The Darkest Star In The Commodities Boom

by: Mark Anthony

Every one focuses on the brightest spots in the market. But let me talk about the darkest star instead. Physicists say that the darkest matter also shines brightest when it glows. A savvy investor notices what others ignore, and appreciates the beauty of Cinderella before she is invited to a royal party and admired by all.

The darkest star is literally dark in color. This sector is also at its darkest moment now. It will soon glow from the darkness and become the brightest star. I am talking about coal.

While the Dow and S&P index hit multi-year highs, and the famous adult toy maker Apple Inc. (NASDAQ:AAPL) reaches half a trillion dollars, the U.S. coal mining sector is at its darkest moment. Coal mining shares Patriot Coal Corporation (PCX), Alpha Natural Resources Inc. (ANR), Arch Coal Inc. (ACI) and Peabody Energy Corporation (NYSE:BTU) are at or near their multi-year lows. The U.S. coal price is at a two-year low and the natural gas price is at the lowest in 10 years.

Pessimistic views are rampant. Fellow SA contributor Peter Epstein wrote about the bearish views and quoted pessimistic views from mining executives themselves. But I am bullish. I believe this is the best time to invest in coal mining stocks. An incredible U.S. coal rally, unlike any of the previous ones, is imminent.

How dare I differ from the opinions of coal mining executives? Do I know something that experts in the coal business don't know? Well, in late 2008 I urged managements of North American Palladium Ltd. (PAL) and Stillwater Mining Company (SWC), the only two North America palladium mining companies, to utilize their cash at hand to acquire palladium stockpile at the low price of $200 or even $165 per ounce. I told them to produce from a European palladium mine with 99.9% purity ore grade and below $200 production cost. The mine is called Swiss Bank Vault. I told them that when a commodity is sold below production cost, the low price could not last for long.

No one listened, instead North American Palladium Ltd. (PAL) made secondary public offerings at rock bottom stock prices, hurting shareholders. The SWC to PAL share price ratio used to be 2:3; now it is 1:5. Had they listened they would have turned the $80M cash into $280M as palladium rallied to $700+ an ounce, and they would not have diluted their shares. So savvy investors do have broader views than near-sighted executives who know little beyond their companies. It is no wonder that the executives often predict the market wrong.

Let me say it again, commodities cannot be sold below production cost for long. If the price is too low, money losing producers will have to cut production or go out of business, leading to tighter supply and price recovery. On the opposite side, when price is too high, producers will rush to produce more (if they can), leading to price collapse. It keeps going up and down in repeated cycles, like seasonal changes.

The U.S. coal market is such, as I discovered, that it only takes a small percentage of supply/demand imbalance to tilt the market either way, causing extreme swings of coal mining share prices in a relatively short period of time, providing excellent opportunity to reap huge profits from such big swings.

Most U.S. coal miners are now un-profitable. Some start cutting their productions. That gives us the confidence that we are at or near the bottom. The downside of the sector is limited and will be over soon. So what will continue to keep it down? What about the upside potential?

The U.S. coal price is dragged down by several domestic factors. Warm winter cut electricity demand; abundant natural gas production depressed the price of both natural gas and coal, as utility companies switched to the cheaper fuel for electricity generation.

Are these bearish factors exaggerated? First let's look at some numbers. In fuel energy equivalence:

1 ton of coal = 4 barrel of oil
5.6 mmBtu gas = 1 barrel of oil (1 mmBtu is about 1000 cubic feet)

On Mar. 9, 2012, the Brent crude oil price was $126 per barrel. The U.S. Central Appalachian Coal was $59 per ton. The U.S. natural gas Henry Hub spot price was $2.21 per mmBtu. Thus coal is priced at $14.75 per barrel of oil and natural gas is at $12.38 per barrel. Isn't $15 or $13 per barrel ridiculously cheap, when the Brent crude oil is $126 a barrel?

The so-called U.S. natural gas glut due to shale gas over production was exaggerated. The EIA gas storage data was 3805 BCF and 3850 BCF, respectively for Thanksgiving Day 2010 and 2011. That was little build up in a year, indicating balanced supply/demand. Currently the storage is 792 BCF above the 5-year average. It was only due to a warm winter, a one-time event. 792 BCF is worth about 10 days of U.S. natural gas consumption in the winter, not a big chunk in terms of annual demand.

Few people know that the U.S. is still a net natural gas importer. We import from Canada. Canada has oil sand, which can be cooked using natural gas to produce crude oil. Due to extreme price ratio between crude oil and natural gas, Canada is better off keeping the natural gas to itself to produce more oil sand. We imported 371 BCF in January, 2011, by Nov. 2011, the import dropped to 246 BCF, losing 125 BCF a month, or 1500 BCF a year. If the imports from Canada continue to drop, the pathetic 790 BCF extra storage people talk about will be gone before you notice it. Good for Canada as its LNG export to Asia now fetches $15 per mmBtu, when the U.S. gas is selling for only $2.50.

The new U.S. shale gas wells are said to have a very steep decline rate, with a production drop of 65% to 85% within the first year. Current low natural gas is un-profitable for shale gas producers. As they reduce the rigs drilling wells, the glut may turn into a shortage soon.

Japan boosted its LNG imports in January 2012, by nearly 30%, and boosted coal imports by 7.9%. Japan pays $15 per mmBtu for LNG. Europe is paying $12 for LNG. There is no glut of natural gas. There is a shortage of LNG vessels so all the countries desperate for energy needs will have to turn to coal importation instead.

