Put Some Coal in Your Stocking

12/16/2010 3:30 pm EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Peabody Energy is a gift that will keep on giving as it races to meet Asia's soaring energy demand, writes Elliott Gue, editor of Personal Finance.

Coal remains one of my top sector plays for 2011. Many investors overlook the fact that coal generates half of US electricity, more than 45% of Germany’s power and 80% of China’s electricity.

Most of the news stories mentioning coal highlight the damage it inflicts on the environment and emphasize that US utilities aren’t likely to build many new coal-fired plants, especially when natural gas prices are this depressed. These caveats miss the point: The bullish case for coal isn’t based on US trends, though America will play a huge future role as a supplier.

The idea that China will be able to replace its coal-fired power plants with renewable energy or any other power source is downright laughable. With the exception of hydroelectric power, renewable energy is expensive and unreliable. Although use of renewable energy will increase—it’s coming from a low base—it won’t be significant contributor to China’s grid for a long, long time.

China needs more electricity to feed its growing economy, which, like India's is going through a rapid  ramp-up in per-capita energy consumption.

China has significant domestic coal reserves but lacks abundant natural gas resources; India has access to low-quality domestic coal. Coal is cheap and relatively plentiful in these fast-growing economies. Expect demand for coal to grow.

Consider that average per-capita annual electricity consumption is 12,000 kilowatt hours in the US, 8,000 kilowatt hours in Japan and about 6,500 kilowatt hours in Germany. Compare that to China, where annual per-capita electricity consumption is about 2,000 kilowatt hours, or India, where it’s less than 1,000 kilowatt hours.

The One Coal Stock to Own
Peabody Energy (NYSE: BTU) boasts the best strategic position of any US coal producer: It has limited exposure to near-term weakness in the US market for thermal coal and unparalleled upside leverage to Asian demand through its growing Australian operations. [Jim Jubak is also a fan of BTU, as well as three other suppliers he calls attractive takeover targets—Editor.]

Key Takeaways:

  • Asian seaborne coal markets remains red hot, with strong demand from China, India and other emerging markets and tightening supply because of adverse weather in Australia.
  • Mine expansions will add to Peabody’s Australian production base in coming years.
  • Management has done a good job of controlling costs, boosting profit margins.
  • Near-term outlook for the US thermal coal market isn’t good, but Peabody has sold most of its 2011 production under long-term deals, a move that minimizes its exposure.
  • An October deal to export coal from the Powder River Basin to the UK highlights the potential to boost exports of US thermal coal to Europe and Asia.

Peabody Energy delivered a solid third quarter, beating consensus forecasts for both earnings and revenue. Coal remains a tale of two markets, with ongoing strength in Australian seaborne coal and continued weakness in the US. Peabody’s conference call made me incrementally more bullish on Asian coal markets and more bearish, at least in the short run, on US thermal coal markets.

This basic outlook underscores once again why I’ve recommended Peabody over other US-based coal producers in recent quarters: It’s the only firm with a major Australian operation that benefits directly from rising Asian demand for coal. In the most recent quarter, Peabody generated more cash flow from Australia than from the US.

The next step in the company’s evolution is also overseas. Peabody is increasingly focused on ways to export its US-mined coal to Europe and Asia—even its US mining business will become less leveraged to domestic coal demand over the next five years.

The company’s solid ongoing execution merits a higher buy target; buy Peabody Energy Corp under 61. [Shares traded just below that buy point Wednesday—Editor.]

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