Little Reason For Optimism On Coal

| About: Peabody Energy (BTU)
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Yesterday the coal (KOL) sector enjoyed a powerful rally. Naturally, this rally was helped by the oversold condition on most coal stocks, as well as the general belief that coal stocks are somehow cheap because they've fallen so much.

Also contributing to this powerful recovery, that saw Arch Coal (ACI) climb 7.3%, Peabody Energy (BTU) gain 7.5% and Alpha Natural Resources (ANR) jump 9.9%, was the belief that all utilities that could switch from burning coal to burning natural gas (UNG), had already switched. This theory was helped by FBR's constant promotion of the theme, such as in its research note titled "The Great Coal-To-Gas Switching Hoax," where it argues that as much as 90% of the utilities that were able to switch fuels, had done so already. The underlying reasoning is thus that coal producers need not worry about further demand erosion, since the remaining power stations will be forced to continuing using coal.

It all sounds very credible. But there's a single problem with this theory, the problem being that it's a myth. Not only is it a myth, but it reveals some lack of understanding on how power markets work.

You see, the main problem for coal isn't really the switching on any given power generator from using coal to using natural gas. The main problem is that if natural gas is cheap enough, entire natural gas generators get scheduled to produce, while entire coal-fired power plants sit idle. This comes from the fact that in power pools around the country, the power suppliers have to submit their offers for producing power (usually, for the next day). With natural gas ever cheaper, these offers can be lower and lower - especially as the power suppliers see their old contracted prices rollover to the new prices.

Since producing power with natural gas is now cheaper per BTU than doing so with coal (see my article "The Problem With Coal"), and since natural gas power plants are usually more efficient burning it as well (which means that coal needs to be as much as one-third cheaper per BTU to even be on equal footing), this means that more and more natural gas power plants will be scheduled instead of coal-fired plants.

So no, the substitution of coal for natural gas hasn't reached its nadir yet. It's just following a different process right now.


As long as natural gas remains pressured, there's little reason to become optimistic on coal.

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