Thermal coal is the next iron ore--and the stocks haven't run away from investors yet

04/12/2010 5:27 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Forget about iron ore. It’s old news.

The global explosion in demand for that commodity and the huge 80% to 100% price increase that has resulted as demand outstripped supply and in the price of stocks such as Vale (VALE), BHP Billiton (BHP), and Rio Tinto (RTP.)

The new story, and one you can still catch, is thermal coal. You know the black lumps of carbon that the world burns to produce electricity (and lots and lots of greenhouse gases.)

The catalyst, as it was with iron ore, is China. China became a net importer of thermal coal in 2009 for the first time. Last year China bought about 80 million metric tons of coal from overseas producers. That’s a huge turnaround from 2005 when the country exported 70 metric tons.

But China isn’t the only big demand-side story.

The demand for imports of thermal coal from the Indian economy is growing like an uncontained boiler explosion. India imported 70 million metric tons of coal in the fiscal 2010 year that ended on March 31. That’s double India’s imports in fiscal 2009.

Recent negotiations between thermal coal producers and Japanese utilities have set benchmark prices for the fiscal 2011 year that started on April 1, 2010 about 40% above last year’s annual contract price. The price of thermal coal on the Australian market hit a low of $61 in March 2008. The new annual contract, with prices of $98 to $104 a ton, is above spot prices of $95 a ton. When the price of a commodity on an annual contract is above the current spot market price, you can bet that customers are worried that prices are headed higher.

How much higher and for how long are key questions for investors who don’t want to buy into the shares of thermal coal producers if this upward trend in coal prices is near an end.

 I’d say, however, that coal prices have at least another two years to run before supply has any shot at catching up with demand. In February Credit Suisse raised its estimates for thermal coal by 13% for 2010 and another 13% for 2011 on rising demand from India and China and infrastructure bottlenecks that would keep exporters from meeting demand. (The need to handle rising volumes of coal is one reason that China has been investing so heavily in its rail system.)  A lack of road and railroad infrastructure prevents the Indian coal mining industry from meeting demand. Coal shortages resulted in power generation growing by just 5.45% in 2009 instead of the planned 6.5%, according to the Indian government.

Now that China has become a net importer of thermal coal, the country has begun aggressively scouting the world to line up supply. The country recent made its first buy ever of coal from Columbia, for example. (Don’t expect China’s overseas activities in the coal market to reach the frenzy that we’ve seen in iron ore and other commodities. China is largely self-sufficient in coal and could probably met demand from domestic sources except that China’s government has decided to consolidate or shut down many of its smaller mines in order to reduce the appalling rate of death and injury in China’s coal mining industry. In 2009 2,631 miners—or 7.2 a day--died in China’s coal mines according to the State Administration of Coal Mine Safety. The death total in the U.S. coal industry was 34 in 2009. 29 miners died in last week’s Upper Big Branch coal mine in West Virginia.)

But the biggest sources of thermal coal for the Chinese, Indian, and Japanese markets will be producers in Australia and Indonesia. Those countries are the global suppliers nearest to customers—so they gain an advantage from lower shipping costs—and they are two best placed to increase production in 2010 and 2011.

So what stocks do you buy to take advantage of this trend in thermal coal?

One from Indonesia, one from Switzerland with big mines in Australia and South Africa, and one from the United States with big plans to become an international player.

Indonesia is the world’s largest producer of thermal coal for export. In 2009 Australia produced 141 million metric tons but Indonesia produced 201 million tons. Most Indonesia coal travels by river rather than rail and that has helped the country avoid the internal transportation bottlenecks that have plagued other producers. But exports are still limited by a shortage of terminals for loading ocean-going carriers. Only three of the eight are big enough to handle the largest bulk carriers.

PT Bumi Resources is the largest Indonesian coal producer. The company produced 50 million metric tons in 2009. Unfortunately, the stock trades only on the Jakarta exchange (BUMI). The shares are extremely volatile now: The company is planning a sale of its non-coal assets to raise capital to pay down debt and while the market approves of this use goal, it’s not sure that the price that Bumi Resources is asking is high enough. If you can find a broker who can buy this for you, see if you can catch it on a down day—or just wait until the volatility is lower.

Xstrata (XSRAY—ADR) is the second largest coal producer in Australia. (It’s also a major producer in South Africa and Columbia. September 2009 production of 11 million tons trailed only BHP Billiton’s 18 million. But I have a slight preference for Xstrata over BHP Billiton because the Swiss company seems to have put thermal coal higher up its list of corporate priorities. And since Xstrata doesn’t have the iron ore profile of a BHP Billiton, (and it isn’t an Australian stock to most investors) its share price hasn’t galloped quite so far ahead of the market.

Peabody Energy (BTU) isn’t just a U.S. coal company any more. In 2006 it snapped up Excel for $1.5 billion, tripling its Australian coal assets in one move. The company clearly hasn’t finished. It’s a bidder in the war to acquire Australia’s Macarthur Coal (MACDY). And the company is in talks with Coal India that would expand Peabody’s presence in the Indian market and give Coal India a stake in four of Peabody’s Australian mines. Again, because Peabody Energy isn’t either an Australian stock or an iron-ore miner the stock hasn’t run up significantly. It trades at 28 times trailing 12-month earnings per share but at just 11 times projected forward earnings per share.

If you’ve got some patience, Peabody offers the most upside, I think. If you’ve got patience and a way to buy on the Indonesian market PT Bumi Resources is the best long-term story.

Full disclosure: I own shares of Vale in my personal portfolio.

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