It appears natural gas prices bottomed at $1.91 per thousand cubic feet (Mcf) on April 19th. A surprising rally began that carried prices to $2.74/Mcf by late May. The rally was driven largely by expectations for natural gas to continue growing its share of the power generation market from coal-fired plants.
Low natural gas prices have made it easier for electric power generators to use their gas-fired plants instead of coal-fired ones, not only because the cost of the fuel was lower but also because gas plants produce fewer greenhouse gas emissions.
At various meetings, power company executives have been quoted saying that they have been using their gas-fired peaking power plants for base load electricity generation due to the lower cost of the fuel. As a result, according to the Energy Information Administration (EIA), the share of power generated by burning coal recently fell to 34%, the lowest of any month since 1973.
The peak share of coal-fired power generation occurred in 1985 and remained high for most of the 1980s when natural gas was restricted by law from being burned as a boiler fuel due its perceived shortage. Once fuel-use restrictions were removed by the Reagan administration, natural gas steadily gained market share in the power generation market, principally due to its use for peaking power plants, which have been concentrated on combined cycle gas turbines (CCGT) as the cheapest and most efficient plants to meet this need. These peaking plants can ramp up to peak generating capacity rapidly enabling their use to meet electricity demand surges. These are also the preferred backup plants for renewable power facilities that are by their nature variable in their power output and thus create periods when power supply surges are needed.
As natural gas prices have fallen in recent months and the government continues to wage a campaign to restrict the use of coal-fired power plants, CCGTs have been the electric power industry's preferred response for meeting demand. The result has been that the share of power generated by natural gas has risen to about 30% from its historical (1973-2012) average of 15.5%. This gain contrasts with coal's loss of market share. In March 2012, coal only produced 34.3% of all power generation for the month, which is down from its historical average of 50.3%.
The impact of the market share gain by natural gas has been a significant increase in coal inventories at power plants. In March, coal stocks at power plants totaled 196.4 million tons, up 18% from March 2011. This was the highest monthly total since November 2009. The March inventory is unusual for this time of the year as typically coal stocks peak in late fall and late spring.
As a result of the build-up of coal stocks and the market share gain by natural gas generation capacity, coal prices declined. A chart prepared to accompany an article published by The Wall Street Journal shows how natural gas and coal prices, based on British thermal units, converged in the second half of 2011 and then actually came together in 2012. The recent rebound in natural gas prices appears to be opening a window for coal to regain some lost power generation market share. That relationship is best demonstrated by the chart in Exhibit 12.
Energy Intelligence has calculated the value (Exhibit 13) at which it makes economic sense for a power plant operator to switch from burning natural gas to burning coal. As shown in that chart, natural gas prices (in red) have rebounded and are moving toward the indifference value (in blue) between coal and gas. At that point, power plant operators may consider other factors besides just the economic cost of gas versus coal. Will the regulatory pressures on power plants to stop burning coal become a more important factor in raising the blue line?
The increase in natural gas demand, due to its greater use as a fuel to generate electricity has been a pleasant, surprise. The industry is hoping for increased industrial use and possibly for natural gas to become a significant transportation fuel--markets perceived as providing more stable demand and potentially offering new growth opportunities. Recent natural gas gains in the power generation market may be limited in the future due to the decline in coal prices and the buildup of coal inventories.
If the natural gas industry can demonstrate it can increase reserves and production at current low prices, then there may be hope for gas to carve out a larger and more permanent share of the energy supply mix. The jury is still out about the economics of natural gas.
G. Allen Brooks is Managing Director of Houston-based investment banking firm Parks Paton Hoepfl & Brown. This article originally appeared in the June 5, 2012, issue of PPHB's newsletter "Musings from the Oil Patch."
