A perfect storm was brewing for the coal industry in 2008:
carbon-capping climate legislation looked increasingly likely to be
approved, demand for electricity began to fall sharply and natural
gas -- which can also replace coal in many power plants -- saw a
sharp price drop. In addition, the incoming presidential
administration promised much more rigorous enforcement of health
and safety regulations for miners, which would end the extended
period of laissez-faire treatment. With this scenario, the
Market Vectors CoalExchange-Traded Fund (
slumped from $55 in the middle of 2008 to just $15 by year's end.
Today, the industry's obituary looks premature. A host of factors
has led to a sharp rebound in coal prices since that crash in
2008 and the coalindex has tripled since then. In fact, it's risen
nearly 50% since this past Labor Day. Investors are anticipating
brighter results in 2011 and are bidding upshares in advance. But
thecommodity 's winning streak looks set to dim in subsequent
years, so this recent rally may indeed be the last sharp upward
move that coal will ever see.
From headwinds to tailwinds…
The winning streak began in 2009, when the coal industry managed to
control the damage caused by present circumstances -- demand for
electricity in the United States fell 4% that year, while
demand for coal dropped a sharp 10% in the same period, as a number
of dual-fuel plants switched to natural gas only. Coal producers
met that challenge by cutting output by a commensurate amount. With
supply and demand back in balance, prices rebounded impressively
for both met coal and thermal coal (higher-priced met coal burns at
very hot temperatures and is used by steel makers, while
lower-priced thermal coal is generally used by power plants).
The industry has also started to cheer a growing export opportunity
thanks to China. Until just a few years ago, China was a net
exporter of coal, but domestic supply constraints and rising demand
has led the country to import more than 40 million tons in 2010
alone. Australia has served as a key provider of thecommodity as
well, though plague-like rains in the state of Queensland have
prices around the world. As a result, investors began to assume
that U.S. coal exports would keep surging, especially as Australia
has run up against major transportation bottlenecks and can't keep
up with demand.
Lastly, recent changes in the political landscape in Washington
have led many to conclude that the Obama administration will now be
greatly hampered in its efforts to boost clean energy use at the
expense of carbon-spewing coal power plants.
...and back to headwinds
But coal's recent powerful rally seems to ignore some major
potholes in the road ahead. These problems are unlikely to become
apparent in 2011, but as investors look ahead the dips will likely
be reflected in declining stock prices, and the picture of 2012 and
beyond becomes much more sobering.
For starters, energy investors have switched statements such as
"the United States is the Saudi Arabia of coal" to "the United
States is the Saudi Arabia of natural gas." With the discovery of
recent shale plays, natural gas reserves have become so abundant
that this source of energy is likely to stay quite cheap for some
time. Natural gas also produces less carbon dioxide (greenhouse
gas) than coal or oil. For a host of reasons, new gas-fired plants
are being built while a wave of coal-fired plants are slated to be
de-commissioned during the next five years. Existing plants that
can burn either fuel are likely to stick with natural gas for the
In addition, Washington is unlikely to pass any major climate
legislation in the next few years, especially any package that
taxes greenhouse gas emissions -- even if the Obama administration
tries to take advantage of the fact that the U.S. Environmental
Protection Agency (EPA) can now monitor and regulate carbon dioxide
emissions of power plants and oil refineries. It's still unclear
what this government supervision might mean to the industry, but an
ever-increasing number of coal-fired plants could be forced to
upgrade emissions scrubbers or even shut down completely.
And although greenhouse gas emission taxes do not have bipartisan
support, state and federal governments are likely to steadily
increase the renewable portfolio standards (RPS) to roughly 20% by
2025 (RPS is the minimum percentage of energy derived from
renewable resources that electricity providers must generate).
These RPS mandates could start to really eat into coal demand.
Let's not forget about China, which derives roughly two-thirds of
its electricity from coal. The country is working hard to boost
other energy sources such as wind and solar, but unless it can get
major efficiency gains from them, coal will remain the primary
energy resource in that country. Yet it's also unlikely that the
United States can play a major role in the Chinese energy industry
in the long term. Australia, which is located much closer and thus
holds key logistic advantages, is slowly tackling its shipping
bottlenecks. Only within a few years the land Down Under may be
able to drastically improve exports.
Analysts' predictions range from neutral to bullish on most coal
stocks, anticipating a decent supply/demand environment in 2011.
Even as they don't generally focus on the longer-term looming
headwinds, they note thatshares are already fully-valued on what
currently looks to be a solid pricing environment in 2011. However,
they seem to be unanimously optimistic on one name: coal company
Peabody Energy (NYSE:
. The appeal is simple. Peabody has been heavily investing in
Australia and will soon see half of itscash flow derived from that
country. As production at Peabody's mines continues to ramp, so
free cash flow
, which is projected to be a cumulative $5 billion during the next
four years, according to Goldman Sachs.
Action to Take -->
The coal sector looks more appealing on the short side than the
long side, though no clear negative catalysts exist in the
near-term. The only ones that might pop up in 2011 are a sharp
slowdown in China, which will curtail demand; early stirrings of
any bipartisan efforts to tackle climate legislation, which again
won't be as onerous as thought to be a few years ago; or even
further drops in natural gas prices, which will accelerate fuel
source switching at power plants. Short sellers should start to
look at the math for 2012 and beyond, and look to set up short
positions in 2011.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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