The Other Black Gold: Coal Providers Royal Dutch and Peabody About to Ignite (RDS.A, BTU)

Includes: BTUUQ, RDS.A
by: Investopedia Advisor

Investopedia Advisor submits: As oil prices continue to reach new all-time highs due to the usual mix of political uncertainty and continuing strong global demand, the price of that other “black gold”, coal, has also been enjoying its own rally.

Increasing demand from fast-growing Asian consumers, such as India and China, pushed prices 20% higher in 2005, reaching a new high of US $54/ton. While prices subsequently plunged to around US $36/ton later in the year, spot prices have now bounced back to the US $52/ton level.

Fears that the market could experience a replay of 2005’s price correction this year were partially laid to rest last week.

Australia’s largest coal producer, Xstrata, surprised most industry watchers when it renewed its fiscal 2007 supply contracts with its major Japanese electric utility customers, at an average price of US $52.50/ton – a price realization virtually unchanged from the previous year.

So why were the Japanese buyers happy to lock-in at today’s prices despite the latest run-up? The long term outlook for thermal coal continues to remain bullish for a number of reasons.

Despite declining demand for thermal coal in the developed world due to tighter emissions regulations, demand in the third world is expect to more than offset this, as more than a billion and a half people in Asia are still without access to electric power.

China’s efforts to keep more of its production at home to meet its growing energy needs is also expected to have a long-term bullish impact on prices. In addition to meeting its electric generation needs, the Chinese are also showing renewed interest in developing a domestic coal-to-oil conversion capability.

Last Monday, Royal Dutch Shell (NYSE:RDS.A) and a unit of the top Chinese coal producer, Shenhua, announced they would begin detailed feasibility studies on the proposed construction of a US $5-6 billion coal-to-liquids plant in China. If completed, the plant would be capable of producing 70,000 barrels per day of coal-derived oil – about 1% of China’s current consumption. Developing an economical way of producing oil from coal would be a huge win for China, which has the third largest coal reserves in the world.

Needless to say, all this has prompted a re-think on coal prices by industry pundits. In a recently released study, analysts at Credit Suisse raised their long-term thermal coal price outlook by 20% to reflect this renewed interest in coal-to-oil conversion demand. They now expect the long-term price beyond 2010 to stabilize at US $45/ton, up sharply from their earlier forecast of US $38/ton.

Given these positive industry fundamentals, it’s no surprise the number one U.S. producer, Peabody Energy Corp (BTU), stepped up to the plate last week with a new deal: a US $1.34 billion offer to buy Excel Coal Limited, which is one of Australia’s largest independent coal producers.

The move would give Peabody, which has supplies to meet 10% and 3% respectively of the US and world’s demand for thermal coal, an even bigger stake in the Australian coal fields and a strategic position to participate in the long-term positive demand outlook from Asia, which is expected to see Australian production grow 55% by 2030.

While analysts covering the stock where generally positive on the acquisition, they are predicting a positive earnings contribution to Peabody of between 10-15% starting next year, but the leading ratings agencies, Standard & Poor’s, Moody’s and Fitch, all raised cautionary flags.

The acquisition will be initially financed primarily by debt, as the agencies were quick to point a collective finger at the 40% increase in the company’s net debt resulting from the deal. S&P downgraded Peabody to 'stable' from 'positive', while Moody’s dropped their ratings outlook from 'stable' to 'negative'.

For investors looking at Peabody, this is a case of short-term pain and long-term gain. I reckon that the “pain” part of the deal, in terms of the recent ratings downgrades, will generate enough negative sentiment in the short-run to push the share price lower before investors resume their focus on the positive long term fundamentals underlying the coal business.

Right now, the stock isn’t exactly a bargain – it trades at about an 11x forecasted EV/EBITDA multiple for 2007, vs. 8.3x for its peer group. If this premium narrows meaningfully, it would set up a decent entry point for the longer-term investor looking to participate in an Asian infrastructure play that looks like it still has decades to run.

By Eugene Bukoveczky, Contributor - Investopedia Advisor

Eugene Bukoveczky is a freelance writer for He holds a Chartered Financial Analyst (NASDAQ:CFA) designation and has broad experience in investment research and portfolio management. He has traveled extensively during his career, working in Toronto, New York, London and Dubai. He graduated from York University School of Business with an MBA.

At the time of release Eugene Bukoveczky owned no shares in any of the companies mentioned in this article.