Even as summer heat is bolstering air conditioning load and, consequently, power and coal demand, high coal stockpiles are muting the upside for coal prices. With coal prices subdued and gas prices climbing, coal producers may not receive the proper price signals to increase supply to match higher levels of demand. As a result, coal shortages are possible, perhaps even likely next year.
Displacement of coal-fired generation by lower cost combined cycle units has driven a dramatic decline in US coal production. Indeed, coal output through June 2016 is off a staggering 33% compared to the same period just two years ago.
Coal producers have responded to slackening demand in various ways: mine closures, employee lay-offs, cutting back on hours worked and prolonged periods of low capital expenditures. According to the Mine Safety and Health Administration (MSHA) reporting, the number of employees at Powder River Basin (PRB) mines – the largest producing US coal basin - has declined by more than 15%, dropping from about 6,500 to 5,500 over the last two quarters.
Consequently, quarterly production has fallen from about 100 Mst to about 75 Mst for the PRB. Based on the current level of employment – assuming productivity can return to historic norms – we forecast 85 Mst of quarterly PRB production. At that rate, PRB production in 2016 and 2017 would end at about 310 Mst and 340 Mst, respectively; compared to over 400 Mst in 2015.
Low gas prices in 2015 and 2016 have had a similar impact on gas producers; the number of active drilling rigs have fallen 65% since the beginning of 2015. We project that the bottom of the gas market is behind us and gas prices will rise to cover the marginal cost of drilling new wells, at a minimum. Our forecast also shows that natural gas prices will average nearly US$3.60/mmBtu in 2017, and with higher gas prices, we expect coal consumption to increase considerably in 2017. In fact, annual coal demand in 2017 will be more than 400 Mst, even considering a historic 50 Mst draw down in coal inventories.
In our H1 2016 base case, we assume that significant latent capacity exists and production rates similar to 2015 are achievable. In that case, the market should balance nicely. Prices will strengthen slightly, with new contract prices continuing to be settled in the US$12-13/st range, and bloated stockpiles will shrink to more normal levels, from over 60 full burn days to around 40 full burn days. However, our base case assumptions are reasonable only if coal producers can increase production quickly. Higher mine output requires bringing thousands of miners back to work, repositioning and re-starting idled equipment and adjusting mine plans. We do not doubt that miners have the ability to expand production over time, but the question is: how quickly can they ramp back up to take advantage of improved market conditions?
Unfortunately, coal producers are receiving little if any encouragement to prepare for an increase in demand. Year-to-date in 2016, the amount of coal delivered classified as ‘"contract"’ is 27% lower than in 2015. The percentage of coal under long-dated contracts is running about 10% lower than average over the previous four years. The result could be a severe shortage of coal with the potential to spike coal prices. Based on the our estimates for natural gas prices, PRB prices as high as US$17/st could be justified.
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