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First, the obvious: coal in the U.S. is used overwhelmingly to produce electricity. During 2011, 92.9% of the coal consumed in the U.S. by weight went to produce electric power. Natural gas competes with coal for that purpose, even if it also has other uses such as heating or as a feedstock for industrial processes.

When natural gas gets low enough, such as it did during 2012, more natural gas fired generators get scheduled to produce electricity ahead of coal-fired generators. I called this phenomenon "dispatch switching," since it results from the dispatch rules which are used to select which generators will run and produce power. This process was the basis for my article "The Barriers Natural Gas Faces." It was also the basis for my bullish call on natural gas back in April at around $1.90.

Now, as we all know, since April, natural gas has gone up strongly, but coal (and coal stocks) didn't move much. This has led to the question "why is it any different now, if the last 50% jump in natural gas had no effect?"

Why is it more important now?

The reason why the last 20% (from $3.00 to $3.60) move in natural gas ends up being more important for coal than the first 50% move (from $2.00 to $3.00) is simple to explain. Coal never reflected the drop in natural gas towards $2.00, instead, coal (CAPP coal) continued trading at prices which implied dispatch switching around $2.70-$3.00. That was the prime reason why every time natural gas got close to $3.00, it faded. When natural gas got to $3.00, we had dispatch switching from natural gas back to coal.

Now, as natural gas tries to trade decisively over $3.00, with contango in the next two months implying prices as high as $3.90, once again we'll see dispatch switching from natural gas towards coal. This will have two possible effects:

  • Either we see increased coal pricing or;
  • We see increased coal usage (volume). Or both.

Contrary to the move from $2.00, which had no direct effects on coal other than improved sentiment, these two effects are unavoidable. They're a mechanical consequence of the present natural gas pricing. And that's what makes this last move materially different from the larger move which preceded it.

The main risks

As natural gas loses usage to coal, once again its excessive production can overwhelm demand. Although we're already seeing (and have been for a while) reduced drilling, it's still not certain that natural gas production will slow down enough to enable the higher pricing to stick.

A smaller risk has little to do with natural gas. The companies with met coal exposure will see little benefit from higher natural gas pricing. Met coal pricing is more reliant on developments happening in China, since China produces almost half the world's steel.

Finally, coal can be seen as cyclical, even if its future is linked to natural gas. This means that if the market sells off on economic fears, cyclicals can get hit and coal can get hit with them. Right now PMIs are below 50 in most of the world's most important economies (except for India and the U.S.), making these fears quite possible.

Conclusion

The latest increase in natural gas pricing is sure to improve thermal coal's pricing and usage. This will be broadly positive for the coal sector (NYSEARCA:KOL) as well as many different coal stocks, such as Peabody Energy (NYSE:BTU), Alpha Natural Resources (NYSE:ANR), James River Coal (JRCC), Arch Coal (NYSE:ACI), Cloud Peak Energy (NYSE:CLD) and others.

Disclosure: I am long ACI, ANR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Why Natural Gas Pricing Matters For Coal Right Now