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King Coal Abdicates to Natural Gas

By Roger Conrad on August 24, 2012

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Long the undisputed king of American energy, regulators have forced coal to the ropes in recent years. Efforts to regulate carbon dioxide emissions from burning the black mineral have even reached nations as far-flung as Australia.

In the US, however, even a Democratic supermajority in Congress couldn’t push through cap-and-trade legislation in the last session, and so much as a mention of such a regulatory approach is heresy among Republicans. Although that legislation was ultimately stymied, North American coal mining and coal-burning companies have nevertheless felt the pinch of tightening regulation. Officials of successive presidential administrations have progressively restricted emissions of mercury and acid rain gases for public health reasons from power and industrial plants. Meanwhile, aggressive mining techniques have also been cut back, most often due to fierce local opposition.

The biggest blow to King Coal has come from the crash in the price of natural gas. Thanks to the rapid discovery and development of reserves from shale over the past few years, America has an abundance of gas that’s likely to last years.

And don’t look for exports to provide any meaningful arbitrage with higher priced global energy commodities anytime soon. At this point, liquefied natural gas (LNG) facilities in North America are exclusively geared toward imports. That’s the legacy of Hurricanes Katrina and Rita, which in 2005 interrupted Gulf of Mexico production, devastated the Gulf Coast, and ran gas prices to the high teens per million British Thermal Units.

At the time, few envisioned the need would ever arise to export North American gas to foreign shores. And the construction of the facilities necessary for such exports faces formidable regulatory and environmental permitting hurdles, just as building the LNG import assets did. That means the most likely sites are located at existing import facilities. It’s hugely expensive work, which further limits the number of companies that can handle it. And even when those challenges are overcome, it still requires substantial time to complete and test such complex engineering projects before they can commence operation.

The upshot: It will be the end of the decade before even the projects already announced–such as Dominion Resources’ (NYSE: D) Cove Point Maryland facility–will be up and running. That means North America’s shale gas abundance can’t be distributed overseas until then. So prices are likely to stay low for a long time.

Moreover, natural gas emits less than half the carbon dioxide of coal when burned to generate electricity, and only a tiny fraction of the mercury, acid rain gases and particulate matter. By favoring natural gas over coal, power companies can not only cut their fuel costs, they can also protect their operations from current and future federal regulations on emissions.

And there’s no shortage of companies willing and able to build the needed infrastructure to bring shale gas supplies to utilities. Spectra Energy Corp (NYSE: SE), for example, has centered the lion’s share of its $8 billion current capital spending program toward bringing gas to power companies. The energy midstream giant has major projects underway to bring Marcellus Shale gas to the traditionally coal-dependent Southeast US, as well as to dramatically expand gas transmission capacity into the relatively energy-starved Florida.

Even smaller companies are finding ways to get into the act. Carolinas-based gas distributor Piedmont Natural Gas (NYSE: PNY), for example, has built and now operates gas storage facilities for units of Duke Energy (NYSE: DUK). Those facilities provide fee-based income under long-term contracts for Piedmont in all seasons, which has enabled the company to escape some of its dependence on the crucial winter heating season.

Small wonder then that America’s power utilities are making a dash for gas, with a corresponding retreat from coal. This year, gas will generate 23 percent more electricity in the US than it did in 2011. Use of coal, meanwhile, is on track to fall by 12 percent, even as electricity demand is on the rise again, as industrial firms recover from the downturn and consumers increase their dependence on devices needed for expanding global connectivity.

Even Southern Company (NYSE: SO), long one of the largest consumers of the black mineral in the world, is radically revamping its generating fleet. Some 47 percent of the company’s power is now generated from gas, up nearly threefold from just five years ago. At the same time, coal has fallen from 70 percent of output to just 35 percent. The Atlanta-based utility isn’t wholly abandoning its coal plants. In fact, it’s keeping its largest and newest facilities, and continues to develop a state-of-the-art integrated gasification combined cycle (IGCC) plant in Mississippi. If the IGCC plant is able to operate in an efficient manner, it will likely eliminate coal’s environmental disadvantages almost entirely.

Additionally, Southern has dramatically improved its fuel flexibility. It’s ready to proceed with whatever fuel makes economic sense in terms of price and the cost of regulation. And the result is that one of North America’s biggest consumers of coal is no longer dependent on the black mineral.

These developments don’t bode well for coal, which has suffered a relentless price decline in the US, along with falling output. Second-quarter 2012 was a tough time for many coal companies, and there’s no indication the situation will improve much during the second half of the year or in 2013.

However, King Coal did score a major victory in the courts this week. The Court of Appeals for the District of Columbia struck down the Environmental Protection Agency’s (EPA) rules on cross-state air pollution.

This decision vacates a controversial plan enacted by the EPA to radically increase the pace of cuts of acid rain gases. Power producers that still depend on coal claimed such cuts would cost billions of dollars and force them to make changes to the power supply that would not make economic sense otherwise. The rejection of the Obama administration’s plan reinstates Bush-era rules that stretch the timeline for compliance to the end of the decade and beyond. The decision is a major victory for electric utilities that have historically been heavily reliant on coal, particularly Southern and American Electric Power Company (NYSE: AEP).

It also benefits the embattled unregulated power generating unit of Edison International–Mission Energy–which may be headed for bankruptcy anyway. And it’s a plus for the now private equity owned Energy Future, formerly TXU. This could have implications for the Texas power market, which is nearing a capacity shortage, as low natural gas prices discourage building additional infrastructure. Energy Future says it will now keep two facilities open it had otherwise planned to shutter.