There is no coal glut in the U.S., either. Based on EIA data (pdf), the U.S. coal stockpile is smaller than it was the same time last year. The stockpile was 243M tons in Oct., 2010, and 209M tons in Oct., 2011. Restocking alone would require 34M tons of coal. So much for the 50M ton decline in U.S. coal demand that coal mining executives were worried about.

50M tons of coal is a significant number to tilt the supply and demand of the U.S. coal market of about 1 billion tons a year. But it is a small number compared with the big scheme of things globally. The U.S. exported (pdf) nearly 110M tons of coal in 2011, a record year, beating 2010's exports of 82M tons and 2009's 59M tons. At this pace of rapid increase the U.S. could easily add another 35M tons of coal exports this year, to 145M.

India is projected to import 140M tons of coal this year versus 114M last year. So here comes another 36M tons of extra demand from India.

But the biggest story is China, which has a giant and rapidly growing coal demand. China's coal production and demand saw double-digit growth for more than 10 years and it is not slowing down any time soon. Last year China produced about 3.78 billion tons of coal and imported 182 million tons, thus become the world's No. 1 coal importer only two years after it became a net coal importer in 2009.

The Chinese government predicts a 30 to 40 GW power shortage this year, worse than 2011. China has enough installed fire-powered generation capacity. The problem is that government control of the electricity price makes power plants reluctant to buy coal to generate electricity at a loss. They will have to wise up and let the free market determine the prices. China needs 200M tons of extra coal just to plug the hole of 40GW power shortage. (0.55 kg coal is needed to generate 1 KWH of electricity)

The Chinese demand growth is not slowing down any time soon. The numbers are still small compared with the Chinese population. China generated 4.7 trillion KWH of electricity in 2011, versus 4.1 trillion KWH in the U.S. Averaged over the population, each resident in China enjoyed an average of 390 watts of constant electricity power, barely enough to light a bulb and run a computer at the same time.

But China's coal production growth may slow down or even slide in 2012. According to BP p.l.c. (NYSE:BP), EIA and World Energy Council, China's coal reserve is roughly 100 billion tons. That is not a lot of coal compared with 3.5+ billion tons a year production.

I predicted that China has reached or is near peak coal production. There are a few signs that China has reached peak coal. Industry users have been complaining about the inferior quality of coal: the same amount of coal containing less amount of heat. Coal miners would not intentionally produce inferior coal. They would always dig the best qualify coal first to fetch good money. They only turn toward low quality coal as the mines begin to deplete and the low hanging fruit has been picked. There are numerous reports of entire villages in Shanxi collapsed due to hallowed out coal mines underneath. How long can they keep digging?

Peak labor also plagues the Chinese coal mining industry. The method of coal mining has not changed dramatically. To produce 10% extra coal, you would need to dig 10% more coal wells, utilize 10% more equipment and electricity, and hire 10% more miners to do the job. As the Chinese coal mining industry expanded rapidly over the decade, there was never a shortage of young migrant workers from the poor rural villages willing to take up the dirty and dangerous job for a very moderate salary. The army of coal miners kept expanding rapidly.

But the unlimited expansion is coming to a sudden end. China's One Child policy is finally taking its toll and ending the much talked about demographic dividend. After the Chinese New Year break at the end of January 2012, when factories throughout China reopened and wanted to expand their businesses, they found they could not find many migrant workers to hire! "Yong Gong Huang"(labor scarcity) became a new buzz word in the Chinese blogosphere. Worst hit must be the coal mining industry. I saw job ads of up to 10,000 yuan ($1600) per month for freshman coal miners. Typical city jobs for migrant workers pay about 2000 to 3000 yuan. There must be a coal miner shortage.

Peak Water is another factor that means China cannot grow its domestic coal supply in unlimited fashion. There is no doubt that China, especially Northern China where the bulk of coal is produced, is in a water shortage crisis. The entire Chinese coal industry costs 120 billion cubic meter of water resource a year, 24 times the water consumed by Beijing in a year.

The Chinese authority is completely aware of the conflict between coal mining and water resource, as evidenced by a heated debate during recent sessions of the National People's Congress in China.

As the reserve depletion and labor shortage limits growth of Chinese domestic coal production, the authority understands the need to limit growth and preserve the resources for longer. Inner Mongolia, where coal production reached 979 million tons in 2011, announced that it will cap the production below one billion tons before 2015, which means little more growth allowed from the 2011 production level. Shanxi province announced that it will limit 2012 production to 850M tons, which is a cut of 22M tons from the 2011 level.

Inner Mongolia and Shanxi alone accounted for the entire Chinese coal production growth from 2010 to 2011. If these two provinces do not see higher production in 2012, China will see little production growth.

As China's coal demand continues to grow aggressively while domestic coal production is limited by reserve depletion, labor shortage, water shortage and the decisions of authorities to limit production to preserve the energy resource longer, China must rely more on coal imports.

The outlook for the U.S. coal market cannot be better and there cannot be a better entry opportunity into the U.S. coal sector than right now. Coal mining stocks are at their lowest levels since 2009. During the U.S. coal rally from 2007 to 2008, I reaped only a small profit but missed the big part of the rally, when James River Coal Company (JRCC) went from $3.56 to $62 in only 10 months (+1700%). I regretted it ever since.

But the darkest star in commodities is going to grow brilliantly soon!

I am so happy that history repeats itself and I can try to do my best this time around in the U.S. coal sector, are you ready to do the same?

Disclosure: I am long JRCC, PCX, SWC, PAL.