Great Time to Accumulate Quality Coal Stocks for the Long-term

By: Elliot_H_Gue

We're now in the heart of earnings season for the energy patch. By and large, energy companies have reported impressive numbers, but there are some clear winners and losers.

Some of the losers this quarter were the coal stocks, which have seen unprecedented selling pressure during the past two weeks and haven't reacted well to their earnings releases. I think the weakness is vastly overdone.

When evaluating coal stocks, it's useful to divide the sector into two pieces: the Eastern-focused miners and those focused on mining in the Powder River Basin (PRB) or other markets in the Western US. The Appalachian coal region in the East has been a prolific coal producer for more than a century.

But this region has seen a growing list of problems of late. It's getting harder and more expensive to mine these reserves as seams become thinner; that's why many miners in the region have missed their production targets in recent years.

The bear case for the coal mining stocks is simple and, in fact, very similar to the bearish case for natural gas. Because of the hangover from the warm winter of 2005-06, stockpiles of coal at utilities have risen to excessive levels.

This is the same basic reason that natural gas storage levels are so much higher than normal right now. Because the utilities are well supplied, demand for coal has fallen and so have prices.

Adding to that are concerns regarding climate change policy. Coal is public enemy No. 1 when it comes to global warming, and a few plants that had been slated for construction have been delayed or canceled because of uncertainty surrounding the future of US environmental regulations governing carbon emissions.

These two points were discussed ad nauseam on every one of the five coal miner conference calls that I've listened to so far this season. The question-and-answer sessions have become an endless debate over these factors.

As I've stated before, these are valid points. However, the weakness in coal is massively overdone. The fact is that the US needs more generation capacity soon, and as I've outlined on numerous occasions, alternative energy and conservation efforts just won't meet those needs. 

Nuclear plants take a long time to build, so they're also not a great candidate for meeting near-term (two to three years out) needs. Coal and gas are the only realistic solutions, and coal is far and away the cheaper alternative--even with natural gas prices at depressed levels.

Although it's clear that uncertainty over climate change policy will affect new coal plant construction, new coal plants will be built in the US. In fact, about 9 gigawatts of new coal-direct capacity is already under construction, and an additional 10 gigawatts have received permits and are close to breaking ground. Assuming just the 9 gigawatts of plants under construction are built, that's another 35 million tons of coal demand annually.

Outside this broader argument, a few additional points surrounding shorter-term production trends are worth noting.

New regulations being imposed on East Coast miners are starting to have a dramatic impact on coal production from the region. Recently, the Mine Safety and Health Administration (MSHA), part of the US Dept of Labor, drastically changed the regulations governing how mines are sealed.

Basically, in underground mines, abandoned sections of mines are sealed off from the rest of the mine. This is to prevent any dangerous gases from moving to areas that are being mined.

During the past year and a half, MSHA has changed regulations governing the way mines are sealed on a few occasions. The end result is that about 372 of the 670 active underground mines in the US will need to make changes. MSHA estimates that this will cost the industry some $40 million annually to comply. According to the management team over at International Coal Group --a stock I recommend avoiding--some mines in the East have more than 100 seals in them.

No one really knows how much the new seals will cost because very few have been placed yet. But it will be upward of $15,000, and they'll take days to put in place. This regulation is causing some higher-cost mines to shut down because they can't afford to comply. Better-capitalized miners are meeting the new regulations, but they're forced to halt production for days.

In addition to that, a decision regarding the way dirt and debris from Eastern mines is disposed of has made it far harder to get permitting for new mines. So far this year, no new Eastern surface mines have been permitted in the US, compared to 15 by this time last year. This is also having quite an effect.

Finally, the scheduled expiration of a synfuel credit at the end of this year will render even more mines uneconomic. The synfuel credit is a quirky tax subsidy that was originally designed to promote alternative uses for coal back in the 1980s. The way the law was written, however, meant that all producers had to do to qualify for the credit was to alter the coal in some way. This could include spraying diesel fuel on coal or simply treating it with anti-dust chemicals.

Many companies have been taking advantage of this by mining coal solely for the purpose of qualifying for the tax credit. When that credit disappears at the end of this year, some of these high cost tax-arbitrage mines will likely close, further reducing production from the east.

The consensus I'm hearing from the conference calls is that coal production from the East is already falling. This trend will accelerate after 2007 because some mines are now selling coal under contracts that expire at the end of the year.

Those contracts, signed some time ago, provide for decent, above-market prices. Once they expire, unless coal prices improve, those mines will shutter.

Bottom line: Coal production is coming down and will soon come down fast. This will bring those inventories into line during the next few quarters. In my view, the market is overreacting to the short-term bloated inventory picture.

And we can't ignore the international story. China is now a net importer of coal, and seaborne coal prices are on the rise as the country really ramps up imports. With coal prices depressed in the US, some shipments of US coal are being exported to markets where pricing is more favorable. Right now, this is mainly metallurgical coal, an ultra-high quality coal used in steel production.

The big market for exporting coal to China is Australia. Australian coal exports have been hampered this year by a number of factors, including unusual weather; a deluge of rain recently affected infrastructure near key ports. The other problem is just port congestion--too many ships waiting in the harbor for coal shipments. These are high-quality problems in my view, a sign of just how strong Chinese demand for coal is right now.

A year from now, I firmly believe we'll look back on the current period as a great time to be accumulating select coal stocks with high-quality reserves.

By Elliott H. Gue
The Energy Letter

© 2007 Elliott H. Gue
Elliott H. Gue is editor of The Energy Letter , a bi-weekly e-letter as well as editor of The Energy Strategist , a premium bi-weekly newsletter on the energy markets. Mr. Gue is also associate editor for Personal Finance , where he contributes his knowledge of the energy markets.

Mr. Gue has a Master's of Finance degree from the University of London and a Bachelor of Science degree in Economics and Management from the University of London , graduating in the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that university.

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