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A Comeback for Coal?

After unrelenting bad news driven by retirements of coal-fired generation and the persistence of cheap natural gas, a round of summer reverse switching may boost the prospects for coal over the next 18 months. While there is too much surplus coal inventory to drive significant production growth in 2016, stronger natural gas pricing sets the stage for solid growth in 2017.

Natural gas storage and pricing trends

This past mild winter led to a large surplus of natural gas, keeping wintertime prices to electric generators highly competitive. This ensured that the very large displacement of coal that took place during the 2015 spring shoulder season resumed in full force once the summer ended, effectively extending coal's losses through the entire winter. Overall, coal producers lost over 135 million tons of annual production to lower coal generation. By the end of 2015, natural gas generation surpassed coal for annual market share for the first time.

For coal, a poor 2015 followed by a worse 1H 2016

2016 has started out little better, with coal dropping another 65 million tons of shipments through the end of the mild winter and into the 2016 spring shoulder season. To put the overall market decline in perspective, since coal production approached 1 billion tons in 2014, production has fallen by over 200 million tons through the second quarter of 2016, with 150 million tons of demand reduction (coal retirements and displacement by natural gas), 20 million tons of reduced exports, and 30 million tons of excess inventories.

Coming off the bottom?

But the recent rally in natural gas prices may set the stage for rally in coal demand as well. While the mild winter left natural gas inventories more than 800 Bcf in surplus and Henry Hub pricing routinely below $2/mmBtu, that surplus has been whittled away since late April. With a head start on storage fill, the market has been injecting gas at rates below normal, cutting the surplus by 40% to 524 Bcf by mid-July. Natural gas prices have responded by moving up by $1.15/mmBtu, nearly reaching $3/mmBtu at Henry Hub. Coal prices during this time have moved up much more slowly, with the market still burdened by excess coal inventories. The result is a growing price spread in favor of coal that is driving greater coal plant utilization and beginning to reduce coal inventories. This effect can be seen in slowly growing coal shipments since late June.

Correspondingly, the strong rally in natural gas has stalled shy of $3/mmBtu, suggesting that gas-fired generation is starting to give way to regional coal plants, primarily in the West, Midwest, and Gulf South where Powder River Basin and Illinois Basin coal producers are in closer price competition with natural gas. Displacement of natural gas generation resulting from this new price spread is estimated at 3.25 Bcf per day, creating a price headwind of 6-10 cents/mmBtu. Meanwhile, if pricing spreads between gas and coal implied by the forward strip hold, incremental demand for coal could grow by 74 million tons over the next 18 months, sufficient to clear excess inventories and finally spur new coal demand.

Despite a drawdown in coal inventories, power plants are still expected to have a surplus at the end of 2016, keeping coal prices low. These factors – higher natural gas prices and the lagged response of coal in terms of inventory reductions – create the conditions for a rebound in 2017coal production that will at least partially lift it out of the steep hole created by 2015-2016 dislocation from natural gas.