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# The Basics In Understanding The Energy Market

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I will discuss some basic concepts in the energy markets of natural gas, coal and electricity.

Source of Energy Supply and Demand Data

The EIA and FERC have a mountain of data on US energy markets. But monthly data on coal and natural gas comes out a few months late. With some efforts, investors can get more fresh data from:

Basics in understanding natural gas, coal and electricity

You need to know some basics to understand energy data. I will discuss them in details in an instablog post.

• Coal fires electricity generation capacity is 319.186GW.
• Natural gas power generation capacity is 438.727GW.
• Capacity factor: If the capacity is utilized 100%, electricity generated in a month equals to the capacity times hours in the month. The actual capacity factor is obtained by dividing the electricity generated, by the capacity and by the hours. It tells how often utilities use their generation capacities.
• Fuel efficiency: I calculated fuel efficiencies using EIA data. See column H to M in the data table. Conversion factors are:
• 1 ton (coal) = 1.859 MWH (electricity)
• 1 mmBtu (NYSEMKT:NG) = 0.129 MWH (electricity)
• 1 ton of coal = 14.41 mmBtu for power generation.
• 1 KWH = 0.538M tons of coal = 7.752 BCF of NG
• A fuel energy calculator is handy

US coal is mostly used for electricity. In 2011, we consumed 1003 million tons of coal, with 928.558M tons (92.58%) in power plants.

Natural gas is more diversified. In 2011, annual supply of NG was roughly 23,000 (in BCF, billion cubic feet) in dry production and 1948 in net imports, total 24,948.

On NG demands: 2069 (in BCF) was spent in plants and pipelines, with 22300 delivered to end users; 7896 for commercial and residential usage; 6802 for industrial and vehicles; and 7602 for power generation. So power demand was only 34% of the total.

Understanding Electricity Generation

Electricity is generated from coal, natural gas and other sources.

Below is a survey of electricity generation from different source, with data up to March of 2012:

During the winter, over-production from shale gas wells combined with demand-damping by warm weather caused natural gas spot price to drop to \$1.90/mmBtu on April 19 of 2012, depressing the coal sector as well. NG price has recovered to \$2.70/mmBtu now.

But coal prices so far failed to follow the NG rally so far. I discussed that the coal and natural sector is inherently cyclic since the supplies and demands are quickly rebalanced. When can we expect coal prices to rebound? Let's study the market data to find out.

Massive coal production curtailments

EIA weekly coal production reports indicate big production cuts:

The cuts reached 47.70M tons by May 19, 2012. Total 2012 coal production cuts could reach 160M tons, way bigger than the expected reduction of domestic coal demand in 2012.

Are coal production cuts so far really big enough? Why natural gas rallied without significant production drop yet, but coal hasn't rallied despite of unprecedented production curtailments. How much coal demands were taken away by the weather, and by natural gas?

The fuel switching from coal to natural gas

It is widely suggested that power plants are switching from coal to NG in generating electricity. There are incentives to switch fuel, as natural gas price is cheap. Southern Company (NYSE:SO) reported that they run their NG turbines to 70% capacity.

Coal power units burn coal. NG power units burn NG. To USE more NG and less coal, utilities must install new NG units and retire some old coal units, or run NG units more often and coal units less often.

Installing new NG generators is expensive. Knowing that NG prices are historically volatile, utilities would hesitate to invest money until they are convinced that low NG prices will stay.

If utilities run their NG units more often, capacitor usage factor of NG units should go up. The first two months have 60x24= 1440 hours. Electricity from NG was 182,473 GWH. Divide it by 438.727GW of NG capacity and then by 1440 hours, the NG capacity factor was 28.88%. That's below 37% in July 2011, and way belong the 70% capacity factor reported by SO. It proves that most utility companies did not run the full potential of NG units.

In January, utilities run their coal units to 54.35% capacity factor, based on my calculation.

When coal units are run almost twice as often as NG units, you cannot say that power companies are trying hard to burn less coal and more NG. My take is some fuel switching did occur, as the power sector consumed more NG and less coal in recent months. But it is not a massive fuel switching as Paulo Santos claimed.

How Much Coal Demands Were Displaced

The result of my data analysis of coal supply/demand in the first 5 months of 2012 is summarized in the table below:

In the table, all monthly numbers are scaled to 30 day months for better comparisons. The May numbers were projected using partial data available for the month.

On domestic coal supply: Production dropped 41.098M tons from last year; exports increased by 8.660M tons. Total supply removed was 49.758M tons by the end of May. The net exports accelerated in March. I expect much higher export increases in the following months.

On domestic demands: US electricity from coal lost 116316 GWH from a year ago. This loss was attributed to the followings:

• 49941 GWH of decreased total electricity generation. (42.9%)
• 93563 GWH of increased NG electricity generation. (80.4%)
• 27187 GWH of decreased other source generations. (-23.3%)

The loss in coal demands amount to 135.7 * 0.538 = 63M tons. The cut in supply is 50M tons so far. There is still an 13M tons stock gap.

But the tide is turning. In May, the coal supply cut is 16.27M tons. The demand drop is only 2825 GWH, or worth 1.52M tons of coal. The difference is 14.75M tons per month. If status quo remains, in one month we will return to the coal stockpile level at the end of last year.

Things can move sooner due to two things:

• Natural gas rally forces utilities who did switch fuel to switch back to coal, as the NG price incentive disappears.
• China's coal imports from US must accelerate soon.

