The Power Race: Natural Gas vs. Coal

by: EconMatters
While the natural gas market is still recovering from the flash crash, ExxonMobil (NYSE:XOM) came along and delivered a booster shot by announcing its latest acquisition – $1.69 billion for two privately held natural gas companies in the Marcellus play--Phillips Resources and related company TWP Inc.
Exxon’s Shale Gas Rush
The deal will add about 317,000 acres for exploration in the Marcellus shale basin with proven reserves of 228 billion cubic feet equivalent of natural gas. The Phillips companies produce about 50 million net cubic feet per day of natural gas. This came after Exxon spent about $30 billion last year to buy shale gas company XTO Energy, and around $700 million to buy Ellora Energy, picking up Ellora's position in the Haynesville shale.
Exxon, already the largest producer of natural gas in the United States, has said it is taking a long-term view of natural gas markets, betting a surge of natural gas price in coming years on power demand in developing countries like China and India, and a possible use of gas as a cheaper and cleaner substitute to other fossil fuels.
Nuclear Renaissance Dimmed by Fukushima
Nuclear power was on the verge of a renaissance before Japan’s Fukushima crisis, which was a rude awakening to one of the world’s worst nightmares—a possible nuclear meltdown. Meanwhile, the ongoing war and chaos in the Middle East and North Africa (MENA) illustrates the peril of relying on energy sources from unstable regions.
With the nuclear renaissance taking a break, and a heightened sense of energy security, natural gas stands out as one fuel source that’s more reliable than oil and a lot less costly than clean coal and renewables. So the stage seems ready and set for a global energy paradigm shift towards natural gas.
Coal Playing Second Fiddle
The advance of new drilling technology (horizontal drilling and fracking) has unlocked 100-years worth of natural gas supplies in U.S. shale formations that was previously considered unrecoverable.
Between the two large energy consuming sectors that could be targeted to expand natural gas use, power generation, which already has its infrastructure in place, seems to hold more promise than transportation.
Among the current fuel sources (including renewables) used for power generation, coal currently provides about 45% of the electricity in the U.S. while natural gas fuels less than a quarter of the nation’s electricity (See Chart below). However, in this new "golden age of gas," as the International Energy Agency dubbed it, king coal is increasingly playing second fiddle to the blue flaming gas.
Energy Holy Grail #1 – Economic
Henry Hub gas price has been held down at around $4 per mmbtu for the most part since the Great Recession, due to an inventory glut from surging shale production and stagnant domestic demand. This new trend of steady and low prices has made a compelling economic case for capital investment in gas power plants. Complying with the new emission regulation from the EPA is another incentive.

Morgan Stanley estimated that natural gas at $4 per mmBtu is about equivalent to Central Appalachian coal at the $49 per short ton range, which is well below marginal mining costs. But gas prices would have to dip below $3.25 per mmBtu to be cheaper than Illinois Basin coal and to $2.75 per mmBtu to compete against Powder River Basin coal.
John Rowe, chairman of Exelon Corp. (NYSE:EXC) noted that building new gas plants costs half the price of new nuclear and is much cheaper than wind and solar. Supply chain management professionals also indicated gas power plants are easier to source with shorter lead time, less technical complexity, and can come online a lot faster than nuclear and coal plants.
Energy Holy Grail #2 – Reliable
In the past, a long history of price volatility (Chart Above) and the lack of a reliable and economic supply base is one reason that the industry had been reluctant to build an investment case around gas power plants. Even with the new found shale abundance, the reliability part of the gas supply base remains iffy since many of the shale producers are independent E&P companies that are typically cashflow-sensitive, and are quick to stop or switch drilling in response to commodity market movements.
But the industry landscape has changed significantly now that integrated oil majors like ExxonMobil, ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX) and Shell (NYSE:RDS.A) are putting their resource and expertise behind shale gas. Most of the oil majors are usually very methodical in their investment decisions. They may not pounce as fast as the E&P’s, but once a commitment is made, these majors are in it for the long haul.

