Is It Coal's Turn for a Price Spiral?

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Regardless of whether or not your occupation has any connection to the energy industry, as consumers you are well aware of the significant increases in natural gas and oil prices over the last few years. The cost of a full tank fill up at the gas pump now approaches what we used to spend on groceries for an entire week, and consumers living in colder climates also noticed increases in home heating bills this past winter! Not so visible, however, have been the recent increases in the cost of another important energy source, which could lead to even higher out-of-pocket increases for consumers. Among the data in the latest U.S. generation and fuel consumption report recently released (5/16/05) by the U.S. DOE-EIA is the fact that the average cost of coal delivered in January at electric power generating plants was $1.46 per mmBtu, a 5-cent increase, or 3.5%, compared to December of 2004. More importantly, the 12-month increase over January of 2004 was 17 cents or 13.2%. However, to put those increases in perspective, the corresponding increase in the delivered cost of natural gas for power generation from January 2004 to January 2005 was 29 cents per million Btu, and prior to that, gas had increased about $2.50/mmBtu over the last few years. So these coal price run-ups pale in comparison to what has happened on the gas and oil side of the energy business. Fortunately for us electricity consumers, natural gas price increases have not had much impact on the average U.S. retail electricity price, as the DOE data also shows that the average annual retail electric price has gone up less than 10% in the past decade. But coal fuels over 50% of the electricity produced in the U.S., so that these recent coal price increases will likely be passed on to the consumer and will show up in our electricity bills in the near future.

These coal price increases come at a time when there is considerable renewed interest among power producers in building new coal-fired generating plants (see May 25, 2005, news article - Development of New Coal-Fired Generation Continues to Grow – But How Much Will Actually Be Built?). In fact, the first few new coal-fired plants from this new wave of interest have recently come online or entered construction. Is this coal price rise indicative of a trend that could derail plans for new coal units, or is it just a bump in the road? Before we call our brokers to load up on shares of coal company stocks, a look at the history of coal prices may reveal some interesting trends. The average U.S. delivered price of coal declined each year from 1991 through 2000, bottoming out at $1.20 per million Btu. Looking back further, the average mine-mouth coal cost peaked in 1975 and has been on a steady decline since 1979. A fundamental economic theory is that lower prices are caused by reduced demand. But at least during the 1990’s, a lack of demand for steam coal from power generators cannot be blamed, as the total volume of coal consumed for power generation increased each year from 1991 through 2000. The total increase during this period was over 25%, for a respectable compound annual growth rate of 2.5%. Therefore, the traditional economic price-demand relationship was inverted, as the price decreases in the 1990’s occurred despite relatively strong demand for coal from the power sector! There are many other possible reasons for this downward trend: improved coal mining productivity, greater usage of low cost coals such as lignite and low-sulfur western coal, reduced demand from non-power industries, among others, but also the low prices of gas and oil. Most steam coal is bought under long-term contracts. During the 1990’s, the prices of gas and oil were very low. The low gas prices, along with technology advances improving the output and efficiency of gas turbines, suggested that gas was not only cleaner, but was also a more economical choice for new power generation. In fact, late in the decade, the infamous gas turbine building boom started. Also, oil is a significant cost component in the mining and transportation of coal. These factors, along with increased mining productivity, placed the coal producers at a disadvantage upon renewal of any contracts that expired during the 1990’s. So, lower prices and lower delivered coal costs resulted.

Click on the image at right to view Chart 1.

Then along came the new millennium and, with it, a reversal of the downward coal cost trend. During each year since 2000, the average delivered cost has increased, and the total increase in those four short years is over 13%, or about 3.2% per year. Chart 1 starts at 1991 and shows the decline, the bottoming out, and the upswing since 2000. It must be pointed out that there was a major change in the DOE data reporting classifications in 2002, such that comparisons of costs between years prior to 2002 and after 2001 could be misleading. The change related to the inclusion of Independent Power Producers and Combined Heat and Power producers in the fuel cost data, starting in 2002. Because these latter categories generally pay higher costs for coal than the high volume electric utilities, the overall average price probably was higher in years prior to 2002 than shown, so that perhaps the actual bottoming out occurred in 2003. But the data starting in 2002 is consistent, and since then the average annual price has increased 11 cents per mmBtu or 8.8%.

