The Key Is Coal

12/16/2005 12:00 am EST

Focus:

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

"Oil and natural gas prices continue to garner all the media attention while coal is largely ignored," notes Elliott Gue, editor of The Energy Strategist. "This is a big mistake, as coal will remain a key investment theme for some time to come."

"Interest in building new coal plants is rising. A few years ago, none of the utilities wanted to build new coal plants; all the new construction plans were for plants running on natural gas. But with rising gas prices, coal is definitely back on the table. Further, many utilities are currently running on uncomfortably low inventories and short-term demand for restocking those inventories will be high.

"Most of the demand will fall on low sulphur coal, due to new environmental regulations. Because it will be some years before the utilities can install cost-effective scrubbers to remove sulphur, many are choosing instead to burn low sulphur coal. Much of this low sulphur coal is coming from the Powder River Basin (PRB) in the Western US.

"Meanwhile, it's increasingly tough to actually boost production or meet production goals in the East. Seams of coal are getting thinner and deeper, requiring complex underground mining methods to recover the coal. It's also increasingly expensive to hire miners to perform more dangerous underground mining operations. Meanwhile, coal in the PRB can be strip-mined. This requires less labor and is less expensive in terms of equipment.

"To make a long story short, rising demand coupled with supply issues will mean higher coal prices. The value of PRB coal is also rising relative to other coals due to its lower sulphur content. I continue to recommend two coal master limited partnerships, Penn Virginia Resources (PVR NYSE) and Natural Resource Partners (NRP NYSE). Both pay tax-advantaged yields and will benefit from higher coal prices.

"My favorite miners are Peabody Coal (BTU NYSE) and Arch Coal (ACI NYSE). They have the most extensive exposure to low-sulphur coals. They'll both see cost inflation due to higher wage and raw materials costs. But because both of these miners have relatively young, productive mines cost inflation should be much milder than for eastern-focused miners. And both Peabody and Arch have the low-sulphur reserves that the utilities need to meet environmental regulations.

"The final way to play the coal story is via the railroads. Rails are the key to moving coal from mines to utilities and due to high demand they've been able to drastically raise their hauling rates. For the first time in many years, the rails are seeing so much demand they're actually trying to build out their networks. And as eastern utilities switch to low sulphur PRB coal, the distances over which coal is transported are getting larger. The best play in the rails is Burlington Northern Santa Fe (BNI NYSE), which has the most extensive network of coal lines in these areas."

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