There’s Still Money in Coal

A year ago, few investors wanted anything to do with the coal markets. Inventories of coal at US utilities were tight at the end of 2005, but a warm winter in 2005-06 changed all that: Inventories ballooned, and coal prices plummeted. Most coal stocks saw declines of 50 percent or more from May 2006 through early 2007.

Now the situation couldn’t be more different. I’ve highlighted the ongoing tightening of supply and demand in the US coal markets before in The Energy Letter and in my paid newsletter, The Energy Strategist. The Nov.16, 2007, issue of TEL, The Great Coal Grab, offers a summary of the forces at work.

Although the coal mining firms aren’t as inexpensive and depressed as they were back then, the fundamentals continue to improve; I see the potential for a further spike higher in coal and coal-related stocks in the coming weeks.

Far too many investors and pundits made the mistake of misinterpreting the fourth quarter earnings releases from the major coal mining firms. Several of the big US-based coal producers either missed or barely met expectations for fourth quarter earnings; the stocks tended to sell off sharply in the immediate aftermath of these reports.

Some investors were puzzled by the seemingly weak results in the face of sky-rocketing coal prices. The reality was that these results were widely expected and nothing new. Check out the chart of Big Sandy Barge coal prices over the past few years.

Source: Bloomberg

Clearly, spot coal prices—the price of a ton of coal for immediate delivery—are trading at new highs. US coal supplies have tightened notably over the past year because of a series of new environmental and safety regulations primarily targeting mines near the East Coast of the US.

Smaller miners simply couldn’t shoulder these costs, especially with coal prices so depressed earlier in the year. Many smaller operations shut down entirely, while larger, better-capitalized players scaled back production from their highest cost mines.

At the same time, demand for US coal is on the rise. Ironically, much of this demand comes from abroad. Specifically, China became a net importer of coal in 2007 for the first time in its history. China is already the world’s largest consumer and producer of coal, but consumption has been growing far faster than production in recent years.

The situation became so dire earlier this year that the Chinese government actually banned exports of coal from China, at least temporarily. Then, to make matters even worse, China was struck by its worst snowstorm in 50 years, crippling coal transport infrastructure. The end result: a series of major power blackouts in China as the nation’s utilities literally ran out of coal supplies.

And China isn’t the only country with weather and infrastructure problems. Australia, traditionally the world’s largest coal exporter, was struck by severe rains earlier this year, flooding some of the nation’s key mines. Mining giant BHP Billiton recently noted that it could be six months before those mines are back to full capacity. And even before the rains, Australia was having difficulty staying on top on coal demand because of congested ports.

Then there’s South Africa. Because of serious power capacity shortages, the nation has experienced several blackouts that shut down mining production. South Africa is another key exporter of seaborne coal.

The end result of all these forces is that coal supplies are tight in China, and the Chinese are keen to import more supplies. Any exporters with spare capacity are exporting coal there; however, this leaves Europe in a terrible bind. Traditionally, Europe has relied on seaborne coal shipments to meet demand. But with those shipments headed to Asia, Europe is turning to the US.

For the first time in more than a decade, European utilities are contracting with US producers for coal supplies. US exports of coal are rising rapidly. And Europeans are paying top dollar to ensure coal supplies under long-term contracts. Already, according to mining giant Consol Energy, there are two- to five-year contracts being signed. And there are also ongoing discussions for 10-year deals.

With exports rising and production pressured by new regulations, inventories of coal in the US are falling. In Consol’s fourth quarter report, the company noted that inventories in the eastern US are currently about 20 to 25 percent below the levels utilities like to maintain to ensure continued supply.

The obvious question is why the US coal miners didn’t benefit from higher coal prices and a tightening market in the fourth quarter. In other words, how could earnings have missed despite the rapidly strengthening coal market?

The fact is that most coal companies sell only a small part of their production under spot deals; coal miners instead contract with utilities for longer-term supply at fixed or relatively fixed prices. The reason earnings lagged is that fourth quarter earnings were based primarily on contracts signed about a year ago at much lower coal prices.

Over time, those older contracts will roll over to new deals signed at much higher prices. The realization of this fact is likely why most of the mining stocks quickly recovered from their post-earnings malaise.

But this contract cycle isn’t really the key point to emerge from the recent earnings season; this is well known to any coal analyst. What’s far more interesting are some of the bullish comments to emerge from fourth quarter conference calls. Consider the example of Union Pacific, the largest railroad in the US and a key transporter of coal.

The railroad noted weakness in transport volumes for a variety of consumer items as well as a few commodities such as lumber. Lumber demand has some leverage to the weakening housing market.

The market where Union Pacific sees the most strength for 2008: moving coal, particularly out of the Powder River Basin (PRB) of the western US. During the conference call, coal transport demand seemed to be one of only a handful of business lines where Union-Pacific has high visibility in terms of demand and pricing for 2008. In fact, the railroad continues to work on improving efficiency on its coal routes. This suggests that demand for moving coal continues to outstrip rail capacity.

Union Pacific went on to note another few important trends. First, management highlighted that the demand for moving coal is tied to export demand. Coal from the PRB hasn’t traditionally been exported because it has a lower heat content. (A given amount of coal contains less potential energy.) PRB coal does, however, have the advantage because it’s cheap to mine and is typically ultra-low in terms of sulfur content.

It’s likely that coal from the eastern US is being burned locally or sent off as exports to Europe. This has the effect of tightening inventories in the East to uncomfortable levels. To fill that gap, producers are shipping coal east from the PRB, which is why PRB coal prices are rising just as quickly even though there’s no current export market for this coal.

That said, Union Pacific did offer a tantalizing hint that PRB coal may find a direct export market. Management alluded to the fact that some producers want to move coal out of the PRB to the West Coast, likely for export to a coal-starved Asia. This would be the first time that’s happened.

Another interesting coal-related conference call to listen to was Consol Energy. This company noted that, although coal prices are rising, they’re not yet at levels that would encourage producers to actually open new mines. Management noted that although there are plenty of potential unexploited reserves in the US, producers are currently just looking for ways to produce a few additional tons from existing mines.

This suggests two points. First, coal prices can move a good deal higher from where they are today. And, more important, there will be no rush of new coal supply from new US mines until prices rise further from current levels.

And Consol’s management appears to be acting accordingly. The company still has more than half of its planned 2009 production unsold. Management went on to say that the company is in no hurry to contract that coal. That clearly suggests the firm believes the coal price bull market hasn’t played out yet.