Tags: Coal, Coal Prices, EIA, Energy, ETFs Article, OECD

Are Coal Prices Ready to Burn Hot in 2010?

By , Contributing Writer, Money Morning •

For most of the past 50 years, since the birth of environmental awareness, coal has been the "black sheep" of the power-production family. Now, thanks to more efficient furnaces, better exhaust-scrubbing systems and other technological advances, coal is regaining favor in the world's energy markets.

However, the biggest factor in coal's recent price surge is steadily increasing demand for the fossil fuel in power generation and steel-making process, abetted by rising costs for other types of fuel, like oil and natural gas.

The question for investors, of course, is will this rising demand continue - and how can you profit if it does?

The answer to the first part of that question is almost certainly, "yes," but solving the second part is a little trickier.

Simple Supply and Demand

Coal has two primary uses - as fuel for the commercial generation of electricity and heat and for conversion into coke, which is used as both a fuel and a reducing agent in the process of smelting iron ore in a blast furnace to make steel.

Roughly 92.8% (1,041.6 million short tons) of total U.S.coal consumption (1,121.7 million short tons) was used for electricity production at 22 major coal-fired power plants in 2008, the last year for which complete figures are available. Roughly 1.9% (22.07 million short tons) was used in coking, while the remainder was used for other industrial purposes and private and institutional (e.g., hospitals and universities) power and heating plants. On the production side, U.S. coal output rose by 2.2% in 2008 to a record 1,171.5 million short tons, helping fuel a sharp increase in coal exports.

U.S. consumption totals in all sectors were down slightly in 2008 from 2007 - reflecting the relatively mild winter and the sharp economic slump - and numbers for the first three quarters of 2009 showed a continued decline, though preliminary figures for the fourth quarter and the first two months of 2010 show that trend reversing in all sectors but coking, thanks to the record-setting winter weather and a modestly resurgent economy. The continued decline in the coking sector reflects the ongoing loss of U.S. steel production to overseas competitors, most notably China.

Indeed, according to all major industry sources and the U.S. government's Energy Information Administration (EIA), China will be the driving force in the coal markets for at least the next two decades, accounting for more than half of the world's total consumption by 2025. Growth in consumption will also be far stronger in other emerging-market countries than in the developed nations.

The EIA projects growth in coal consumption in the U.S. and other nations of the Organization for Economic Cooperation and Development (OECD) will grow from 47.3 quadrillion British thermal units (Btu's) in 2010 to just 48.3 quadrillion Btu's in 2025, an increase of only 2.1%. By contrast, coal consumption in China is projected rise from 62.7 quadrillion Btu's this year to 90.1 quadrillion Btu's in 2025 - a 43.7% increase.

For those wondering why we've been describing consumption and production in quadrillion Btu's rather than the much simpler and more straightforward tonnage, it's because there are significant differences in the quality of coal, depending on where it's produced. Thus, it's more precise to talk about the energy values in coal.

Total non-OECD consumption, including China, is projected to rise by 36% from 93.3 quadrillion Btu's this year to 126.9 quadrillion Btu's in 2025. So in just 15 years, emerging nations will account for more than 72% of the world's annual coal use.

Worldwide demand for coal will rise to 175.2 quadrillion Btu's in 2025 from 140.6 quadrillion Btu's this year, an increase of 24.6%, the EIA said.

Meanwhile, the mining industry has barely managed to keep up with the increase in global demand in recent years. In 1990, total world demand was 89.2 quadrillion Btu's, while total world production was 91 quadrillion Btu's, a surplus of 1.8 quadrillion Btu's, or just over 2%. By 2006, the last year for which complete production figures are available, global demand had climbed to 127.5 quadrillion Btu's, while global output had risen to just 128.49 quadrillion Btu's - a surplus of just 0.99 quadrillion Btu's, or 0.77%.  

Given the increased worldwide restrictions on mining operations and the shrinking likelihood of new coal discoveries, it's hard to see where another 47.7 quadrillion Btu's worth of coal are going to come from, especially since projections for 2010 are already showing a potential production shortfall and depletion of existing stockpiles. (There's also no anticipated improvement longer term, since the World Coal Institute estimates there are only enough proven coal reserves to last 155 years if the rate of consumption remains unchanged.)

Investing in Coal

Unlike with many other popular commodities, individual investing in coal is generally not a simple matter of buying basic futures or forward contracts. That's because different types of coal have extreme variances in quality.

In the United States, for example, there are five primary classes of coal, each with a different Btu rating. Northern Appalachia coal, rated at 13,000 Btu per short ton, is the highest quality, while Powder River Basin coal (from Wyoming and other Rocky Mountain states) is the lowest quality, with a rating of just 8,800 Btu per short ton. Because of those quality differences, the spot prices for Northern Appalachian coal and Powder River coal at the close of trading on March 5 were $64.00 a ton and $12.70 a ton, respectively.

