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Coal has an image problem. Casual observers of energy markets view coal as an anachronism more at home in a 19th century factory than in modern developed economies.

As I write this article, world leaders are attending a UN Climate Summit in Copenhagen, ostensibly to hammer out the outline of a new global pact to reduce carbon dioxide emissions. It's no secret that addressing global warming and climate change are cause célèbre for environmental groups and a top legislative priority for the Obama administration.

Coal-fired power plants produce roughly 45 percent of the world’s energy-related carbon emissions, far more than any other fuel. That makes it impossible to discuss climate change without addressing coal.

Several countries around the world have passed legislation to control emissions. And although the timing and severity are far from certain, the US will likely pass some form of legislation that limits emissions. The bill in the Senate isn't likely to pass muster as it's currently written, but the US House of Representatives has already passed a measure that aims to reduce US carbon emissions 17 percent by 2030 and 83 percent by 2050.

Whether you believe global warming is hyperbole or the biggest crisis of our era, it would be foolish to ignore the potential impacts of new regulations, laws and public sentiment concerning carbon dioxide emissions.

And don’t forget that coal is the world's most important and fastest-growing fossil fuel. In the US, coal-fired power plants produce roughly half the nation's electricity. The most recent projections from the Energy Information Administration (EIA) forecast that total electricity output from US coal plants will jump 18 percent by 2030 and coal plants will retain a 47 percent share of the US electric grid.

Despite efforts to halt or disrupt projects, there are a total of 83 power plants in various stages of construction and permitting whose total capacity would be in the neighborhood of 47,000 megawatts (MW).

Most of those plants will never be constructed or put into service. According to EIA data, in 2002 utilities had announced plans to construct 36,000 MW of new coal-fired capacity by 2007. Of that total only around 4,500 MW actually made it into service. However, plants near or already under construction are far more likely to be built than plants that have simply been announced; 25 coal plants with 15,000 MW of capacity are currently under construction, and companies are close to breaking ground on facilities that would add another 882 MW of capacity.

Bottom line: Even assuming a significant cost attached to carbon emissions, coal plants will remain a relatively low-cost source of power for decades to come. Further, coal plants represent a reliable source of baseload power.

While the US coal market is far from dead, the international coal market is positively booming. Coal accounts for 42 percent of global electricity generation and that share should grow over the next two decades. The developing world is the primary driver of this growth; China and India produce 80 and 70 percent of their power from coal, respectively.

Asian countries outside the Organization for Economic Cooperation and Development (OECD) currently generate roughly 70 percent of their power from coal. Coal-fired generation in the region is expected to soar more than 176 percent by 2030.

click to enlarge


Source: EIA

Although the media tends to focus on China, India is a market that gets far too little attention from investors. But India is also a major consumer of coal and needs to build considerable capacity to meet growing demand for electricity. Indian officials state that the nation will need to import as much as 200 additional tons of coal over the next five years, making the country the world's fastest growing importer.

And don't forget that there are two main types of coal: thermal coal and metallurgical (met) coal. Thermal coal is used primarily in electricity generation.

Higher quality, more expensive met coal is used to make coke--a dense, nearly pure form of carbon that burns at an extraordinarily high temperature. It's made by burning met coal at a high temperature in a sealed environment. Coke is in turn used in steel production and other industrial applications.

The main difference between thermal coal and met coal is that met coal contains more energy. Met coal also typically produces far less ash when burned than thermal coal.

Demand for met coal is sensitive to the health of the steel industry. China is the world's largest steel producer and has been forced to import significant quantities of met coal in recent years to supplement locally produced coal.

The Coal Recession

Although the long-term outlook for coal remains bright, the recent global downturn took its toll, particularly on US operations. This graph compares US electricity generation from different types of plants in the first eight months of 2009 against the same period in 2008.


Source: EIA

As the graph shows, total US electricity demand is down 4.9 percent in the first eight months of 2009, and coal generation declined 12.6 percent. Coal-fired generation was off more than total US electricity demand due to the precipitous drop in natural gas prices from mid-2008 through summer 2009. Falling natural gas prices prompt fuel switching; generators that can burn either coal or gas to produce power opt to burn cheap gas.

As a result of the severe drop-off in US thermal coal demand, stockpiles of coal at US power plants are glutted. US coal stocks stood at 194,145 short tons in August, down only slightly from 198,215 in June; based on average coal consumption so far this year, that's more than 70 days of coal supply. A more normal historical range is 30 to 40 days’ worth of stored coal.

