This week the good folks at the Raymond James’ energy research desk put out a very solid take on what it’s gonna take, price-wise, for generators to move away from natural gas and back to burning coal. Marshall Adkins’ crew at Raymond James has put a good deal of time into this topic over the past 18 months, and have called it fairly well so far. Just saying. – the editor.

“Over the past year, the single most important change to the US natural gas market has been the huge surge of gas demand related to power generators switching away from coal toward natural gas. Through just the first seven months of the year, we estimate that US natural gas demand has surged by a whopping 5.5 Bcf/d, solely due to coal to gas-fired power switching, and for the full year, we expect 4.2 Bcf/d of switching. It is primarily this fuel switching-related gas demand that has allowed a severely oversupplied gas market to rebalance via lower gas prices. As gas supply growth slows, industrial demand picks up and weather normalizes, it will be the reversal of this price–induced, coal-to-gas switching that will be the most important determinate of 2013 US natural gas prices. In other words, the question now becomes, “What gas price will reverse enough coal-gas switching to keep the US natural gas market balanced in 2013?” Raymond James says.

In a related bit of research last week, Raymond James believes that an average natural gas price of $3.75 in 2013 will be needed to reverse over 2 Bcf/d of the 4.2 Bcf/day that switched to gas in 2012.

Looking back, it was largely due to the rapid growth in US natural gas supply, combined with a record mild Winter, that left the gas supply/demand equation severely overbalanced in early 2012. As a result, natural gas prices tanked to decade lows, ultimately breaching the $2/ mcf threshold in April. As gas prices fell, utilities had an incentive to burn cheaper natural gas relative to contracted coal, Raymond James notes. Year-to-year switching peaked at nearly 7 Bcf/d in May and should average about 4.2 Bcf/d for the full year, they add.

“As you can clearly see in the graph above, the coal-switching equation is incredibly sensitive and tightly correlated to natural gas pricing. For example, the recent gas price rally has already begun to narrow switching levels since the max in May. Given the high correlation of gas prices to coal-to-gas switching (~95 percent since 2011), we expect the trend will hold up going forward. If we assume the correlation remains extremely consistant we can back into the gas price that will be needed to balance the gas system in 2012. As shown on the next page, our latest gas price forecast should result in an average of 2.1 Bcf/d of switching away from gas and toward coal in 2013 (in other words, gas demand falls more than 2 Bcf/day relative to 2012). Of course, any significant deviation from our pricing forecasts would likely result in a similar divergence from our switching forecast given the extreme price sensitivity of power producers. Note that the shape of the switching curve (in red) is almost an inverse of the switching curve last year, even though the expected magnitude of switching reversal is roughly half of the 2012 switching.”

Image

What gas price points are important and who benefits? Another way of analyzing the gas price sensitivity of coal-to-gas switching is to examine the pricing dispatch curve for different types of coal, Raymond James says. Each of the main regional coal types has different economics based on some common characteristics such as energy content, sulfur content and distance from the end user, i.e., transportation cost. “In order to come up with our estimate, we look at delivered fuel costs at utilities, adjusted on a natural gas equivalent basis ($/MMBtu). With natural gas prices now having recovered to levels well above $3.25, it appears that the majority of Powder River Basinfueled power plants should be in the clear. Likewise, at our recently revised 2013 gas price estimate of $3.75/Mcf, a high percentage of plants burning coal from the Illinois Basin should become economic again. This leaves Appalachian coal-fueled plants that still require higher natural gas prices (we think $4.50-plus/Mcf) in orderto dispatch ahead of natural gas once again, depending on the specs, price, and distance traveled. As a result, our long-term gas price expectation of $4.25/Mcf likely leaves some remaining coal plants running at reduced utilization levels.”

The chart below points out how PRB-fueled coal power plants (far right) should dispatch ahead of combined cycle natural gas (CC Gas) in both RJ’s 2013 ($3.75/Mcf) and long-term ($4.25/Mcf) gas price forecasts. From there, you can see the ILB is close to CC at RJ’s 2013 gas price outlook and more favorable under its long-term view. Central Appalachia is the only region that still struggles against gas under the long-term price view, at least at prices that keep recent CAPP coal production levels intact, RJ notes.

Why won’t we see a complete reversal of the coal-to-gas switching that occurred this year? “We expect an average of 2.1 Bcf/day of gas demand to switch back to coal in 2013. This compares to an average of about 4.2 Bcf/day that will switch from coal to gas in 2012. So, if gas prices are rebounding to near 2011 levels, the obvious question is why won’t all 4.2 Bcf/day switch back to coal in 2013? The answer is twofold. First, coal contracts previously entered into by utilities have artificially kept coal burn higher than what pure spot price economics would have suggested. In other words, coal utilities have been forced to take minimum volumes agreed to by contract, despite less favorable economics. Secondly, coal plant retirements in 2012 and 2013 will mean that a portion of the 4.2 Bcf/d of switching will be permanent.”

ImageRJ noted in the report that they conducted a plant-by-plant analysis and concluded that coal plant retirements have led to the permanent switching of 0.75 Bcf/d of coal demand toward gas.

Will coal demand continue to trend downward as old plants are steadily retired? “This is an important question for coal investors and something many struggle with as the EPA has continued to tightened the screws on coal-fired plants. While there is admittedly a fair number of coalfired plants scheduled to retire, most of the plants on the cutting block are older, less efficient coal plants that have already experienced significant utilization reductions due to lower natural gas prices. As such, while these retirements obviously do not bode well for future growth, the incremental hit to coal demand is likely much smaller than the plant capacity might otherwise imply. Also, believe it or not, there has been 1,500 MW of new coal generation that has come on line so far this year. This additional capacity, combined with potentially higher utilization at existing, more efficient plants, should help put a lid on gas-fired power plant gains in the near term, at least until other sources of industrial/LNG demand come to fruition over the next few years.”

Image

So, the bottom line is that while switching by power producers away from coal and toward gas has been the single largest reason that the US natural gas market is no longer oversupplied, Raymond James says rising industrial gas demand, stagnating North American gas supply and normal weather should soon tighten the US gas market to the point of reversing some of the coal-to-gas switching that occurred in 2012. “Simply put, we think US natural gas prices will rise enough in 2013 to drive over 2 Bcf/d of gas demand back to coal-fired generators. Normally, this transition would occur slowly and gradually through the year. However, 2012’s abnormally mild Winter is leaving 2013 well positioned for sharply higher natural gas prices (and gas-to-coal switching) this Winter. That means investors should expect a sharp spike in gas prices this Winter and lasting into the Spring. Likewise, look for a sharp y/y decrease in switching-driven gas-fired generation demand beginning this Winter and lasting though the Spring. At the end of the day, look for gas to coalfired switching to keep a lid on natural gas prices as we move through the second half of 2013.”