Why coal is still king

Given a choice between money and a vague ethical principal, such as making a personal sacrifice to try and prevent global warming, most people will choose the money.

That’s exactly what’s happening in the energy debate as global warming’s number one enemy, coal, makes a surprise return thanks to its status as the world’s leading low-cost fuel.

The change does not mean it’s time to rush out and buy shares in coal-mining companies. Nor is it time to sell them.

But it is time to reconsider the financial status of a fuel that appears to have hit a price bottom, with more potential to rise in the future than fall.

In simple terms there is no evidence of a decline in the worldwide use of coal, despite its status as an environmental pariah.

Coal price reflects higher demand

The current low-price for thermal (electricity generating) coal and metallurgical (steel-making coal) is a function of excess supply, not diminishing demand.

Click to enlarge

Click to enlarge

Peak Oil, the argument which sounded good until a few years ago, was based on a belief that the world would soon run out of petroleum in its many forms, from oil to gas.

In time, perhaps after another century has passed, the Peak Oil theory might be proven correct. But today it’s a busted flush, with the world awash in petroleum thanks to rising (not falling) production and increasing (not decreasing) rates of discovery. This is due to the ability of technology to unlock once-impervious reservoirs of gas and oil.

The importance of oil (and increasingly gas) in the global energy mix is that it is the benchmark by which all other energy prices are set. And in the US, home of the so-called “shale gas” revolution, energy prices have fallen, giving that country’s economy a boost. This has also given the US a cost advantage over its primary rivals, Europe and China.

Layered on top of the fundamental change in the availability of energy caused by rising supplies of oil is the complex web of government rules and subsidies aimed at encouraging a switch in energy sources from fossil fuels, such as coal and oil, to renewables, such as wind and solar.

The theory, from a save-the-planet perspective, is ethically reasonable. But that’s an environmental debate, and one which has little bearing on how companies and households react to rising energy prices.

It is in the marketplace for energy that consumers, whether industrial or personal, are rebelling against the enforced use of high-cost energy in a very traditional way. They are looking for cheaper alternatives and that, unfortunately for the renewables sector, means a switch back to coal.

Before looking at an example of what this means, there is another factor at work in the financial equation. That is the ability of governments, which are already carrying heavy debt burdens, to continue subsidising renewable energy and in enforcing increasingly contradictory regulations.

At some point the system of subsidies will collapse because of a taxpayer revolt when they wake-up to the fact that factories are closing because of high energy costs, which are the result of the enforced use of renewables.

Refiring Australian coal

Last week, Australia saw a perfect example of a how a distorted energy market can produce an unexpected outcome. A power station using gas, a relatively clean-burning fuel, was closed and a more polluting power station, using coal, was re-opened.

Remarkable as it sounds, at a time when the world is supposed to be encouraging the use of less polluting fuels, that’s precisely what happened at Queensland’s Stanwell power station. The state government agency that operates the station, Stanwell Corporation, made a financial decision to sell the gas it is buying under a long-term, low-priced contract, into the east-coast gas grid for a handy profit. It is now replacing the electricity the gas was to have produced by resurrecting a mothballed coal-fired power station.

From an environmental perspective it is a shocking decision. From a business perspective, it is perfectly logical.

Europe’s energy confusion

In Europe, which was once the place that Australia looked to as an environmental and energy policy trend-setter, there is total confusion over power policies. There is also a rising tide of concern that unless changes are made some of the region’s heavy industries will relocate to the world centre of low-cost energy, the US.

Germany and Britain are the focal points of what seems to be a collapsing energy system, which has been reshaped to accommodate wind, solar and other forms of renewable power. But this has been done without sufficient thought being given to the cost involved or the reliability (and continuity) of renewables, which need wind or sunshine to work efficiently.

The upshot of a market distorted by government decrees designed to encourage the use of renewables is that major electricity producers have been forced to burn more of the world’s cheapest and most polluting forms of coal, lignite – also known as brown coal.

