Saturday, June 14, 2008

the case for coal

sometimes extremely promising investment opportunities present themselves. the coal industry currently offers on such chance for huge long-term upside with relatively low risk.

coal stocks have started moving higher in the last 6 months or so. I believe they're still in the early stages of a large trend that has the potential to enrich investors for years. it will also bring bring wealth to areas in the U.S. that have long been considered economic backwaters, such as west virginia. the way to profit from these trends will be to buy coal stocks and west virginia real estate. for disclosure, I own Peabody Energy (BTU) and the coal-sector ETF (KOL).

why coal? several reasons:

1- relative to other sources of energy, it's very cheap.

  • one ton of coal has about 20mln BTUs and costs $50-$100. that's 200k-400k btu per dollar
  • one thousand cubic feet of natural gas has 1mln BTUs and costs about $8. that's 125k per dollar
  • one barrel of oil has 5.8mln BTUs and costs about $130. that's 44.6k per dollar.
2-coal exports are rising rapidly and will continue to surge. coal exports rose 19% to 59.1mln short tons in 2007. helping this argument, china's currency remains on a one-way path upwards, which will make our dollar-denominated coal increasingly attractive to them. consol energy, for instance, said it might expand its export facilities in baltimore to accomodate strong international demand.

3-coal prices only started moving higher early this year... below is a chart from the Energy Information Association web site:

4-coal companies are raising their earnings and sales estimates. peabody energy raised its EBITDA guidance by $500mln, while alpha natural resources raised its estimates for both overall production and the price it gets per ton.

5-coal inventories are low and need to be built up. this is more of a short-term consideration, but it should keep coal hot for several months.

  • Consol Energy indicated low stockpiles at its customers on the east coast and mines.
  • China's "social coal reserves" (whatever that is) fell 4% in the first 4 months of 2008. source
  • UBS raised its forecast for coking coal prices because of tight supplies
6-coal pricing is shifting to the spot market from the long-term contract market. typically, coal is sold under contracts with prices locked in over a period of several years. increasingly, it will be priced according to daily trading markets. that means speculators can enter and drive prices much higher.

interestingly, oil was also priced under so-called "official prices" until the embargos of the 1970s, when the spot trading became the dominant way to value the commodity.
I have long hypothesized that the shift from contract to spot pricing will augur well for coal. consol energy CEO j brett harvey confirmed this in the company's last earnings report:

"What is most significant about these developments is the influence spot pricing is having on long-term transactions for delivery beginning in 2009. "

finally, most US coal production comes from the powder river basin in montana and wyoming. but I suspect west virginia real estate will be a big beneficiary. so far, there has been little but anecdotal stories about mines hiring more workers. overall, the state's coal production has been flat for years. with rising prices globally, it seems like companies will ramp up production (maybe that's why I've been hearing about increased hours being worked at the mines). that will mean spending in the local economy and rising incomes. so far, it's just a hunch.
I think some kind of commercial real estate would be the ideal play. the people in that state have been burned many times and feel beaten down by nature. it might be possible to buy land in key locations at cheap prices before the locals even know what's happening.

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