Click on the image at right to view Chart 2.

Chart 2 shows the monthly delivered cost for each month in the last two years, plus January of 2005, along with the annual averages for 2003 and 2004. As expected, the monthly data show some cyclicality, as there are monthly increases and decreases and successive months of no changes. But, in general, the trend is upward, and the 24-month increase is nearly 17%! It is also evident from chart 2 that most of the increase since January 2003 has occurred in the last seven months!

Why did this happen? Was it demand? As mentioned, the 1990’s saw declining prices despite relatively healthy growth in the demand for steam coal, but from 2000 through 2004, the total increase in demand, as measured by the annual consumption for power generation, was 3.5%, or less than 1% per year! There was even a year of negative growth in 2001, as a soft economy was made worse by 9/11, resulting in a decrease in economic activity and reduction in demand for electricity of 1.7%. But even since 2001, the total increase in steam coal consumption has been 5.8%, or only 1.9% per year! So once again the traditional price-demand relationship has not held, as the recent price increases have occurred during periods of relatively modest demand for coal! Unlike during the 1990’s, any long-term coal contracts that expired in the last few years expired at a time when the prices of gas and oil were high. Unlike a short-lived gas price spike in early 2001, high gas prices have been sustained, and, as a result, have effectively terminated the gas-fired power project building boom. High gas prices have given coal producers the upper hand at the bargaining table at contract renewal time. Also, the cost of oil has certainly increased both the mining cost and the cost of coal transportation. Despite relatively soft near-term demand, spurred by the gas price run-up, coal producers have remained optimistic on the long-term outlook and have made significant investments in new plants and equipment. This renewed bargaining power has enabled these costs to be rolled into the new contracts, as well.

How long will the price continue to increase, and how much higher will it go? Could there be a leveling off, or even a decline? There has been a lot of publicity about all of the new gas-fired generation that has been built and how that will result in much additional gas being burned for power generation. But that boom has been significantly delayed and reduced in capacity. With natural gas at $6.00/mmBtu and higher, not even the new highly economical combined-cycle gas-fired plants can displace coal or nuclear power for base load energy. Even if the optimistic plans for LNG imports into the U.S. are fulfilled, will LNG producers accept prices much lower than the market price of natural gas? So, with a few exceptions, gas-fired plants will be relegated to intermediate and peaking duty and, as a result, will not provide a significant increase in electric energy generated – or, stated another way, will not displace much energy from the traditional base load stalwarts of coal and nuclear. Although there is also a renewed interest in new nuclear plants, the nuclear industry does not expect to have any new units online before 2015.

How about renewables? Late last year, the federal government renewed the production tax credit for development of wind energy through the end of 2005. In addition, about twenty states have mandated renewable portfolio standards that dictate the minimum capacity of renewable electric generating sources (wind, biomass, solar, etc.) that utilities must own or procure through power contracts. Although these sources have low variable costs and perceived environmental advantages, they are, in general, relatively small in total capacity, compared to large coal and nuclear plants. In addition, their operation is dependent on weather conditions, so they are classified as “non-dispatchable,” or intermittent. As a result, utilization rates of 20 to 30% are considered high for these technologies, and, therefore, their energy contribution will also be very limited.

If electric demand increases uniformly across the load duration curve, there will be growth in the base load that will have to be met by both underutilized existing coal units and the proposed new coal units. There is recent interest in IGCC plants, which can burn coal cleanlier than traditional pulverized coal boilers. New IGCC projects have been announced, and development of this technology would offset many of the environmental issues that could derail the growth of conventional steam coal.

More than 100 new coal-fired power plants have been proposed across the country, and the federal government is predicting a 25% increase in the amount of U.S. energy derived from coal by 2025. These factors suggest that future coal prices will again follow the more traditional price-demand equation and will continue to increase along with demand. This is yet another reason to start building nuclear plants again!

For more information on capital spending in the Power Industry check out Industrialinfo.com's 2005 Power Industry Forecast.

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