How much this decision helps the two sectors worst hit by coal’s long descent–coal miners and coal-reliant independent power producers–remains to be seen. NRG Energy’s (NYSE: NRG) ongoing acquisition of GenOn (NYSE: GEN) suddenly looks a lot smarter, as it convinces investors the synergies and scale of the deal are worth the additional $6 billion debt burden. But the rule change isn’t likely to be of much help for Dynegy (OTC: DYNIQ), as it tries to emerge from bankruptcy while preserving some shareholder value.

Coal mining companies, meanwhile, still face the crippling dynamic of low natural gas prices, which make it very hard for thermal coal to compete in power generation. Reviving industrial activity in North America as well as China’s insatiable demand for steel is likely to keep demand steady for metallurgical or “coking” coal. And mining companies often have other resource wealth on their lands in addition to coal, such as timber and valuable minerals.

These sources of cash flow are likely to prove especially important to dividend-paying coal miners, such as master limited partnerships and royalty trusts, in coming years. These companies’ ability to scale up, lock in long-term contracts, and potentially export to friendlier shores will also be key to their resilience. The future of the biggest players such as Peabody Energy Corp (NYSE: BTU), meanwhile, is indisputably overseas, particularly in Asia, and they’ve been directing their capital spending accordingly the past several years.

These companies still have a future. And arguably, investors’ tendency to view outcomes as “all or nothing” has left many of these companies trading at bargain valuations, which means solid returns for those who seek value.

No one, however, should expect this Appeals Court decision to return King Coal back to its throne atop North America’s energy heap, even if there is a new administration in the White House come January. Rather, consider it a reprieve that allows the industry to adjust to a long-term trend that appears inevitable.

Most companies have now reported their second-quarter earnings. As such, it’s time for those of us who look at the market and economy from the ground up to put what we’ve seen into perspective.

 

My first takeaway was just how low the drama quotient was on actual news. A handful of dividend-paying companies–primarily producers of commodities hurt by falling prices–did cut their dividends. Those moves, however, were mostly expected by the market, which limited the fallout on share prices.

 

For most companies, however, it was another quarter to focus on the blocking and tackling of running a business in an economic environment that was neither bullish nor bearish. And for most, the conservative financial and operating strategies employed since the crash of 2008-09 have put overall results on a mostly even keel.

 

There was, of course, no shortage of drama in the mainstream financial media, which after all is in the business of getting investors’ attention. But even when a widely publicized negative opinion of a stock did make headlines and spur selling, the downside impact on the share price was short-lived. In fact, several times we saw speculation drive stocks down, only for them to pop back up sharply when the actual release of numbers refuted the rumor.

 

The lesson to draw from this is to keep an even keel yourself and don’t just blindly accept bearish opinion just because it seems astute. Even if those views are not self-interested, they’re not necessarily correct. Look at the numbers yourself and make up your own mind.

 

My second takeaway from earnings season is just how cautious management of most companies sounded in conference calls. That’s certainly a good sign as far as dividend safety goes. And it likely means companies are going to continue to limit their exposure to near-term debt maturities as well.

 

There’s certainly plenty of justification for being cautious now, for individuals as well as corporations. Europe has not resolved its challenges, though they have at least temporarily faded from the headlines. Data from Asia are opaque as usual, but it’s pretty clear that growth has slowed over the past year, and it may take a while to get things going there. And the US economy is still stuck in a “two steps forward, one step back” situation.

 

There’s plenty of room for companies to fall between the cracks if management isn’t careful. And a stumble is all it takes to set off a selling wave that will feed on its own momentum.

 

But being hunkered down also leaves a lot fewer targets. And in any case, it’s a sharp contrast with the situation before the 2008 crash, and a pretty good reason why such a catastrophe is unlikely this year. That alone is good reason for optimism following a second-quarter earnings season that generally produced numbers supporting dividends, balance sheet strength, and even companies’ plans for long-term growth.

 

There’s no substitute for picking apart the numbers of companies you own. And every investor needs to understand just what measure of profits is funding the dividends he or she is receiving, whether it’s sustainable, and if it provides ample cash flow coverage for dividends.

 

Despite today’s very low interest rates, I would still advise avoiding companies that would be hurt if capital markets were to suddenly tighten. That means most companies with hefty debt maturities between now and the end of 2013.

 

One good measure is the total debt needing to be rolled over as a percentage of market capitalization. Anything less than 10 percent isn’t likely to be of consequence. But the higher that number goes, the more risk. Keep in mind that dividend cuts at European telecommunications companies like Telefónica (NYSE: TEF) weren’t caused by falling revenue, but to avoid having to roll over debt at exorbitant rates.

 

The most important lesson of this earnings season is to beware of momentum. Now perhaps more than ever, investors seem to be equating falling share prices with growing risk, and rising share prices with safety.

 

That’s perfectly understandable, given what the markets have been through the past few years. But it’s the very antithesis of value investing, which is the basis for making real money as an individual investor. Investors who chase momentum will always pay too much for their shares. And dumping stocks while shares suffer downward momentum will always fetch a poor price.

 

The nice thing about earnings numbers is that they give investors a basis for defying mindless momentum. You can make up your own mind about what a company is worth and whether its stock is worth buying. And that’s what it’s all about when it comes to buying low and selling high.

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