Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
King Coal: The Fuel of the Future
11/26/2004 12:00 am EST
"The energy bull market looks set to continue for some time," says Roger Conrad, editor of The Utility Forecaster. "That's good news for other sources of energy. One that's enjoying a renaissance is coal, which may just be the fuel of the future." Here's how to play that trend.
"As with oil and gas, the US remains a key market for coal, with half of our electricity coming from plants burning the fuel. Coal was under attack in the 1990s as the Clinton administration began to aggressively enforce clean air laws. Today, after four years of far looser smoke stack emissions regulation and soaring natural gas prices, King Coal is back on top in the US; and he's likely to stay there for the rest of the decade at least. The Bush administration is set to continue its policy of limiting punishment of coal-burning utilities for pollution violations while encouraging investment in clean coal technology. Pressure for coal companies to clean up emissions is going to grow in coming years. Dozens of utilities are proactively reducing their carbon dioxide emissions and increasing spending on plants to reduce other dangers such as mercury. That could become very important in coming years as the wave of lawsuits makes its way through the courts.
"In addition, despite an 80% rise in coal prices over the past year, it still costs less than half to generate power from a coal plant than a gas-fired plant. Also, in contrast to the supply situation with oil and gas, North America still has abundant reserves of coal. The other key markets for the mineral are China and, to a lesser extent, India. Alarmed by their growing dependence on imported oil--particularly from the politically unstable Middle East—the world's most populous and fastest-growing countries are increasingly turning to coal. Together, they're expected to make up two-thirds of global coal demand through 2030. Both have ramped up domestic production, but are also importing from overseas.
"There are several ways to play the rise in coal use and corresponding pressure to reduce emissions. The most direct is to buy companies that produce coal. These have become very expensive. The most attractive play is still PVR (PVR NYSE), a limited partnership owning coal lands that collects royalties from actual producers. Its reserves are primarily low sulfur or "clean" coal, which is of a higher grade and is less polluting. Another way to be on coal is to buy the leaders of clean-coal technology. Here General Electric (GE NYSE) is by far the early leader, both for 'retrofitting' older coal plants with pollution-reducing equipment and for constructing a new breed of power plants that essentially turn coal into natural gas. GE also has stakes in other energy sources and remains a mainstay of American business. The shares have rallied in the past couple of years, but the stock is still a solid long-term holding.
"A third way to buy into coal today is to pick up shares of a utility that also produces coal. Here my favorite is MDU Resources (MDU NYSE), which also produces construction materials and oil and gas. The company has been a consistent fast-grower for more than a decade, balancing its regulated utility with more cyclical businesses. MDU has risen sharply, but based on its earnings power, the stock is a buy up to $26. Meanwhile, storing, shipping, and operating terminals is another way to play the resurgence of King Coal. While shares of most of the big players in the US have been rising sharply, Westshore Terminals (WTE.UN Canada or WTSHF Other OTC) remains a relative bargain, yielding well over 5%. Westshore is a Canadian income trust, which essentially pays out all of its cash flow to unitholders. Canadians withhold 15% of the distribution, unless the trust is held inside an IRA. But investors can reclaim the amount by filing IRS Form 1116 with their income taxes, or the more complicated Canadian form NR7-R. The distribution actually received is considered a qualified dividend and is taxed at 15% to US investors.
"We caution that should oil and gas prices continue to slide over the next few weeks and months, coal prices will likely come off as well. A drop under $40 per barrel for oil and to the $5 to $6 per million BTU range for gas could trigger a selloff in our recommended coal stocks. But over the long haul, all four of these coal plays should do well as energy use rises and consumers, businesses, and governments look for the cheapest ways to generate electricity."