The primary cause of Germany’s power crisis is a law passed in 2000 that guarantees 20 years of subsidies for power generated by renewables, with producers of solar and wind power also having priority access to the national electricity grid.

That has led to a situation similar to Stanwell, with big German electricity producers forced to close loss-making gas turbines and turn to their cheap-fuel option, coal, in order to compete with rival power sources that are being propped up by government subsidies.

Last year, in a totally contrary reaction to what was expected from Germany’s attempt to encourage the use of clean fuels, the country burned the most lignite coal since 1990.

In Britain, the situation is morphing into a farce which could be a script from the “Yes Minister” comedy show, which is exposing the nonsense of government interfering with business.

While one arm of government (Britain) is issuing political directives and encouraging the use of renewables by paying subsidies to consumers, another arm of government (Europe) is issuing warnings that the subsidies might be both (a) anti-competitive, and (b) a waste of taxpayers’ money.

It is, to say the least, a complex situation but it is entirely man-made and highly likely to trigger a push to unwind and rewrite the contradictory and unworkable laws that have been designed with the best intentions (save the planet), but which are causing more harm than good.

Exports set to fire

Meanwhile, back in Australia, the coal industry is starting to recover from a grim period of low prices, pit closures, job losses and low share prices.

Overall coal production, thanks to strong domestic and export demand, is rising rather than falling, contrary to the objectives of the many legislative and environmental attacks on the coal industry.

In its latest analysis of the coal-mining industry the federal government’s resource forecasting agency, the Bureau of Resources and Energy Economics (BREE), noted that total thermal coal production is expected rise this year by 4% to 247 million tonnes. Exports – aided by the lower value of the Australian dollar – are forecast to rise by 5% to 191 million tonnes, and the value of exports to rise by 6% to $17.2 billion.

When compared with other minerals and fuels, coal exports are the second-fastest growing by volume (after iron ore) and fifth-fastest by value (after iron ore, alumina, LNG and copper).

What this boils down to as an investment thesis is that coal remains a resource sector leader, despite the best efforts of government and environmentalists.

However, what investors (and environmentalists) also need to recognise is that the price of coal is not likely to recover quickly, despite strong worldwide demand, because supply is strong and rising.

In other words, coal is likely to remain the “go to” energy source for decades, because it is the cheapest energy source.

Among recent projections for coal prices are those from the investment bank, J.P. Morgan, which sees thermal coal creeping up from around $US84 a tonne to $US87/t over the next 12-months, and metallurgical coal behaving in a similar way with a rise from $US155/t to $US165/t.

The exchange rate, if it falls further, will aid Australian coal exporters, which is why some mining stocks with heavy coal exposure are looking relatively cheap.

Behind the coal play

BHP Billiton and Rio Tinto are major coal producers, though their coal interests tend to be drowned out by other commodities such as iron ore, copper and oil.

The purest coal producer of any substance still listed on the ASX is Whitehaven Coal, a company once the plaything of Nathan Tinkler, an entrepreneur who has decamped to live in Singapore after a tumultuous few years as Australia’s mini coal king.

Today Whitehaven is on a roll, with rising production and revenue, but perhaps not yet rising profits.

UBS, in its latest assessment of Whitehaven, reckons the company will report a modest loss of $13 million for the half-year to December 31 when it files its accounts later this month, and then return to profit because it is successfully cutting its operating costs.

Macquarie, in perhaps the most optimistic comments about a coal company in several years, reckons Whitehaven is on track to convert last year’s pre-tax loss of $39.9 million into a pre-tax profit this financial year of $91.2, and might even squeeze out a dividend of 1.2 cents a share.

But the key comment from Macquarie about Whitehaven is that the broker reckons the stock is heading towards a share price of $3, or 87.5% higher than its current $1.60.

That price tip is optimistic, but the more interesting aspect is that it is about a coal mining company and it’s been a long time since anyone was that optimistic about anything to do with coal.