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Bullish Signs for King Coal

Commodities / Coal Jun 11, 2007 - 07:35 PM GMT

By: Elliot_H_Gue


Coal is far and away the world's most-important source of electric power and has been for decades. There are two good reasons for this:

Coal is more abundant than oil or gas, and it's cheap.

Coal is a greater pollutant than either natural gas or emission-free nuclear power. But new scrubbing technologies and plant designs can minimize that pollution. And there's no way the world could replace all its coal-fired plant capacity in any reasonable time frame.

China, for example, is building nuclear plants at the most rapid pace of any country on Earth; most analysts believe, however, the country will actually see its reliance on coal increase in the next two decades. Bottom line: Coal is here to stay.

Coal stocks had a rough run in the latter half of 2006. But they're cheap and pricing in a great deal of negative news flow on coal prices. It's time to increase our exposure to the group.

Comprising the largest percentage of global electricity generating capacity, coal is still the biggest play on energy. One company of which I've long been a fan not only makes a great model in the industry but a great forecaster as well.

Global Supplier

There's no single technology or power source that will be a magic bullet for meeting the world's electricity and energy demands.

Certainly, nuclear power will play a role and will account for a growing slice of global power generation. Long-time subscribers know that we've been profitably playing the nuclear theme for some time now.

And natural gas and renewables will also play a part. But when you get right down to it, coal still rules the grid globally. Talking about electricity generation without mentioning coal is a bit like ignoring the elephant standing in the corner of the room.

Energy Information Agency (EIA) data suggests coal currently accounts for roughly 30 percent of global generating capacity; the EIA projects that coal will roughly maintain that share over the next 23 years. Because electricity demand globally is rising quickly, maintaining that steady share for coal means a 79 percent jump in global coal-fired capacity during this time frame. And global coal capacity is already higher than for any other single type of plant.

But it's important to note that the figure above massively understates the importance of coal to the global grid. As I've highlighted before in my newsletter The Energy Strategist, there's a huge difference between capacity and generation: Just because a utility may own a plant with 1,000 megawatts of capacity doesn't mean that plant is operating at that capacity at all times. In fact, that's highly unlikely to be the case.

This brings us to the important distinction between baseload and peaking power. Baseload power refers to the base demand of electricity that needs to be available for around-the-clock usage.

In other words, even at 3 am, there's some demand for power and generators must meet that usage.

Of course, power demand varies throughout the day. When demand exceeds baseload levels, generators fire up peaking plants to meet those surges of demand. This capacity can be shut down again when power demand slackens.

Although this is a slight overgeneralization, coal and nuclear plants are examples of common baseload capacity generators. Both types of plant can be run around the clock and produce predictable, continuously available electricity supply. In contrast, natural gas is often used in peaking plants.

Gas-fired turbines can be more easily and quickly switched on and off than coal or nuclear facilities; capacity can be quickly brought to bear when demand rises. But gas-fired power tends to cost more than coal or nuclear power; it's perfect for meeting those demand spikes but not for 24-hour generation.

Wind and solar power, at least in reference to the modern grid, aren't ideal baseload power sources either. That's because the power outputs from such plants aren't constant; those outputs depend largely on weather conditions in a given area.

The long and short of this is that baseload power plants are run more consistently and continuously than peaking plants. Therefore, the actual output from baseload plants tends to run closer to their maximum rated capacity than for peaking plants.

This is why coal plants account for only 32 percent of US installed capacity but produce more than 52 percent of the nation's power.

Meanwhile, gas-fired capacity in the US is more than 40 percent of total generating capacity; however, gas-fired plants account for less than 20 percent of US power output.

This is precisely why coal and coal producers have been and will remain a key investment theme within The Energy Strategist. My favorite play on coal remains Wildcatters Portfolio holding Peabody Energy. The company's recent earnings release and conference call highlighted some major trends at work in the coal industry.

The first point that struck me in listening to Peabody's call is just how much this company has morphed in the past five years.