International Demands on US Coal is Booming

China's coal imports in first four month increased 69.6% from a year ago to 86.55M tons, with 15.88M tons from the US, up by 11.1%. A Chinese trader commented that 6400 KCal energy grade US coal is priced at Y600/ton delivered to Chinese ports, while Chinese coal of 5500KCal grade is asking for Y780/ton. (US\$1.00 = Y6.30) The winner is clear. Coal specialist Huang Teng believed that total US coal exports this year could reach 200M tons! The report projected a +140% increase of US coal exports to China in 2012. I bet this export increase will soon show up in US data.

China imports most of its coal from Indonesia, Australia and Vietnam.

Vietnam started to import coal from Australia and Indonesia. It plans to become a net coal importer by 2015.

Australia could not meet demands from Japan, India, Korea and the whole world while keep selling more coal to China.

So China's coal import increase mostly came from low quality cheap Indonesia coal. China could import more from Indonesia, an island nation with only 0.6% of the world's coal reserve, only thanks to India' government's feet-dragging on coal imports from Indonesia, and to rampant illegal mining in Indonesia.

Both Indo governments will come to their senses. India will speed up the imports as its industry needs coal. Indonesia has vowed to crack down on illegal mining and impose hefty taxes to preserve its natural resources. China will have to look else where for coal: the USA.

Understanding NG Demands

I can use EIA Weekly NY Updated data to track week by week change in NG supply and demand, as in the chart below:

The NG supply and demand is summarized in the table below:

The chart below shows supplies and demands of NG during the winter, compared with past years:

In the other article, I discuss how the NG demands were affected by the warm winter and why the demands were recovering. This chart showing how NG power demand increased during the winter, but the demand gain is disappearing as summer arrives:

(click to enlarge)

I predicted that the NG storage will reach a normal peak level at 3800 BCF by the fall, not reach full capacity as some predicted.

Looking at the above chart, the NG storage appears to be on target to reach a normal peak just as I predicted.

The Overall Electricity Demand Has Recovered

The FERC data shows that overall electricity demand has recovered to well above multi-year average level:

The electricity generation was significantly below average during the summer. But starting in late April it went above average by roughly 5000 GWH per week. That translates to about 2.68M tons of extra coal demand per week.

The Data Tells Us Coal Is Bullish

It seems to me that all the factors that caused weaker demands in both coal and natural gas, and caused some utilities to switch fuel to natural gas, have either disappeared or are going away: Warm winter; weak residential/commercial demand; over-production of natural gas; attractive NG prices versus coal. All are going away. The NG power demand is going back to the main peak in the chart.

But all coal bullish factors remain: Higher coal exports will come; Natural gas production decline slowly shows up and the price rally forces utilities to switch back to coal; Coal producers continue to curtail their productions; Shorts in coal stocks still hasn't covered.

NG production is still higher than last year by only 2.7%, yet NG prices have rebounded strongly. Coal production has been curtailed massively. It is a matter of time before coal starts to rally. The coal rally was delayed only because the market has not realized the scale of coal production cuts, the recovery of electricity demand, and that the limited effect of coal-to-NG fuel switch is disappearing.

We learned the following facts from the EIA data:

• The episode of warm winter and excessive NG production depressed coal demand is now behind us, with no long lasting effect. NG demand is back to normal. Same is the electricity demand. Coal demand will follow next.
• The gain in NG consumption in the power sector does not seem to last. Many people feared that increased NG power would permanently displace some coal demand. That fear was proven false, as the NG demand gain is disappearing.
• NG production is dropping slowly; a bigger drop will show up. Natural gas prices have rallied recently as investors realized that NG demand is back to normal just as production drops.
• The massive coal production curtailments and boost of coal exports will lead to a price rebound soon.
• Investing in coal is better than in natural gas companies like Chesapeake Energy (NYSE:CHK) or EnCana (NYSE:ECA). Not to mention the ongoing controversy on shale gas.

Coal stocks like Patriot Coal (PCX) that I recommended continued to drop, suggesting that the world must be ending, as some believes. The CEO of James River Coal Company (JRCC) and Patriot Coal must be getting a lot of calls from worried shareholders asking whether they could be going bankrupt. The same pessimism existed in the coal sector in August of 2007. We knew what happened then.

Theoretically any coal companies can eventually go bankrupt if depressed coal prices last indefinitely. But based on history, and based on supply/demand characteristics of the coal sector, this industry never stays low for long. It always bounces back fiercely.

Market fear in coal is so hysterical that you might think some coal company might file bankruptcy tomorrow. If you are like me, you would let data, facts and rationality guide your investment, not greed and fear. I still recommend these great values in coal:

• James River Coal Company (JRCC)
• Patriot Coal (PCX)
• Arch Coal Inc. (ACI)
• Cloud Peak Energy (NYSE:CLD)
• Alpha Natural Resources (ANR)
• Consol Energy (NYSE:CNX)
• Black Hills Corp. (NYSE:BKH)
• Walter Energy (NYSE:WLT)
• Westmoreland Coal (NASDAQ:WLB)
• Peabody Energy (NYSE:BTU)
• Nacco Industries (NYSE:NC)
• Alliance Resource Partners LP (NASDAQ:ARLP)
• Market Vectors Coal ETF (NYSEARCA:KOL)

I am buying more coal stocks.

Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.