Three Energy Trends at Work

 | Apr 28, 2014 | 5:30 PM EDT
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In energy, it is important to understand where the industry is heading. While no one can accurately predict, several trends appear to be exerting an influence. Understanding these trends will help long-term investors formulate strategies. Today I'll discuss three trends, and I'll discuss others on Friday.

Coal Will be Dethroned

At first, it will be a burst. Then it will be a slow fade. By 2016, tens of thousands of megawatts of capacity will permanently retire. Dozens of power plants will be decertified, and then they will be demolished. After 2016, coal-fired power plants will retire one at a time. A decade from now, coal will remain part of the fleet, but it will not be the dominant player.

Three drivers are nudging coal out of the markets. The first driver is economics. Coal is no longer the fleet's cost leader. From mine mouth to light bulb, coal is labor intensive and expensive.

The second driver is regulation. Federal, state and local governments lost patience with the industry. For decades, the coal industry took natural capital as a free economic good. These companies polluted the state's air with particles, dust, volatile organic compounds, lead, mercury, sulfur, carbon monoxide and a host of other toxins. They polluted land by stripping mountaintops and leaving thousands of acres of ash ponds, tailings and other residuals. They polluted rivers, streams and aquifers with toxic leachates. Compared with other industries, the coal industry has paid little to use and consume the states' natural capital. That is about to change.

The third driver is public trust. Companies rely on public trust as an important part of their branding. It is also an important component of their balance sheets' goodwill. As younger chief executive officers replace the old guard, more and more will decide that coal is simply not worth the effort, particularly when there are easier alternatives.  

While the fleet will shrink, coal will not disappear. Large and efficient plants will continue to operate profitably as prices for delivered natural gas become volatile.

There may be short-term opportunities for coal miners such as Peabody Energy (BTU), Arch Coal (ACI) and Alpha Natural Resources (ANR), which will likely seek overseas markets or find that their business declines.

Natural Gas Will Be Crowned King

Natural gas has become the least objectionable fuel. While there will remain an issue, the impact on states' natural capital is significantly less than it is with coal. A natural-gas-fueled power plant has almost no impact on drinking water. Because there are minimal waste chemicals or ash that require disposal, there are no issues regarding landfills or land pollution. Air emissions are largely limited to carbon dioxide and nitrous oxides.

If generating utilities need to build new base-loaded power plants, natural gas will provide the path of least resistance. Capital costs for combined cycle gas turbines, the industry's highest and most efficient technology, are about $1 million per megawatt. By comparison, new coal and new nuclear facilities are about $4 million to $5 million per megawatt.

Cost leadership will benefit advanced turbine manufacturers. Leading companies such as General Electric (GE) and Siemens (SI) should benefit as power producers search for high-reliability and least-cost alternatives.

There will be challenges. Delivered natural gas prices will likely remain volatile. As was learned in the winter of 2014, hub prices are not relevant; delivered prices at the other end of the pipe are everything.

Nuclear Is the Crowned Prince

Troubled times are ahead for nuclear power. Over the next several months, investors will be surprised by the number of nuclear plants seeking early retirements. Industry experts expect that 30% to 50% of the nation's nuclear fleet will be forced out of the markets.

Currently, five reactors are under construction. One is Watts Bar, which is owned by the Tennessee Valley Authority. Watts Bar has already booked horrific cost and schedule overruns.

The other four reactors are healthier, at least for now. Southern Company (SO) is building two new AP-1000 units, and SCANA (SCG) is building two additional units. So far, their projected costs are consistent with starting estimates. However, if there are substantial cost increases, it could spell trouble for the entire industry.

Nevertheless, North America is out of options. To serve base load, the grid must have access to reliable and economic sources of power. If it is not fueled by natural gas, nuclear is the only remaining alternative.

If natural gas prices remain unstable, then nuclear power will become attractive. Most industry insiders believe that smaller nuclear units will become an attractive solution. However, before they can be deployed widely, there must be adjustments to energy and regulatory policies. Small reactors are at least a decade away.

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