Management pointed out that five years ago only 1 percent of the company's earnings base came from international operations; now that figure is closer to 33 percent. That's a massive jump in just the past few years.

More Bullish Signs for Peabody

Consider the following factors:

Declining Production In The East--Recall that the region known as Central Appalachia (CAPP) is a major, important, coal-producing region of the US. It's also very mature and has been exploited for more than a century. Coal seams in the region are getting thinner, and a more-specialized and skilled labor force is needed to exploit the underground mines common in the region. Bottom line: Production costs are relatively high.

As coal prices soared in 2004 and 2005, companies started up more marginal, high-cost mines. A host of smaller operators in the region struggled to bring production on-line and take advantage of rising prices.

But many of these Eastern mines and the smaller, undercapitalized producers started bleeding cash when coal prices began falling last year. Mines that made economic sense at $60 per short ton were big money-losers under $40 per short ton. To make matters worse, labor, energy and raw materials costs continued to rise last year; that made mining operations more expensive in general.

The final result of this is that a number of these smaller, higher-cost producers folded and abandoned their mines. This has resulted in a meaningful production decline from the CAPP region.

Overall, Eastern mine production is off more than 7 percent over the past year; this more than offsets a small increase in Western Coal production.

Mountaintop Permitting Decision--Many mines located in CAPP are underground mines; miners actually enter a network of shafts. But some operations are what are known as mountaintop mines; producers simply scrape the earth and rock from the top of a mountain to expose the coal seams. The economic benefit of this practice is that it's often cheaper than underground mining.

The problem traditionally has been that all that dirt and rock—known as overburden—must be put somewhere. Typically, miners would get permits to dump this material into a neighboring valley. As you can imagine, environmental groups aren't terribly enthralled with this idea; one group recently sued and challenged the validity of such mountaintop removal permits.

The judge ruled that the permits granted to several mining firms were invalid because the overburden would permanently destroy streams. This has knock-on effects for other mining projects that now won't be able to get permits. Bottom line: This decision will further limit production from CAPP and tighten coal supplies. That's bullish for coal prices and for some coal-mining firms that weren't seriously or directly affected by the decision.

Seasonal Strength--The peak demand season for natural gas is the wintertime, when consumers look to heat their homes. This is when we typically see gas inventories decline.

In recent years, gas has become more heavily used in power plants, which has resulted in a second period of high demand--the heat of midsummer. But, at this time, the winter heating season trumps the summer cooling season when it comes to gas.

Not so with coal. Coal, as noted above, is the workhorse for the US electric grid. When electricity demand is high, utilities tend to draw down their coal stockpiles. Summer brings heavy cooling demand and high electricity usage.

Some will remember that, last summer, electricity demand soared to record levels during the hottest days of July. This is a key time for the coal market. Coal stocks have historically tended to rally heading into summer in anticipation of this period of high demand.

Inventories Likely Declining-- Coal inventory data from the EIA is less timely than for natural gas. In the inventories chart above, it appears that stocks are just coming off their highs.

But the coldest weather this year was in February and March--a period for which we don't yet have complete inventory data. It's likely, however, that the cold snap brought with it higher demand for coal just as it brought higher gas demand. And with production down in much of the US, inventories have likely continued to decline.

Finally, it's worth mentioning that current coal inventories only look excessive when compared with the past few years' worth of data--years when coal stocks were considered ultra-low. On a historical basis, coal stocks in the US really aren't all that high for this time of year.

By Elliott H. Gue
The Energy Letter

© 2007 Elliott H. Gue
Elliott H. Gue is editor of The Energy Letter , a bi-weekly e-letter as well as editor of The Energy Strategist , a premium bi-weekly newsletter on the energy markets. Mr. Gue is also associate editor for Personal Finance , where he contributes his knowledge of the energy markets.

Mr. Gue has a Master's of Finance degree from the University of London and a Bachelor of Science degree in Economics and Management from the University of London , graduating in the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that university.

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