(AEP) Coal Industry Stock Review – December 2011 – Industry Outlook

Coal has been used for nearly as long as mankind has thrived, for everything including cooking, making clay pots, heating, as fuel to run steam-powered trains, to make weapons, heating homes, generating electricity, powering railroads and boats, and fueling factories.

Today, coal is burned as fuel or gasified to create a synthesis gas (syngas) that can then be used as a feedstock for the production of chemicals, fertilizer and electric power. Coal is also used for producing heat through combustion.

The USA, Russia, Australia, China, India and South Africa have the largest coal reserves in the world. Coal is produced in 25 states in the US spread across three coal-producing regions, but majority of the current production originates in just five states: Wyoming, West Virginia, Kentucky, Pennsylvania and Montana.

The most recent figures available from the U.S. Energy Information Administration’s (EIA) report as of January 1, 2011, show that America’s estimated recoverable reserves of coal stand at 261 billion short tons.

Like all commodity sectors, the fortunes of the coal industry are also closely tied to the health of the global economy. The post-recession demand recovery in the U.S. has helped improve the industry’s earnings power, with most coal companies solidly profitable in 2010. This uptrend in demand, largely driven by the improvement in the global economic activity, rebound in domestic power demand, favorable weather patterns and soaring coal demand from Asian countries, also continued into 2011.

Coal Dominates U.S. Power Generation: As we already know, coal as a major source of fuel for power generation dominates the Utility industry. Coal is used to generate about half of the electricity consumed in the United States, and is also the largest domestically-produced source of energy. Electricity generation absorbs about 93% of total of U.S. coal consumption. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country.

However, the EIA estimates U.S. coal consumption for electricity generation to decline by 16 million short tons (MMst) or 1.6% in 2011. According to EIA, the modest growth in total electricity generation in 2011 will be more than satisfied by increases in generation from natural gas and renewables other than hydropower.

Projected increases in generation from natural gas, nuclear and non-hydro renewables, combined with lower electricity consumption, contribute to an additional 4.6% decline in electric power sector coal consumption in 2012.

By contrast, petroleum and nuclear power as sources of power generation have been losing market share, displaced by the strong growth of renewable sources of generation and natural gas-fired generation. Petroleum is losing out to coal because it is becoming increasingly expensive.

Not Just Electric Generation: Electricity generation is just one use of coal in the United States. In addition, manufacturing plants and industries use coal to make chemicals, cement, paper, ceramics and metal products, to name a few. Methanol and ethylene, which can be made from coal gas, are used to make products such as plastics, medicines, fertilizers and tar.

Certain industries consume large amounts of coal. For example, concrete and paper companies burn coal, and the steel industry uses coke and coal by-products to make steel for bridges, buildings, and automobiles.

Coal as an Input for Steel Industry: Due to its heat producing feature, today, hard coal (metallurgical or coking coal) forms a key ingredient in the production of steel. Nearly 70% of global steel production depends on coal. The demand for metallurgical coal continues to increase based on the recovery of the global steel industry.

Coal Trade

About 9% of U.S.-mined coal is exported to some 40 countries, including Canada, Japan and Western Europe.

According to EIA’s “Short-term Energy Outlook,” U.S. coal exports rose to 54 MMst during the first half of 2011, the highest since 1982, representing about 35% compared with the same period in 2010. U.S. coal exports likely remained elevated in the second half of 2011, reaching an annual total of 102 MMst. Exports are expected to decline to 91 MMst in 2012, as supply from other major coal-exporting countries recovers from disruptions.

Demand for U.S. coal was also strong in the third quarter. This was mainly driven by increased coal imports in China, South Korea, India and Europe. China net coal imports just hit an all-time high in September. South Korea’s coal imports also have set records recently, and India’s thermal coal imports are up more than 40% year-to-date.

Additionally, coal trade in the U.S. continues to benefit from favorable prices for the shipments made. Per the EIA’s latest report, average delivered coal prices to the electric power sector have increased steadily over the last 10 years by an average of 6.7% each year. The EIA sees this trend continuing in 2011, largely because of a rise in transportation costs.

The projected average delivered coal price to the electric power sector, which was $2.26 per MMBtu in 2010, rises to $2.41 per MMBtu in 2011 and $2.44 per MMBtu in 2012.

Demand Upsurge in Asian Countries: The increases in coal demand in Asian economies like China and India have been a key price driver since the end of the recession in 2009. We expect this trend to continue in future mainly due to the growing energy needs in India, China, South Korea and Europe.

China, the world’s fastest growing major economy, has massive coal reserves. However, its domestic coal production continues to fall short of meeting its rapidly growing demand for coal, resulting in the continuous rise in coal imports. China has since overtaken the U.S. as the world’s largest consumer of coal.

Similarly, in India, the rising population and economic growth continue to call for increased coal consumption for electricity generation. Coal accounts for nearly 55% of the country’s energy consumption needs. The last four decades have seen the country’s commercial energy consumption rise by about 700%. Going forward, India plans to double electricity generation capacity by 2012, which could see the country importing in excess of 200 million tons of coal.

