Why the sun isn't shining on coal

The coal and railroad businesses go hand in hand. CSX and Norfolk Southern get almost one-third of their revenues from coal, Union Pacific and BNSF Railway roughly one-fourth. So when BNSF has almost 130 trainsets of coal cars in storage — think of a line of cars 150 miles long — you know the coal business is hurting.

Three phenomena are at work. One is the unusually warm winter we just experienced. The second is substitution of dirt-cheap natural gas for coal. And the third is the anticipated closing between now and 2015 of small, old coal-fired electrical-generating stations which cannot economically be retrofitted to meet tougher environmental standards.

Right now coal production is down about 15 percent from 2011 levels. Roughly three-fourths of the decline is in the east, the rest in Wyoming’s Powder River Basin. (Output in the Illinois Basin is about even with last year.)

So what’s going on? Paul Forward, who follows mining for the investment firm Stifel Nicolaus, extrapolates from data that about one-third of the drop in coal production can be explained by the warm winter. What goes around comes around, and for all I know we will have a scorching summer that has the reverse effect on coal demand by electric utilities.

By implication, the rest of the falloff in coal output can be traced to historically low gas prices. Credit hydraulic fracturing of shale formations in places like Pennsylvania, Texas, Arkansas, and Louisiana for a huge oversupply that drove gas prices to the current level of about $2.50 per million British thermal units (MMBtu). This reversed a decades-old relationship between coal and gas. Until now, says Forward, coal has been cheaper than gas when converted into electricity. But now gas undercuts coal. Concludes Forward in a presentation made earlier this month: “We will see a long-term wave of decision making by utilities to abandon coal plants and to utilize existing gas power capacity as well as make new build decisions that will be natural gas.”

It’s a good thing for railroads that their power utility customers are regulated monopolies almost guaranteed their profits. And railroads should thank their lucky stars that few if any gas providers will sign long-term contracts. Otherwise, the decline in coal usage would be not an orderly march but a rout. Analyst Anthony Gallo of Wells Fargo makes this comparison: For central Appalachian coal to be competitive, gas would need to be priced above $5.87 MMbtu instead of the current $2.50. Powder River Basin coal would require a gas price of $2.95 MMbtu to be in the running. If they choose, utilities can ignore these economic realities, for a while.

The prevailing wisdom is that gas substitution will ebb this year. Not so, contends a team of six analysts at Sanford C. Bernstein, a premier Wall Street research firm, who studied gas-for-coal substitution and its impact on railroads. This team, led by Hugh Wynne (utilities), David Vernon (railroads), and Bob Brackett (oil and gas), says today’s pricing of gas “is consistent with massive substitution” of gas for coal in 2012. The analysts forecast a drop in coal consumption by utilities of 100 million tons from Appalachia and 85 million tons from the PRB this year due to substitution..

I have a lot of respect for Wynne’s work. He was among the first to quantify two years ago the impact that new environmental regulations against mercury would have on demand for coal, particularly in the east. His longer-term forecast for coal goes like this: That massive substitution of gas will eat up the excess supply and drive gas prices higher by next year, allowing a partial recovery for coal demand. But down will go the roller-coaster as utilities close plants in anticipation of the mercury rule taking effect in 2015.

The Bernstein team’s bottom line for this year is a decline in CSX coal tonnage in the range of 16-19 percent. NS will see a drop of 14-16 percent, the team says, and UP 6-8 percent.

But guess what? Rail carloadings this year are up a bit over 2011. God must love railroads, because they are finding new business to take the place of the old. The irony is that a lot of that new business is fracking sand and steel pipe on its way to the gas fields.—Fred W. Frailey