Coal may provide enough power to fuel its own comeback

Out of favor for years, coal is cheap, competitive with other energy sources

 

May 21 - McClatchy-Tribune Regional News - Kathleen Gallagher Milwaukee Journal Sentinel

Coal took its share of lumps in 2006.

While the prices of oil, copper, gold and other commodities hit record highs, coal slogged through one of its worst years ever in terms of demand.

But better days lie ahead, says a graduate student in the University of Wisconsin-Madison's business school.

Coal helps generate about half the electricity in the U.S., with most of the rest coming from nuclear and hydro-electric plants, said Nick Dame, who is seeking an MBA in finance and is a participant in the school's Applied Security Analysis Program.

"Hydro and nuclear run at capacity, so coal really only competes with natural gas for marginal power needs in the U.S.," Dame said.

Big power plants typically are able to switch between coal and natural gas to fuel their power generation. If the price of natural gas is above $4 per million BTUs, coal is more economical, Dame said.

The June contract for natural gas is at more than $8 per million BTUs, so the economics are in favor of coal right now, Dame said.

Coal prices have stayed low, though, because mild weather last year stunted demand and created big stockpiles for utilities.

Dame sees three catalysts that should shrink those stockpiles and lead to higher coal prices:

--Coal is gaining share in electricity generation because of high natural gas prices, and constrained hydro-electric capacity due to dry conditions in the West.

--Lower coal prices have driven closures of a lot of Appalachian coal mines, which are higher cost because of more labor-intensive mining techniques.

--U.S. electricity consumption is running about 6% higher than last year. It typically rises at about the same pace as GDP, about 2% to 3%.

Longer-term, there are political drivers, such as increasing interest in cutting our dependence on foreign oil, that could help boost coal prices, Dame said. Also, growing economies like China and India -- which together are expected by some to make up more than 70% of the increase in worldwide coal consumption -- are expected to contribute to healthier coal prices, he said.

Dame recommended what he says is a "best-of-breed" firm that should benefit from rising coal prices:

Peabody Energy Corp. (BTU, $53.51, up $2.21 Friday), St. Louis, is the world's second-largest coal producer behind China Shenhua Energy Co.

Peabody operates in all of the coal-mining regions in the U.S., so it doesn't have the high level of firm-specific risk associated with smaller producers for whom a mine cave-in, for example, could be a much bigger setback.

Peabody also moved into the fast-growing Asian markets with its acquisition in October of Excel Coal Ltd., one of the largest independent coal companies in Australia.

Dame says most investors are valuing Peabody based on its annual production, which ignores the company's 10 billion tons of coal reserves that are mostly in the U.S. Those 10 billion tons represent a potential 206 quadrillion BTUs of energy -- compared with the entire U.S. natural gas reserves of 167 quadrillion BTUs, Dame said.

"Peabody's reserves are valued at less than 10 cents per 1,000 cubic feet of gas equivalent, compared to $3 per MCF for most of the major oil and gas producers," Dame said.

The biggest risk Dame associates with the stock is the possibility of tighter emission standards that would make it harder for utilities to use a lot of coal. He says he expects some kind of tax on coal in the form of a so-called "cap and trade" system, where utilities that emit too much carbon dioxide will have to trade for more credits.

"Peabody is so cheap -- coal is cheap -- the news weighing heavily on coal prices is worry about carbon trading and the effect it will have on industry," Dame said.

The catch is that the public is wary of carbon dioxide in the atmosphere, but people also don't want to be dependent on foreign oil, "and you can't have it both ways," he said. Higher oil prices make wind energy economically sensible, but people often complain when wind turbines are proposed near their homes, he said.

Dame would buy Peabody shares up to $55 and says they could go as high as $63 in the next 12 to 18 months.