Given the growing demand from the fast-growing Asian economies, we find companies exporting coal to the emerging regions attractive for investment. Some of the names are Peabody Energy Corporation (BTU) and CONSOL Energy Inc. (CNX).

Other key thermal coal players who stand to benefit from the increasing demand for coal include James River Coal Co. (JRCC) and Cloud Peak Energy (CLD). Apart from this, certain coal master limited partnerships (MLP) including Penn Virginia Resource Partners L.P. (PVR), Natural Resource Partners L.P. (NRP) and Alliance Resources Partners L.P. (ARLP) are also good investment bets for people seeking exposure in the coal sector.

Common Threats

Coal is plentiful and fairly cheap relative to the cost of other sources of electricity, but its use produces emissions that adversely affect the environment. Coal emits sulfur dioxide, nitrogen oxide and mercury, which have been linked to acid rain, smog and health issues. Coal also emits carbon dioxide, a greenhouse gas that contributes to climate change.

Coal accounted for 37% of the total U.S. emissions of carbon dioxide released into the Earth’s atmosphere in 2010. Without proper care, coal mining can have a negative impact on ecosystems and water, and alter landscapes and scenic views.

Environmental Legislations: Coal has been losing its importance as a fuel source over the last few years, particularly in the U.S., vis-à-vis other sources that have a lesser impact on the environment. Concerns on the emission of greenhouse gases and global climate change have resulted in the formulation of new legislations and policies which emphasize on the use of environment-friendly fuel sources, particularly in the power sector.

This has considerably slowed the expansion of coal-fired capacity in the power sector, with utility companies now building new natural gas-fired plants and resorting to alternative sources of energy generation like wind, solar and hydro power. It remains to be seen what impact the Japan disaster will have on the industry’s fortunes going forward. But it has to be a net positive.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is natural gas. Coal is being dumped in favor of natural gas, which due to extensive exploration and production, has a significantly lower price than in the past. Natural gas is usually an attractive choice for new generating plants because of its relative fuel efficiency, low emissions, quick construction timelines, and low capital costs. Cheaper natural gas and large coal inventories have greatly hurt the U.S. and European thermal coal demand in 2009.

Electric generation through gas-fired plants is likely to become more competitive over the coming years given its abundant domestic availability and the threat of regulation hanging over the Coal Mining industry. Large electricity generators in the U.S. like American Electric Power (AEP), Exelon Corporation (EXC), FirstEnergy Corp. (FE) and others are turning to natural gas for additional electrical capacity.

Not only coal, natural gas also substitutes the use of renewable and nuclear energy for electricity generation, as new natural gas-fired plant is much cheaper to build than new renewable or nuclear plants.

Competition from Alternative Energy Sources: Apart from natural gas, the coal industry has been losing a major share of its electric generation demand to renewable sources of energy like wind, solar and hydro power. Generation from renewable resources grows in response to key Federal tax credits, but it is expected to be lower in 2011 than in 2010 because of lower natural gas prices and higher costs for new wind power plants.

Growth in renewables has also been supported by the many State requirements which stipulate the installation of renewable sources of electricity generation as mandated by Renewal Energy Standards (RES). The share in energy generation of renewable fuels (including conventional hydro) is projected to grow from 11% in 2009 to 14% in 2035, as per EIA’s long-term outlook.

Conclusion

Though there is ample pressure from legislations and competition from natural gas and renewable energy sources, we believe the global power industry will continue to depend on coal for a large part of its generation. Coal as a fuel source will continue to power the growth in emerging nations like China and India, both for utility companies and steel makers.

The EIA estimates that the United States has enough coal to last for more than 200 years at current coal consumption rates. This is promising because, in addition to the many existing ways to use coal, the future holds new methods and potential for growth. Products from coal may soon be part of communications and transportation systems, computer networks and even space expeditions.

In addition to these new and increased uses of coal, new technologies will continue to enhance the ability to identify the shape and composition of untapped coal reserves. New technologies will also continue to improve the effects of the production and use of coal on the environment.

For example, the U.S. Environmental Protection Agency’s Coalbed Methane Outreach Program seeks to work with coal companies to reduce methane gas emissions associated with coal mining.

These new technologies focused on achieving near-zero emissions open up avenues for potential long-term industry growth. Clean coal technology development in the U.S. also has funding earmarked under the American Recovery and Reinvestment Act of 2009. This is an encouraging sign for coal producers.

AMER ELEC PWR (AEP): Free Stock Analysis Report

ALLIANCE RES (ARLP): Free Stock Analysis Report

PEABODY ENERGY (BTU): Free Stock Analysis Report

CLOUD PEAK EGY (CLD): Free Stock Analysis Report

CONSOL ENERGY (CNX): Free Stock Analysis Report

EXELON CORP (EXC): Free Stock Analysis Report

FIRSTENERGY CP (FE): Free Stock Analysis Report

JAMES RIVER CL (JRCC): Free Stock Analysis Report

NATURAL RSRC LP (NRP): Free Stock Analysis Report

PENN VA RESRC (PVR): Free Stock Analysis Report

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