "coking coal") is high BTU value coal which is primarily used to fire steel-making furnaces and has a selling price that is currently 4 times higher than thermal coal. Thermal coal (also known as "steam coal" or "bituminous coal") is primarily used to fire electricity-generating steam turbines. Met coal's high price means that it is never substituted for natural gas. Met coal production is not influenced by natural gas prices. Many domestic coal companies have increased their emphasis on met coal production to the point where the majority of their revenue comes from this source of coal. Yet reviewing the body of work here on Seeking Alpha shows many coal bulls advocating rising thermal coal prices have either recommended or disclosed ownership in the following stocks: Alpha Natural Resources (ANR), Arch Coal (ACI); James River Coal Company (JRCC); Peabody Resources (BTU). Each of the companies has a significant portion of their revenue (over 50%) derived from metallurgical coal, a product that is in no way influenced by changes in the price of natural gas. These stocks would therefore make for a poor execution of a gas-driven bullish thesis.
Second, as natural gas prices fell, power generating utilities underwent a phenomenon referred to as coal to gas switching: substituting natural gas for coal as fuel for generating electricity. The bullish coal thesis calls for thermal coal prices to rise as natural gas prices rise, and switching from gas back to coal occurs. But that thesis tends to rely on an over-simplified view of coal to gas switching. Switching (also known as "dispatch switching" because utilities dispatch different plants to generate power depending on the cost of fuel they consume) is neither as fluid nor as simple as the theory is.
Dispatch switching occurs to minimize the variable cost of generating power and ignores other factors such as fixed costs while still considering reliability and availability. Cheapest fuels are used first, if and where it is available. This means hydro and nuclear are first choices in the generation stack, then coal and gas. Years ago, coal was a dominant fuel source for generating electricity and it handled most of the base load. But environmental concerns have been pushing coal out of favor. Construction of new coal-fired plants has declined in favor of new construction of cleaner-burning gas-fired plants. These newer plants are more efficient and are more flexible to ramp up or ramp down during the day to meet changes in demand. Coal covers the constant baseload and natural gas is used to handle the temporary peaks. In between, the most common sources of cycling capacity are natural gas combined cycle generation turbine (CCGT) plants. They burn gas to make steam to turn turbines to generate electricity and they also recycle heat to boost plant efficiency. CCGT plants are less expensive than coal plants to build and run more efficiently. They can also be ramped up and down more easily than coal and may stop and start many times during the year. Consequently more is at play than simply comparing the variable cost of fuel generation; efficiency and flexibility are major considerations. This has contributed to a steady decline in the relative use of coal in power generation, now at a historic low as shown in the table below:
Third, the bullish coal thesis failed to appreciate that thermal coal enjoys a global market due to its ready ability to be transported on ships, whereas natural gas is primarily transported by pipeline and therefore North American gas producers enjoy mostly a North American market. China, a major consumer of thermal coal, has developed a considerable over-supply of thermal coal at its largest utilities and this has impacted the export side of the domestic coal producing business.
While the prima facie intuitive appeal of the bullish coal stock thesis resulting from a recovery in natural gas prices cannot be denied, the near term evidence has clearly shown that thesis to be flawed. For the last five months, natural gas has been negatively correlated with thermal coal prices and the KOL ETF. The flaws result from most domestic producers having large revenue reliance on metallurgical coal; from failure to recognize gas versus coal plant efficiency and its effect on dispatch switching; and the global nature of the market for thermal coal. Coal producer stocks have certainly been beaten down, and a significant rally seems long overdue. But those of us who had expected coal stocks to rally in tandem with natural gas (yes, I was one of them) need to re-examine our thesis in light of the evidence provided above.