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Exports boost coal prices as domestic markets lag

Coal shipments remained steady through September, aslingering summertime demand drove gains in spot prices for natural gas. Coalprices opened the month soft with strong spreads to natural gas helping to boostshipments and draw down inventories. However, by the third week of Septemberthe global rally in coking coal driven by new Chinese import demand spread toU.S. thermal markets as well. The NYMEX CAPP prompt-month benchmark gained$1.63/ton, or 4.0%. NYMEX PRB continued its surge from August, gaining anadditional $1.40/ton, or 13.2%. The Illinois Basin OTC mark also jumped onexport demand, gaining $3.35/ton, or 11.4%. Physical markers, more reflectiveof domestic spot activity, showed flat to lower movement during September.

Natural gas prices remained firm in September, providingsupport for continued coal burn. The natural gas storage surplus shrank steadily,declining 114 Bcf through Sept. 23. If injections continue at the August and Septemberrate, storage levels will end October at approximately 3.8 Tcf, 200 Bcf lowerthan last year's season-ending level. With fears of a season-ending surpluseased, Henry Hub spot prices averaged $3.00/MMBtu during the month, rallying ashigh as $3.19/MMBtu before closing at $2.98/MMBtu. As pricing spreads betweennatural gas and coal remain favorable to coal in several regions, gas-to-coalswitching for electric generation will limit price growth in natural gasthrough the shoulder season.

August-ending coal inventories have been estimated at 164million tons, approximately 10% above normal levels. If natural gas pricesremain firm through October, coal burn should be sufficient to reduce surplusinventories by an additional 4 million tons. This rate of improved burn couldget inventories back to normal levels by summer 2017.

The chart below shows the current price forecast for the PRB8800 and 8400 markers.

As the largest single coal-producing region, and as theregion having the greatest geographic reach, the PRB has been vulnerable tolarge-scale cutbacks to balance the market over the past two years. But theregion also has the greatest capability to grow production as market conditionspermit. With the rally in natural gas prices, PRB 8800 forwards have moved upto levels above $12/ton through 2018. While the surplus in coal inventoriesshould clear by that time, PRB will have used much of its "headroom"against a higher natural gas strip after factoring in transport costs to plantsin Texas and the Midwest. Combined with further coal retirements in the West,renewed pricing competition against natural gas will tend to limit pricing anddemand growth past 2018.

NYMEX CAPP and physical NAPP pricing held relatively firmthrough the first quarter of 2016 and discounted heavily during the secondquarter shoulder season. ILB markers discounted earlier in the year, bycomparison, and held relatively firm during the shoulder season. Despite a higherlevel of shipments and better export volumes, the inventory surplus worked tokeep prices in check during August. The second half of September saw strongerpricing in bituminous coal, with a surge in higher-btu Central Appalachianbenchmarks. This export-led rally may further boost coal for domestic use.S&P Global Market Intelligence expects bituminous coal discounts willremain in place through 2017 as the region works to build sustainable volumes.However, further price growth in the Appalachian markers will be limited byintra-basin competition and flat-steam generation volumes at least through2021. A similar scenario is projected for Illinois Basin coal as it recoversfrom 2016 market losses to regain market share from Appalachian coal andcompete with Powder River Basin coal.

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The above chart indicates price discounting in bituminousmarkets through 2017, with upward movement to 2019 as supply adjusts to lowerequilibrium inventory levels. S&P Global Market Intelligence expects pricegrowth across the bituminous markets will be limited after 2018, as generationdemand is expected to fall by more than 70 million tons from 2015 levels andexports to fall 15 million tons below 2015 levels.

