The Rebalancing Of The U.S. Coal And Natural Gas Industry

by: Mark Anthony

My article, The Darkest Star In The Commodities Boom, seemed to have sparked off a heated debate on where the US coal and natural gas market was headed in the short to long term, resulting in several comments, and many comments too on The Problem With Coal by Paulo Santos.

Few people disagree that the future of coal is very bullish due to international demand, and that the current coal weakness due to the natural gas glut will not last forever. But people widely disagree on how long it takes to resolve the situation. It seems that the natural gas producers keep producing more, and injecting more gas into the storage than expected. Some people predict that by October, the underground storage will be completely full, and natural gas price will drop to below $1 per mmBtu. They believe the cheap natural gas price will keep the US coal price depressed, and there will be no turning around of the natural gas and coal sectors for the rest of 2012 and for 2013 too.

I disagree. The turnaround of both the US coal and natural market is imminent, with data showing it is happening already. In history and today as well, the US coal industry and natural gas industry re-balance pretty well in response to market conditions. These two energy sectors have never stayed in a depressed market condition for extended period of more than a few months. There are good reasons why that is the case. I will discuss them here.

It is widely speculated that since current natural gas storage is at a record high at this time of the year, if the injection during the summer reach average volume, the underground gas storage will be filled to the 4400 BCF capacity by October, 2012. The nightmare scenario of no more storage space left by the fall is why natural gas spot price just keeps falling week after week.

That speculation sounds right, but was proven wrong many times in history. It's wrong because you don't expect an average injection volume over the summer if the storage is high to begin with. The injection will be much lower. Likewise, if the injection season starts with a low volume, the injection over the summer will likely be higher than average. The natural gas industry looks at the storage volume and adjusts its production accordingly if it can. Although natural gas wells can not be promptly turned on or off at short notice, from now till the fall, there is plenty of time for the industry to cut production.

How do I know? EIA has a chart showing seasonal variation of the gas storage over the years. Looking at it, I noticed that while the bottom positions of the curve varies a lot, driven by unpredictable winter temperature and other factors, the peaks of the curve are consistently nearly the same height, going up slightly over the years as total storage capacity was expanded. It implied that the industry consciously produces more and injects more if the storage goes too low, and it cuts back and injects less if the storage is high.

So I collected the data pairs of the bottom storage levels and the subsequent total injection volume before the next peak storage. Here is what I get when the data pairs are plotted, with the horizontal axis being the bottom level of storage, and the vertical axis being the subsequent total injection volume:

Click to enlarge

The data points do seem reflecting a roughly inverse correlation between the two numbers. The fitting line happens to be at 45 degrees angle, which is expected. The fitted correlation can be roughly written as (in unit of BCFs):

(Peak Injection) = 3250 - (Storage Bottom) + Delta

It looks like the industry has a goal of reaching peak storage level at roughly 3250 BCF, maybe a bit higher, but safely below the maximum storage capacity. It does so by adjusting production level, either consciously or due to the influence of natural gas market price. I remember in early 2006 there were a lot of claims that the storage was too high in spring time, and it could be completely full by the fall. The fall of 2006 passed uneventfully with a moderate storage peak.

There is NO glut in the natural gas market. The gas storage is part of how the natural gas market regulates itself. The gas storage right now is at the lowest point of the year. How could you call the lowest storage level a glut? A glut is when you are about to run out of space and a disaster is about to happen. We will be in a glut if by October the storage is indeed filled to near capacity. Today, the storage still has plenty of room, and we still have many months before it reaches the peak level. When you see a slow moving car one full mile ahead of you on the highway, do you call it an accident waiting to happen?

Any commodity industry has an inherit capacity of re-balancing itself to bring supply/demand back to balance. This works as the market price gives producers incentive to either boost or reduce production, and available inventory storage space can buffer out price shocks.

Some industry works very well in re-balancing, some not so well, depending on price sensitivity, and inventory size. One extreme example I mentioned in the past is precious metal rhodium, which went from $300 per ounce to over $11000 in four years, on a small global shortage of only 3.7%. It was due to absolute lack of price elasticity on both the supply side and demand side, but it is also due to the fact that no one had the wisdom to hoard some rhodium in inventory. If there was a rhodium stockpile, the price could never go so crazy.

Things are quite different for a producer whose products clog the storage space. Taking a car maker like General Motors (GM) for example, if cars are not sold, the car dealers will have full car lots, so they will not request more shipments, and so the storage space at GM is filled up quickly. When there is no more space left, it will have no choice but to shut down the assembly lines and send workers home.

Similarly, the coal industry has a tight constraint of inventory storage space. The amount of coal produced and consumed is a huge quantity. Although power companies stockpile only a few weeks worth of coal, a few weeks of coal is a small mountain! So they can only buy what they can consume soon. To coal producers, if coal users do not take away all the coal produced, a mountain of coal will accumulate fast at the mine sites, resulting in the production activity grinding to a halt, until the excessive stockpile is carried away by coal users.

Such inventory space constraint is what makes the coal industry so efficiently and promptly self-regulated. The industry always promptly respond to market demand change and adjust production accordingly.

This is what makes the kind of market miracles like shares of James River Coal Company (JRCC) surged from $3.56 to $62.86 in only nine months, gaining 1700+%, during the mini coal rally in late 2007 and early 2008. All coal mining shares, Patriot Coal Corporation (PCX), Arch Coal Inc. (ACI), Alpha Natural Resources Inc. (ANR), Peabody Energy Corp. (BTU) surged explosively at the time, far exceeding my wildest dream. Just when you think the sector can't be more depressed, things begin to turn around magically at the drop of a hat.

The weekly coal production numbers from EIA show that the coal industry's self regulation is in action. In the first week of 2012, US coal production was 21.25M tons, up 2% from the same week last year. By the week ending March 31, 2012, the weekly production was 18.214M tons, much lower and a drop of 16.2% from the same week last year. It did not take long for them to go from producing more than last year, to now 16.2% below last year's level. This will boost price.

The coal industry is free to decide how much coal it will dig and produce at any given day. The natural gas industry is less flexible. It takes a lot of effort going from exploration to finally produce gas from the wells. Once they start drilling a well they have to keep going at full speed as the drilling rigs cost a lot of money each day. Once a well is finished, they have to keep the gas flowing because they have already spent all the money. They could end up spending much more if they attempt to cap the wells.

That's why the natural gas industry is much slower than the coal industry in responding to market demand change. It is true when it over-produces. It is also true when it under-produces to cause a shortage. There have been at least five natural gas price spikes in the past decade, each time the price went from $3 or $4 to $12, $15 or $17 in just a few weeks.

Is the natural gas industry indifferent to the natural gas price change and refuses to adjust production accordingly? Of course not! It does care about its profitability. It is making adjustments. It has consistently reduced the number of rigs drilling gas wells. The production cut is not evident immediately, but is beginning to show up, as the weekly gas storage data is getting closer and closer to the predictions each week. The quick depletion rate of shale gas wells, as well as reduced drilling activity is already showing effects.

So relax and sit back to watch the market takes care of itself. Hold your coal mining shares firm. The turnaround of the natural gas and coal mining sector is now, not later in 2012. The gas storage will not be full by the fall. The gas glut will disappear before you know it.

Disclosure: I am long JRCC, PCX, BTU.