Ken Silverstein EnergyBiz Insider Editor-in-Chief

The demand for coal keeps escalating in light of higher natural gas prices. But the rail system that transports the product is constrained. Indeed, the U.S. Energy Information Administration says that the rail industry set a new high for freight traffic transporting more than 1.5 trillion revenue ton-miles, which is a unit of measurement that incorporates both weight and distance. Coal makes up 40 percent of that total, with farm and chemical products totaling 9 percent each.

Utilities, which are sensitive to prices that they try and pass on to their consumers through the regulatory process, are now drawn to coal. But, at least one analyst says that it would be a mistake to think that coal can meet the nation's expected future demand. While such reserves may be plentiful, the rail system that carries the product from point to point is inadequate, says Katie Elder with R.W. Beck in Sacramento. And she doesn't see new investment in rail lines coming anytime soon.

"It's a long process to ramp up," says Elder. "By the time new lines are built, market fundamentals could have substantially changed."

The problems are acute all over the country and particularly in the Powder River Basin in Wyoming. The Energy Information Administration says that the Wyoming region produced about 400 million tons of coal in 2004. The agency expects the demand for that product to rise by 100 million tons by 2010. Spot prices in the Powder River Basin have risen in some measure because of those constraints. They have gone up from $14.50 a ton to $16.50 a ton.

While Union Pacific and Burlington Northern Sante Fe were able to ship about 85 percent of coal mined in Wyoming, they may have some trouble in 2006. According to the National Coal Transportation Association, the rail companies must make significant improvements in restoration efforts to meet a similar demand this year. "We'll be very fortunate if we can ship 345-350 million tons for 2006, says Thomas Canter, executive director of the rail association, as quoted in previous news reports.

Beyond infrastructure issues, the recent mining explosion in West Virginia highlights the perils of coal mining. It's a dangerous pursuit and one that could affect supplies and prices. Massey Energy, for example, has said that it has trouble retaining young miners who see no way out of the coal mining lifestyle. Altogether, Appalachia produced 228 million tons of coal in 2004 -- down from 263 million in 2000, says Platts Coal Data. Coal prices have dropped in recent months in Kentucky, Tennessee, Virginia and West Virginia from $62 a ton to $59 a ton.

Rising Returns

Obviously, market dynamics will shape the coal market. High natural gas prices mean a greater reliance on other fuel sources. And coal has become the chief beneficiary of this -- and the markets will accommodate the adjustment. Right now, it means coal producers are enjoying good times. But, if prices continue to go up and the rail system remains constrained, coal prices could fall.

And it is this reality that keeps coal producers sanguine. Michael Quillen, CEO of Alpha Natural Resources, said at a coal conference in West Virginia that high-cost mines will have trouble competing and will either have to become more efficient, or shut down. Diesel and labor costs are going up.

Shippers of coal are seeing their rail rates rise. It's a problem for some energy producers and specifically the electric rural cooperative utilities that rely on coal as a fuel source. In fact, coal provides the preponderance of fuel for America's generators, at 51 percent. For electric cooperatives, that number is 75 percent. And rail is typically the most viable mode of transportation but often little competition exists among rail carriers in rural areas. To complicate matters, the railroad industry is consolidating into fewer and bigger behemoths with more market dominance.

"Twenty five years after the (current laws passed Congress), deregulation is clearly not working for captive rail customers," says National Rural Electric Cooperative Association CEO Glenn English, in testimony before federal lawmakers. English testified that many cooperatives, held captive by a single rail provider, have unreasonably high rates and non-negotiable terms of service dictated to them on a "take-it-or-leave-it" basis.

The rail industry's return on investment has risen from 2 percent in the 1970s to 7 percent today. With the industry's improved financial condition, the rail companies are investing an average of $6 billion a year in infrastructure and equipment. But in parts of the country, that re-investment is considered inadequate. And that's why the Surface Transportation Board is given the authority to regulate rates where rail competition is negligible and where shippers might need protection. The Surface Transportation Board estimates as of the mid-1990s, 16 percent of all such traffic remained regulated.

There are some proposed rail projects on the drawing board. The Dakota, Minnesota and Eastern Railroad would be the largest such deal to be constructed in 100 years. It would be a 900-mile project involving upgrades and new construction that heads eastward. At the same time, Northfolk Southern is planning to replace its coal cars with modern ones that hold 11 percent more coal and weigh 30 percent less when empty -- a process it expects to take 18 months.

"We have an historic opportunity not only to do something for our customers and America's heartland but for the rest of the country," says Kevin Schieffer, CEO of the Dakota, Minnesota and Eastern Railroad project.

The demand for coal is largely centered on its availability and price. But other fundamentals affect it as well. Today, coal is in vogue. But, tomorrow's forecast is less certain. It's up to utilities to decide which fuel sources generally will serve to meet their environmental and financial objectives. Rail costs are considered along with other expenses such as technology and labor. And, certainly, high-profile mining disasters don't help coal's cause.

Toward that end, coal producers and their utility customers rely on a vibrant rail system. At present, the rail network is inadequate with bottlenecks forming around the nation and particularly in Wyoming. A greater demand for coal would seem to necessitate more investment in new rail lines. But such progress takes time. And by the time new infrastructure would get built, market fundamentals might look different than now.

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