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2013 Natural Gas Prices May Hinge on Coal Switching

Gas-to-coal switching, which has drained some of the excess domestic gas stores, will tell the tale about 2013 natural gas prices, with gas expected to continue to gain in the first six months, while coal regains some of its losses in the second half of the year, according to Raymond James & Associates Inc.

In a note to clients last week, analysts J. Marshall Adkins and James Rollyson said the "single most important change" to the domestic gas market in the past year has been the surge in gas demand to power generation from coal.

"Coal-to-gas switching would be a fascinating case study for students of economic theory, ultimately demonstrating the price elasticity of demand of fossil fuels," wrote the duo. "Lower natural gas prices in 2012 drove utilities to switch away from coal-fired power generation and toward natural gas generation almost in lock step with natural gas pricing."

The switch by generators from coal "has been the single largest reason that the U.S. natural gas market is no longer oversupplied. In fact, we saw the largest ever fuel switching-related surge in gas-fired power demand with 4.2 Bcf/d more switching related gas demand in 2012 versus 2011. Going forward, rising industrial gas demand, stagnating North American gas supply, and normal weather should tighten the U.S. gas market to the point of reversing some of the coal-to-gas switching that occurred in 2012. Simply put, we think U.S. natural gas prices will rise enough in 2013 to drive over 2 Bcf/d of gas demand back to coal-fired generators."

In "normal" conditions, the transition coal switching would have occurred "slowly and gradually," but the "abnormally mild winter" of 2011-2012 leaves 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," which Adkins and his team forecast in late October (see NGI, Nov. 5).

"Likewise, look for a sharp year/year 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-coal-fired switching to keep a lid on natural gas prices as we move through the second half of 2013."

Raymond James' recent 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/d relative to 2012)." Domestic gas demand surged by an estimated 5.5 Bcf/d through the first seven months of this year "solely" on coal-to-gas-fired power switching, said the analysts. For all of 2012, switching should result in about 4.2 Bcf/d of switching, they noted.

"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 U.S. natural gas prices. In other words, the question now becomes, 'what gas price will reverse enough coal-gas switching to keep the U.S. natural gas market balanced in 2013?' As Adkins reiterated from his recent price forecast, "we believe 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/d that switched to gas in 2012."

A "complete reversal" back to coal won't happen in 2013, said the analysts. They expect an average of 2.1 Bcf/d of gas demand to switch back to coal next year -- about half of the switching to gas that occurred this year. "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."

Based on a plant-by-plant analysis, Adkins and Rollyson concluded that coal plant retirements have led to the permanent switching of 0.75 Bcf/d of coal demand toward gas.

Whether coal demand continues to trend down as old plants are retired remains an important question, they said. Most of the plants suggested for retirement "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."

In addition, 1,500 MW of new coal generation has come online this year, said the duo. "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" or until "other sources" of industrial/liquefied natural gas demand appear in the next few years.

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