Friday, October 30, 2009

Temporarily Switching Power Generation to Natural Gas

I read an interesting article last week in the Denver Post about the recent phenomenon of electric power generators using more natural gas than usual over the past few weeks. Of course the reason is the depressed price of gas. But the article gets into more of the "whys" of the switch.

One thing the article pointed out is that power generators buy 90% of their coal through one to two year fixed contracts. Since power generation is about the only customer for coal these days, it leads to less short-term price volatility, but it can lead to big swings as the pricing power swings between the customer and the producer. Producers buy about half of their natural gas supplies on the spot market. Over the summer, spot gas was cheaper than coal on an equivalent energy output basis, so many electricity producers used less coal and bought more gas. Unfortunately for the power generators, the coal contracts are pretty much set, so the hoppers of coal keep coming. As a result of the partial switch to gas and the lessened use of electricity in the recession, the power generators are left with huge stockpiles of coal. As the chart below shows, stockpiles at power generation facilities are much higher than they have been for the past five years.

Electric Power Coal Stocks, Jan. 2006 - July 2009

Unfortunately the data from the EIA is only through July 2009, which was before the spot price of gas really plummeted. To try to look forward a couple of months, I took the EIA coal stock data for the past two years and compared it with the average monthly Henry Hub spot price for natural gas on the chart below to see if there was any visual correlation.

As the chart shows, a correlation appears once the spot price for gas drops. This quickie analysis points to another month or two of rising coal stockpiles, but it also shows the temporary nature of this fuel switch, also pointed out in the DP article. Once gas prices start their seasonal rise as gas storage begins to deplete, the power generators likely will switch back and start whittling down their mountains of stockpiled coal. If, however, natural gas production increases from shale keep the spot price of gas low or if Congress passes a meaningful carbon reducing energy policy, coal producers might be in for a tough time when it comes time to renegotiate supply contracts with power generators.

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