The other classes of U.S. coal, with March 5 spot prices, are Central Appalachia (12,500 Btu, $58.95), Illinois Basin (11,800 Btu, $41.50) and Uinta Basin (11,700 Btu, $40.00).

While the NYMEX division of the CME Group does trade one major and two minor futures contracts - Central Appalachian, or CAPP (trading symbol: QL); Western Powder River Basin, or PRB (symbol: QP); and Eastern CSX Transportation (symbol: QX) - all are fairly thinly traded and used primarily by commercial interests for hedging and supply management. Inconsistencies with the spot prices can also be high - e.g., the nearby CAPP future closed at $52.30 on March 5 compared to the spot price of $58.95.

Coal prices also tend to move separate from coal fundamentals themselves. Instead coal prices track the changes of other energy commodities, primarily crude oil and natural gas, as well as certain hedging commodities such a gold. This was illustrated quite clearly the past three years.

Through most of 2007, Northern Appalachia coal prices ran from $30 to $45 per short ton. They then skyrocketed along with oil in early 2008, peaking near $150 in October 2009, before plummeting back to just over $40 per ton in May 2009. After a couple of months of flat trading, prices again started a steady climb, reaching $64 on March 5.

So, assuming the demand will continue to grow - and oil prices will keep rising, dragging coal and gas along - how should you play the move?

Exchange-traded funds (ETFs) are among the best choices as there are at least four that take heavy positions in coal-related issues, including two that target coal specifically. All are up significantly in price since the March 2009 market bottom, but they should have ample room left to climb as the recovery gathers added steam. They are:

Market Vectors Coal (NYSE: KOL): This fund aims to track the price and yield performance of the Stowe Coal index. It normally invests at least 80% of total assets in equity securities, including American Depositary Receipts (ADRs), of U.S. and foreign companies engaged primarily in the coal industry.

PowerShares Global Coal (NYSE: PKOL): This fund attempts to mirror the NASDAQ OMX Global Coal Index. It normally invests at least 90% of assets in securities, ADRs and Global Depositary Receipts (GDRs) based on the securities in the underlying index, focusing 80% of assets on companies involved in the coal industry.

Market Vectors Steel (NYSE: SLX): Coal is a major cost factor for the companies this fund invests in since all are major consumers or producers of steel. Since steel is a major component in all sorts of infrastructure construction, the fund's holdings should benefit from new spending linked to the global economic recovery.

SPDR S&P Metals & Mining (NYSE: XME): A diversified fund that includes coal mining and processing companies among its portfolio holdings, many of which are international, meaning the fund can also benefit from currency fluctuations as well as changing prices for metals and other minerals.

For those who prefer picking individual stocks to riding along with fund managers, four companies with heavy direct involvement in the coal industry are:

Consol Energy (NYSE: CNX): This Pennsylvania-based company is involved in the mining, preparation and marketing of steam coal, primarily to power generators, and metallurgical coal to steel and coke producers. A darling of the mutual funds and institutional investors (including Carl Icahn, who had 1.36 million shares at one point), which hold 93% of the shares, CNX also has a large holding of in-ground coal reserves.  

James River Coal (Nasdaq: JRCC): After being the focus of takeover talk for more than a year before the economy collapsed, this miner and processor of industrial-grade coal pulled back from the high $40 range in 2006 to a low of $3.86 in August 2007. It then rode the oil rally to $62.14 in June 2008 before sliding all the way back to single-digit levels in late 2008. Since then, it has traded in a fairly tight range from $16 to $22, but it obviously has the potential for another large run should coal prices continue to rally.

Patriot Coal Corp. (NYSE: PCX): Patriot has reserves in both Appalachia and the Illinois Basin, operates 14 mining or processing complexes and is a major supplier of thermal coal to power companies along the upper Mississippi. The company has strong earnings ($1.49) over the past year and, though the stock has made a nice run from its lows last spring, still has a reasonable price-to-earnings (P/E) ratio of just 12.93.

Puda Coal Inc. (AMEX: PUDA): For those who like to go right to the heart of the demand, Puda is one of China's leading suppliers of metallurgical coking coal to the Chinese steel industry. It also has room left to move price-wise, unlike SinoCoking Coal and Coke Chemic (Nasdaq: SCOK), another Chinese mining and coking company, which recently shot from $3.50 a share to more than $30 after uplisting from the Bulletin Board to Nasdaq proper.

Coal prices could suffer a mild seasonal decline as winter comes to an end, but the ballooning long-term demand picture and increasing oil prices appear poised to provide support - and possibly light a new fire under coal-related stocks in the near future.   

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