Coal production anddemand

For the four weeks ending Sept. 24, coal shipments averaged15.8 million tons, only slightly less than August. Year-to-date production is23.9% lower than the same period in 2015, a continued improvement in theyear-over-year shortfall reflected in stronger recent demand. While shipmentsare likely to decline seasonally during October, the higher natural gas priceswill support continued shipments at levels exceeding 15 million tons per week.S&P Global Market Intelligence expects the higher forward strip for naturalgas will add tonnage to the domestic steam market via reverse switching in2017. Even so, the CAPP and NAPP regions are projected to lose 40 million tonsof annual production in 2016 from 2015 levels, while the Southern PRB's marketwill shrink by 104 million tons. Electric-sector demand as a whole in 2016 isprojected to fall to 620 million tons, 153 million tons lower than 2015.

The chart below compares the current production forecastwith recent history. As noted above, electric-sector coal demand is projectedto fall by 153 million tons from 2015 to the end of 2016 before rebounding onmodest electricity demand growth and improved price spreads against natural gasgeneration. However, natural gas will remain competitive with coal for severalmonths of the year. Combined with additional coal retirements in forward years,S&P Global Market Intelligence projects coal generation demand levels at orbelow 700 million tons per year through 2022. Accounting for the expectedrecovery in production and restoration of normal inventories in 2017-2018, theoverall coal market, which includes domestic demand and exports, is projectedto shrink by 105 million tons from 2015-2020.

Production outlook Powder River Basin

S&P Global Market Intelligence projects 117 million tonsof lost production in the PRB compared to 2015, with surplus coal inventoriesstifling near-term demand. Higher natural gas prices will work to reduceinventories in the latter half of 2016 and set the stage for a rebound in 2017,albeit at lower levels than seen historically. Powder River Basin 2016production (northern and southern) is projected at 288 million tons. Demandlevels for non-PRB western and interior (Texas and Upper Midwest Lignite) coalhave held firm, limiting growth opportunities for PRB 8400 mines. However,these mines will benefit the earliest from favorable price spreads againstnatural gas, with surplus inventories likely to clear by the first quarter of2017 under a normal winter and greater volume growth thereafter.

Production outlook Illinois Basin

During the summer of 2015, natural gas pipelineimprovements, most notably the flow reversal of the Rockies Express pipeline,allowed more natural gas from shale to compete in Midwest generation marketsthan was possible previously. During the first half of 2016, this additionalmovement of natural gas at low prices greatly reduced Illinois Basin coal plantburn. The drop in exports this year has been an additional contributor to theweakness in this market. S&P Global Market Intelligence forecasts 2016 ILBproduction at 93 million tons, a 31 million ton decline from 2015. As with PRBproduction, the higher natural gas prices that kicked off this summer areexpected to support a rebound in coal production into 2017. Coal and naturalgas prices are expected to re-align in 2017-2018, limiting further marketgrowth. Growth in Illinois Basin volumes post-2018 will depend on displacingAppalachian coal and export market growth.

Production outlook Appalachian basins

The reduction of Appalachian basin production to coremetallurgical and local steam markets has continued. While demand ininternational metallurgical markets has been reduced through the first half of2016, it is the erosion of the long-haul steam market, particularly in CentralAppalachia, that has driven production declines. S&P Global MarketIntelligence currently expects 2016 production will total 176 million tons, or20.8% less than 2015 levels. After a modest rebound due to reverse-switching in2017-2018, resumption of natural gas competition is expected to drive 2019production down to 170 million tons. Metallurgical coal production hasgenerally been firmer than production for domestic steam markets, maintaining acore of domestic and "local international" markets of approximately50 million tons per year. This number could grow if increased Chinese importsof met coal seen over the last quarter drive a sustained boost in seabornemarkets.

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Coal forecastmethodology overview

Market-indicative coal forecasts produced by S&PGlobal Market Intelligence represent forward curves for spot-tradedinstruments, analogous to a strip of contracts, with shorter tenors (currentyear, prompt year, plus additional years if available) driven by the observedor assessed market, and longer tenors (typically years 3-20 for physicallyassessed markers and NYMEX futures) driven by fundamental estimates of cashcosts of production, accepted returns to capital, regional productive capacityand forecast supply and demand. For the long-tenored portion of the curve,S&P Global Market Intelligence forecasts prices for specific coal markersand defines the remaining markers via historical spreads.