Interfuel Dislocation: Coal/Gas Switching May Hit a Breaking Point In 2016

During several months in 2015, the market share of natural gas generation exceeded that of coal-fired generation as a combination of mild heating season weather and retirement of coal plants nudged natural gas into the lead position. If 2015 represented a turning point in this respect, 2016 is poised to become an all-out rout, with significant consequences for both fuel markets over the next few years. The combination of weak electricity demand growth and the slow but steady expansion of renewable generation has constrained both coal and natural gas producers, leaving them with few options but to compete with each other ever more directly for electric generation.

In hindsight, the three winters spanning 2011-2014 supported steady, if not growing, demand levels for coal that masked its vulnerability to price shocks from natural gas surpluses. Coal demand only bounced back modestly from 2011, as more stable natural gas prices were offset by the leading edge of coal plant retirements and the inability of coal to increase generation much against gas fired generation. However, during the mild winter of 2014-2015, natural gas producers quickly made up supply deficits left over from the polar vortex, and natural gas prices began to decline rapidly.

The U.S. Federal Reserve's end to bond-buying under its so-called "QE3" monetary intervention also had an incremental impact, by reducing credit available for oil and natural gas flows throughout their respective value chains. This October 2014 Federal Reserve shift also strengthened the U.S. dollar, marking the first leg down in crude oil prices almost immediately. The pricing step-down spilled over to natural gas by December 2014.

With these pieces in place, coal markets were confronted in 2015 with a severe demand shock coming from natural gas that traded below $3/MMBtu at Henry Hub and below $2/MMBtu in the Marcellus shale producing region. Since then, natural gas availability has grown continuously, and the surplus of gas in storage accelerated toward the end of 2015.

Overall, the 2015-2016 winter has again been mild. The U.S. Energy Information Administration natural gas inventory report for the week ending March 4 outlined a pull of 57 Bcf from storage. As with most weekly pulls this winter, the withdrawal was small in comparison to the five year average for the week. As shown in the chart below, the storage surplus is estimated at 846 Bcf, putting total storage levels in contention for record natural gas inventories at winter's end. Season-ending storage appears poised to come in near 2.5 Tcf, similar to March 2012 levels. To put the surplus level in perspective, it represents enough natural gas to supply the generation sector for more than one month.

While demand for natural gas generation has expanded significantly since 2012, the cost curve for today's natural gas has become far more competitive, as indicated by the far longer stretches of the winter season when Henry Hub priced below $2/MMBtu. Even without the current surplus, S&P Global Market Intelligence estimates Henry Hub prices would be closer to $2.70/MMBtu, with Marcellus/Utica shale gas pricing at a 70 cent/MMBtu discount.

Looking ahead to mid-year, today's natural gas pricing will spur significant additional demand from natural-gas fired generation, nearly 2.5 Bcf/day above 2015 levels. Combined with slower production growth from shale plays as a response to the low price environment, surplus natural gas in storage is expected to erode to a more manageable 300 Bcf by July or August. A more modest storage surplus combined with summertime demand should support Henry Hub spot prices higher than $2.50/MMBtu.

Natural gas supply stands ready to reduce annual coal demand sharply during the spring and fall seasons. Summer electricity demand provides a modest boost to coal plants, and pricing differentials to natural gas through winter provides a secondary boost. In this view of the fuels markets, S&P Global Market Intelligence projects that natural gas will take the lead in generation market share for the foreseeable future.

At the same time, a coal plant fleet that is static or slowly shrinking in size and ceding a portion of electricity demand growth to expanding renewables results in a smaller overall coal market than coal stakeholders envisioned five to 10 years ago. Appalachian thermal coal — effectively priced out of the domestic market — will principally serve export and metallurgical demand going forward, with the possible exception of niche minemouth coal plants. Coal mines in Colorado and Utah face rapid decline as well, with few prospects domestically. Rockies-sourced coal will increasingly serve a specialty export market for low-sulfur bituminous users. The market share of producers in the Powder River Basin and Illinois Basin will grow to become the predominant suppliers of a lower-volume steam coal market.

S&P Global Market Intelligence estimates the domestic steam generation market in the long-term averaging 685 million tons per year, nearly 300 million tons per year lower than 2014. This translates to total U.S. coal production, including non-electric end users, exports, and metallurgical, of approximately 800 million tons per year.

The severe surpluses of 2016 are likely to drive coal and natural gas markets to a new point of equilibrium. Natural gas is now priced so low that the increase in gas generation will almost certainly stabilize and boost prices through the remainder of the year. At the same time both fuel markets are oversupplied, with only slight prospects for relief from overall generation demand growth in the near term. This has caused coal and natural gas to remain in a direct zero-sum competition for generation market share. Natural gas producers have the initiative in this race to the bottom, but both coal and natural gas producers have reserves enough to remain in competition for the near future, such that a significant increase in the price of one can motivate a production response on the part of the other.

With regard to natural gas, shale gas is in the early stages of a production slowdown. The industry's major test will be the ability to respond when gas generation demand ramps up sufficiently to erase the current surplus. Will shale producers respond to the upward price signals at that time? Production growth from the Marcellus region continued strong against weak natural gas price signals when crude oil prices held above $100 per barrel. If the oil market rallies later in 2016 as some expect, wet gas producers appear ready to respond with increased production of natural gas liquids. This will tend to offset cuts in natural gas production elsewhere.

Coal, by contrast, will cede significant portions of the generation market in the Mid-Atlantic and Southeast, while making modest gains in more traditional mid-South and Texas regions. S&P Global Market Intelligence expects that after giving up ground in 2016-2017, coal producers will regain generation market share in the Midwest post-2017. From that point, the industry should have a pretty good idea how much it can grow from a base production of 800 million tons per year.

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Aug 08, 2016