This Coal Company Will Clean Up

08/27/2012 11:08 am EST


Peter Staas

Managing Editor, Capitalist Times and Energy & Income Advisor

The demand for energy continues to grow, even in a slow global economy, and one coal giant is ready to warm up your portfolio the same way it warms up houses and factories around the world, reports Peter Staas of Personal Finance.

We’ve long eschewed coal producers that primarily serve the US market, preferring Peabody Energy (BTU) and diversified mining giant BHP Billiton (BHP), both of which boast extensive production platforms in Australia.

This positioning reflects a number of long-term secular trends, including declining demand for thermal coal in North America, rising production costs in Central Appalachia, and rapidly growing demand for the fuel among electric utilities and steelmakers in China and other emerging markets.

Peabody Energy estimates that global coal demand will grow by 1.3 billion metric tons over the next five years, with China and India accounting for about 90% of this volume growth.

The Mainland’s thermal-coal imports are expected to increase consistently over the next several years, because of rising electricity demand and insufficient rail capacity to transport output from coal-producing provinces in western China to end markets in eastern and southern China. These logistical bottlenecks, coupled with rising wages and production costs, increase the price competitiveness of imported coal.

We remain bullish on China’s long-term demand for seaborne thermal coal. The country’s electricity consumption increased by more than 10% in 2011. With China expected to build 250 gigawatts of coal-fired generation capacity between 2011 and 2015, imports should increase in coming years. Coal from Australia will be a big part of this story, and Peabody Energy will be a leading supplier.

Meanwhile, Indian demand for thermal coal is likely to outstrip Chinese demand over the next decade. Domestic coal production has lagged the growth targets laid out by India’s Planning Commission in the current five-year economic plan.

Much of this shortfall reflects the operational difficulties facing Coal India, which produces 78% of the nation’s domestic coal supply, and has struggled to ramp up production. Some of these challenges relate to difficulties obtaining mining permits and acquiring land in the densely populated nation.

This massive supply shortfall must be offset by expensive imports, primarily from Australia and Indonesia. In the fiscal year ending March 31, the gap between domestic supply and demand reached 142 million metric tons, and this shortfall will only continue to expand. In 2011, India’s imports of thermal coal surged 35% from year-ago levels to about 85 million tons.

The long-term supply and demand picture for metallurgical coal, the varietal used in steelmaking, is more bullish. Peabody Energy estimates that urbanization in China, India, and other emerging markets will increase global demand for met coal at an average annualized rate of 5% over the next eight years.

With an ambitious slate of organic expansion projects, Peabody Energy expects its Australian operations to produce between 22 and 25 million tons of met coal annually by 2015. We also like the company’s focus on metallurgical (met) coals that tend to command a premium price.

Management estimates that hard coking coal will account for 40% to 50% of the firm’s 2015 Australian met coal production, while low-volatility pulverized coal injections are expected to account for 30% to 35%. The latter type of coal is crushed into a fine powder and injected into blast furnaces as a partial replacement for met coal in the production of pig iron.

Peabody Energy remains our top long-term bet on rising coal demand in China, India, and other emerging economies. For investors with a longer horizon, the stock trades at an attractive valuation.

That said, the stock will continue to trade at a depressed valuation as long as steel production in China, which accounts for about 45% of the global market for met coal, continues to disappoint. Peabody Energy rates a buy up to $45.

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