Due to glutted inventories, utilities have stopped buying coal on the spot market. US coal mining firms have attempted to cut back production by shuttering plants or scaling back operations. Falling mine output, coupled with the recent recovery in electricity demand, will normalize coal inventories over time, but even the most optimistic analysts estimate that this process likely will take much of 2010.

On the plus side, the recent rally in natural gas prices may help to reverse some of the fuel switching that occurred this year.

The most obvious fallout from the Great Recession for the coal industry has been lower prices for its black gold. The average spot price for coal from Central Appalachia (CAPP) reached highs of over $130 per short ton in summer 2008 amid strong US demand and a surge in coal exports.

But the collapse in US demand for coal this year saw prices for CAPP coal fall to $45 per short ton. Lately they've rebounded to $50 to $55 per short ton.

Due to the drop in US steel production, met coal prices also fell from over $160 per ton in mid-2008 to lows under $110 this year. Met coal demand appears to be recovering faster than demand for thermal coal. In the US, steel plants that had been idled have resumed operations in recent months, boosting demand.

More important, the Chinese and Indian economies have recovered more quickly than many pundits expected this year, powering strong global growth in demand for steel. The Chinese economic stimulus package has further bolstered demand for steel used in construction industries. Since the US is an important met coal exporter, rising demand has begun to pull met coal prices higher globally.

The picture for the US coal markets remains murky, but demand and prices are on the rise and reduced mine output should help tighten the market. A rapid recovery in demand outside the US, particularly in developing Asia, is also helping to power exports and push global coal prices higher.

How to Play It

To play growth in the international coal markets and surging demand from China and India, think Australia.

Indonesia is currently the world’s largest source of thermal coal, but Australia is a key exporter of thermal coal and the dominant player in global metallurgical coal exports. But check out the graphs below.




Sourced: EIA, The Energy Strategist

Thanks to a series of planned expansions to mining and export capacity, Australia (the blue bars on the graph) will likely grow thermal coal exports at a faster rate than Indonesia. According to most estimates, Australia will regain its position as the world’s largest thermal coal exporter over the next few years.

At the same time, Australia will remain far and away the world’s largest met coal exporter; the US and Canada are a distant second and third, respectively.

Companies with strong leverage to coal mining operations in Australia are well-placed to benefit from rising demand for coal imports from emerging markets.

US coal markets continue to languish but should recover. One way to play the sector is coal-focused Master Limited Partnerships (MLPs). At first glance, it might seem that the volatile and economy-sensitive coal mining business I just described would be completely unsuited to the MLP structure. After all, volatile mining earnings aren’t exactly a firm foundation for attractive distributions.

But most coal MLPs don’t engage in mining; these firms are in the business of collecting royalties. MLPs own property in coal-producing regions and lease those properties out to mining firms under long-term contracts. The beauty of this arrangement is that the MLPs don’t incur any operating costs associated with the mines located on their properties.

This is a huge advantage because one of the biggest impediments coal mining firms in Appalachia have faced in recent years is the rising cost of complying with ever-changing government regulations.

A typical lease provides several different revenue sources for a coal MLP. First, coal MLPs normally take a guaranteed minimum fee whether the firm leasing their properties mines coal or leaves its mines idle. Even in weak coal markets, this minimum contractual fee means that the MLP is guaranteed some base level of cash flow.

On top of those contract minimums, coal leases generally provide for a fixed fee per ton sold and a percent of the gross sales price generated by coal mined from their properties. This offers the coal MLP multiple layers of protection.

First, per-ton fees are based on volumes of coal mined, not the value of the coal; fluctuations in coal prices don't necessarily impact an MLP’s cash flows. However, the percentage of sales royalties offers the coal MLP an upside cash flow bonus in periods of high coal prices. In effect, the MLP takes on relatively limited downside in exchange for significant upside potential.

Of course, as noted earlier, weakness in coal prices and demand spells lower output from mines and falling coal volume fees. However, this effect is limited somewhat by the fact that most mining firms contract with utilities in multi-year deals. These contracts typically force the utility to accept delivery of some coal each year, regardless of current mining conditions; the nature of the coal contracting business helps to mitigate the risks of fluctuating coal output from an MLP’s mines.

That being said, it's extremely important to note that these factors mitigate but do not eliminate risk; coal MLPs still carry significantly more commodity and economic risk that the straight fee-based midstream MLPs. The upside to that is that they also tend to offer-higher-than-average yields--often above 9 percent--and faster distribution growth potential in rising coal markets.

Disclosure: Long coal

Source: Coal's Bright Future