The One Energy Company to Buy

08/01/2011 7:30 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Emerging markets are not going to wait for the next-generation energy projects to build their economies, so fossil fuels still offer opportunities to investors both domestically and internationally observes Elliott Gue of The Energy Strategist.

Peabody Energy Corp (BTU) is the world’s largest pure-play coal producer, with operations in Australia and the western US.

Demand for both thermal coal (used to generate electricity) and metallurgical coal (used in steelmaking) continues to rise. In the US and other developed countries, emissions standards and environmental objections are an impediment to building new coal-fired power plants.

But it’s a different story in emerging markets: Demand for electricity continues to increase at a rapid rate in India and China, both of which rely heavily on coal-fired plants.

In fact, current estimates suggest that coal-fired power capacity will be the single largest source of incremental generation capacity globally from 2008 to 2020, accounting for an additional 3,516 terawatt-hours, compared to 1,604 terawatt-hours for natural gas and a mere 107 terawatt-hours for solar power.

China and India are expected to add significantly to their coal-fired capacity. Between the two nations, India is the biggest growth market for coal producers. That’s because China has significant domestic coal production capacity, while India relies heavily on imports.

As a result, the supply of seaborne thermal coal is expected to fall 50 to 75 million metric tons short of demand by 2015. Thermal coal prices will need increase to levels that incentivize producers in Australia and Indonesia to produce more coal for export. Already, coal prices in the Port of Newcastle Australia hover around $130 per metric ton, a multi-year high.

China and India will drive demand growth for seaborne metallurgical coal, which Peabody expects to expand by as much as 550 million metric tons by 2020. Based on planned mining and export projects, this market could face as much as a ten to 30 million metric ton annual supply gap. Met coal prices will still need to remain high by historic comparison to incentivize investment in new or expanded production.

Peabody Energy’s extensive Australian operations position the firm to sell into the strong seaborne coal market. The company also plans to open new mines, expand existing mines, and build transportation infrastructure over the next four years. Management expects these projects to expand its Australian production capacity from 27 million metric tons in 2010 to between 35 and 40 million in 2015.

Management has targeted 12 to 15 million metric tons of met coal output and 15 to 17 million metric tons of seaborne thermal coal by 2015. And with much of its 2012 Australian output not yet priced under supply contracts, the company could enjoy a lucrative year if coal prices continue to move higher.

And a recent deal strengthens the firm’s growth prospects in Australasia. Mongolia announced that the Tavan Tolgoi metallurgical coal deposit will be developed by a consortium that includes Peabody (24% stake), China’s Shenhua Coal (40%%) and a group of Russian and Mongolian operators (36%).

Nevertheless, the deal remains shrouded in uncertainty. A government official refuted previous reports and announced that a deal had yet to be finalized. This might have been in reaction to some strong words from South Korea; a consortium of South Korean firms apparently lost their bids even though they were short-listed as potential developers.

At the end of the day, however, Peabody will likely be involved in the play; the Mongolian government is keen to keep the US as an ally.

With demand for metallurgical coal rising rapidly in China and other emerging markets, spot prices have soared over the past several months. Mongolia’s proximity to China makes the Tavan Tolgoi deposit even more attractive.

NEXT: Also Well Placed Domestically

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In the US, I prefer companies that have the potential to grow their met coal output significantly or boast extensive operations in the low-cost Powder River Basin (PRB) or the Illinois Basin, both of which produce thermal coal. Mining outfits in North and Central Appalachia continue to suffer from rising regulatory costs and mature mines that are harder to produce.

Peabody Energy’s US operations are centered in the PRB and Illinois Basin, which produces coal that’s high in sulfur. With many plants scheduled to have advanced scrubbers installed over the next few years, the addressable market for Illinois Basin coal is growing rapidly.

PRB contains less energy per ton, but is extremely low in sulfur and cheap to produce. Mine seams in the region are much thicker than in Appalachia and many are located near the surface, eliminating the need for expensive and dangerous underground mining operations.

Historically, there hasn’t been much of an export market for PRB coal, but that’s changing: Peabody Energy has exported some PRB tons to the UK, where utilities have tested it as an alternative to more expensive tons sourced from South Africa or Colombia.

But the real game-changer will be increased exports out of the western US. Peabody Energy is working on a $500 million export terminal at Cherry Point, Wash. that would go online in 2015, and be capable of sending 48 million metric tons per year of PRB coal to Asia. US exports could help bridge Asia’s thermal coal supply gap and act as an escape valve for excess US inventories.

Peabody Energy sold all of its 2011 US production under contract, limiting exposure to the weak pricing environment. In 2012, when falling stockpiles should begin to push up prices, the firm about has around one-third of its US output available for sale on the spot market. In 2013, 70 to 80% of the company’s US production is uncovered by contract.

With a strong growth platform in Asia and advantaged US exposure, Peabody is a buy.

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