So, international integrated oil majors’ large domestic footprint in natural gas could signal a fairly reasonable and steady price and supply outlook in the U.S. This, in turn, would make it easier for natural gas to build on its existing 20% power gen market share to become the lower cost, reliable fuel choice.
Energy Holy Grail #3 – Low Co2
Although the amount of emission generated from natural gas is still under hot debate, depending on if you take the ‘life-cycle calculation’ approach, natural gas is generally considered cleaner burning than coal and petroleum.
A Congressional Research Service’s 2010 report concludes that

...if natural-gas combined cycle plants utilization were to be doubled from 42% capacity factor to 85%, then the amount of power generated would displace 19% of the CO2 emissions attributed to coal-fired electricity generation.

According to a GE Report, carbon dioxide emissions (CO2) could fall by 150 million tons per year by year 2020 if natural gas-fired combined cycle plants replace coal.

Moreover, natural gas is also a much more economical option for power plants to mitigate Co2 than carbon capture and storage (CCS), for example, and renewable fuels .
Power Gen Coal-to-Gas Switch
In fact, the substitution is already taking place in the domestic power generation sector.
The latest U.S. EIA report shows in February and March 2011, coal-fired generators had, by a considerable margin, the largest fuel-specific year-over-year decline. Coal-fired generation was down 6.9% or 9,988 thousand MWH (megawatt hours).

Analysts estimated that between 1.1-to-2.5 bcfd of gas displaced coal in 2010 with Henry Hub averaging $4.381/mmBtu. The majority of fuel switching happens in regulated power markets in the southeastern US. (See Chart Above)

Bentek Energy, an arm of Platts, expects to see 2.5 bcfd of coal to gas switching in 2011, assuming a $3.75 gas price, -- equivalent to displacing roughly 13,000 MW or about 4% of total U.S. coal power capacity.

20% Early Retirement of Coal Power
Based on a new study by the Brattle Group, new EPA emission regulations could put up to 50,000 MW to 67,000 MW, or 20% installed coal plant capacity into early retirement, and $100-180 billion additional investment may be needed to upgrade existing coal plants to comply with the EPA's potential mandates.
According to Brattle, retirements and increased operating costs would reduce coal demand by about 15% by 2020, while boosting natural gas demand by up to 5.8 billion cubic feet daily or about 10% of total gas use.
Natural Gas – Self Help vs. LNG Export
Some market players believe that increasing exports of domestic gas would drive up prices, which could kill the coal-to-gas switch in the power sector. LNG export may seem to be an ideal outlet not only to get a piece of the action in the Asian LNG market that often fetches tripled the current Henry Hub price at spot, but also to get rid of the domestic natural gas inventory glut.
Nevertheless, as discussed in my earlier article, LNG export is not a magic bullet. Major hurdles include a logistic disadvantage which could diminish the competitiveness of the U.S. against other low-cost exporters such as Qatar, Russia and the new kid on the block—Australia, not to mention several preliminary studies have pointed to the potential of huge shale gas deposits in Europe and Asia as well,

Therefore, although LNG is expected to elevate natural gas into a true globally traded commodity like crude oil with higher prices reflecting global demand, most of the domestic gas probably will end up burning at home, at least in the medium term, which seems to be the shorter and most logical route to fully utilize the ample supply (See Chart Above).
Gradual Shift of U.S. Power Gen Portfolio
The playing field could eventually be leveled as renewables and emission capture technologies become more developed, but that’s probably about ten years away. Before then, even though natural gas will not completely replace coal in power plants, we should see a gradual shift of the U.S. energy generation portfolio towards natural gas.
In the scenario of a steady and gradual demand increase from the power sector, and under normal seasonal pattern, Henry Hub would probably trade roughly $5-7 per mmbtu range in the next five years or so.
Investment Thesis
Construction management firms have seen a distinct falloff in revenue in the past two years. With global economy slowly picking up pace, and ongoing worldwide green initiatives, green design and environmental firms like URS Corp. (NYSE:URS), AECOM Technology Corp. (NYSE:ACM), Michael Baker Corp. (NYSEMKT:BKR), and Veolia Environnement S.A. (VE), should see good revenue growth.
Energy project construction companies such as Fluor Corporation (NYSE:FLR), Shaw Group (NYSE:SHAW) McDermott International (NYSE:MDR), Chicago Bridge & Iron (NYSE:CBI), Foster Wheeler AG (FWLT), and Jacob Engineering Group, will also see a nice pickup in business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.