Some power plants can switch between coal and natural gas for fuel
“Coal-to-gas switching” refers to power plants deciding to use natural gas in place of coal as fuel. Given sustained low natural gas prices, and the fact that natural gas burns more cleanly than coal, coal-to-gas switching rose for most of 2012. This trend increases natural gas demand and provides some support to natural gas prices, which helps upstream energy producers with significant natural gas production. Power producers are incentivized to use more natural gas and less coal when natural gas prices fall relative to coal prices.
In 2012, coal-to-gas switching helped support natural gas prices, but this year’s higher gas prices made natural gas give some market share back to coal
For most of 2012, natural gas gained significant market share (mostly against coal) for use in power generation. However, in 2013, natural gas prices have risen relative to coal, causing natural gas to lose some market share in the power generation sector.
Although the straight ratio of coal prices to natural gas is a simplistic way to view the amount that market share will change between natural gas and coal, it’s an easy way to at least determine directionally where market share will go. Given that the ratio of coal prices over natural gas prices has declined year-over-year for both May and June, natural gas could likely lose market share for these two months as well (on a year-over-year basis). This translates into less relative demand for natural gas, which is a negative indicator. However, note that the reason natural gas is losing market share is because natural gas prices have increased. So although decreased natural gas demand is a negative indicator because decreased demand translates into lower prices (all else equal), higher natural gas prices are actually causing decreased demand in this case.
But the industry expects more natural gas–fueled power generation in the long term
Despite the recent decline in market share on a year-over-year basis, many expect that coal-to-gas switching will continue to be a long-term trend. For example, the government agency known as the Energy Information Administration (EIA) noted in a report from December 2012 that in its forecast, coal remains the largest energy source for energy generation, but “its share of total generation declines from 42 percent in 2011 to 35 percent in 2040.” The EIA also stated that market concerns about greenhouse gas emissions continue to dampen the expansion of coal-fired capacity in its forecasts.
Investors should be cautious
Coal-to-gas switching results in increased natural gas demand, which is ultimately a positive for natural gas prices. However, investors should consider that if natural gas prices become too high relative to coal, they incentivize power producers to switch from natural gas back to coal. We saw this over the prior two months, resulting in a medium-term negative for natural gas demand. Because of the coal-to-gas switching trend, the relative movements of natural gas and coal prices are an indicator to watch for investors holding domestic natural gas producer names such as Chesapeake Energy (CHK), Southwestern Energy (SWN), Range Resources (RRC), and EXCO Resources (XCO). Additionally, if you’re interested in investing in natural gas directly through an exchange-traded fund such as the U.S. Natural Gas Fund (UNG), you may also want to monitor relative natural gas and coal prices.
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