Old King Coal is about to be a much merrier old soul.

After a stunning 60 percent gain for the sector in the first half of the year, and then a correction almost all the way back down, my research suggests that we’re about to see another breathtaking run for the group.

Curiously, it seems to have much to do with the Olympics.

As was widely discussed in the press, China severely cut its use of fossil fuels, particularly coal, right around June in an all-out effort to clean up the air for the Olympics.

What has not been discussed much at all are the global implications of that cutback on the energy markets, and how the resurgence of Chinese energy consumption after the games spells higher prices for grid power and many other commodities…and profits for coal investors.

This week, I take a methodical look at China and coal, and what it means for the US.

Demand

With coal powering 80 percent of its electricity supply, China is both the world’s largest coal producer and its largest coal consumer.

China’s demand for coal rose 9 percent last year. This year, the Coal Sales and Transportation Association of China anticipates that the nation’s requirements will rise another 5.3 percent, to 2.76 billion tons. (By comparison, US consumption of coal last year was less than half that, at 1.1 billion tons, according to the EIA’s July 25 Quarterly Coal Report.)

The reason is simple: About two-thirds of global coal consumption is used to fuel electric power plants, and most of the rest is used to make steel and cement.

China’s manufacturing base is of course utterly dependent on electricity demand to run its factories and assembly plants. It is also the world’s top producer of steel, with more than double the output of the entire EU, the number-two producer by tonnage.

With China’s economic growth rate still running at about 10 percent per year, and India right behind, it’s no wonder the US Department of Energy estimates that 70 percent of the increase in global coal demand over the next two decades will come from China and India.

Neither country can satisfy its needs with domestic coal production anymore, and both have slashed exports this year in order to ensure they’ll have enough for themselves. (My longtime readers will instantly recognize this as another example of the "Export Land Model.")

As the temporary damper on production and consumption for the Olympics comes to an end, and full demand is restored, it’s entirely possible that China may become a net coal importer within the next year.

Production

China capitalized on coal’s run up earlier in the year in a big way, and was a net exporter for the first seven months of the year. Their profits were excellent: China Business News reported that as of July 4, the global price was more than $54 per ton higher than the domestic price, which is controlled by the state.

But then, to clear the air for the Olympics, China curtailed its coal production by restricting consumption, and limiting the supply of explosives used in coal mining.

According to the National Bureau of Statistics, coal output in July fell 8 percent from June, to 220 million tons. (I should note that very recent statistics of any kind on Chinese coal are rare and hard to come by if you don’t read Chinese, and even if you do, their reliability is completely unverifiable. But we use what we can get.)

But the big picture is even clearer.

Five years ago, China sported an 83 million metric ton trade surplus in coal. Last year, that dropped to a mere 2 million, effectively taking 12 percent of the global trade in coal off the market.

Imports

Coal inventories have been chronically low this year in China. A massive heat wave in the early summer had caused its coal consumption to soar, and the supply just wasn’t able to keep up.

"After aligning the current stocks figure for comparison purpose, they were only two-thirds of last year’s highest level," said Li Xinfang of the State Grid, the country’s chief grid operator.

Then came the Olympics, and the kibosh on coal.

China’s coal imports fell 36 percent from May to June, and June imports were down 32 percent year over year:

 

Type of Coal Imported	Change June ‘07-‘08
Anthracite	-51.13%
Coking Coal	-7.41%
Coke and Semi-coke	-53.59%
Non-coking Bituminous Coal	-10.91%
Total	-32.11%

Source: China General Administration of Customs

We’ll get out the outlook for imports in a moment.

Coal Shortages

The scaling back of both domestic production and coal imports produced a predictable result in short order: widespread and frequent outages. I have been reading a steady drumbeat of news reports chronicling the blackouts for the last several months.

Approximately half of China’s provinces are now rationing electricity, with forced limits on local governments and priority allocation to the Olympic venues.

If you doubt that the Olympics are a big deal in energy terms, consider this: Beijing invested over 20 billion yuan ($2.91 billion) to beef up its grid for the Games. It’s a good thing too, because on the first day of the event, peak power demand in Beijing—a city of over 17 million people, just under the population of New York City—jumped 21 percent.

The shortages have been due in part to government-imposed price caps on grid power, which have not kept up with the rising global price of coal. This forced smaller producers to operate at a loss, and so many of them simply stopped running their plants. The large state-owned plants, however, have been compelled to keep the lights on, putting a drain on the national coffers.

According to the China Electricity Council, over a third of the nation’s power plants had net losses over the first five months of the year, most of which were coal-fired. The State Grid reported that about 3 percent of the country’s coal-fired generation capacity was idled last month, due to a lack of coal.

Regional outages can be even worse. Last month, more than 15 percent of generating capacity was shut down due to a lack of steam coal in Shanxi…China’s top coal-producing province. How’s that for irony?

This week, the State Grid Corp. announced that power output was down 17 gigwatts from a year earlier in its territory.

In an effort to restore profitability for coal-fired power producers, Beijing announced a 5 percent hike in electricity rates on Tuesday this week.

Even so, according to estimates by BNP Paribas SA, the price of electricity in China is still 30 percent lower than it would be if it properly reflected the current price of coal.

Import Surge Dead Ahead

Now that the Olympics are nearly over, stocks at coal-fired plants are slowly building again. But supplies are still far too low for comfort, and the central government is signaling that it’s about to further release its restrictions.

A statement this week by Liu Tienan, vice chairman of the National Development and Reform Commission, encouraged power plants to stockpile coal early this year, before the additional demands of the winter season set in. If coal supplies are not soon increased, he warned, power shortages would worsen.

Last week, China’s General Administration of Customs said that coal imports should be increased to bring the grid back up to full power.

And Wang Dexue, China’s vice minister of the State Administration of Work Safety, said on August 9 that China will increase production at its larger mines in the second half of this year.

I have no doubt that the minute the last Olympics tourist flies home, China will be going full bore to produce and import coal, particularly steam coal, once again.

China’s Falling Coal Exports

As of June, with prices at stratospheric levels, China’s coal exports had grown 84 percent over the previous year, to 6.99 million tons. (Bear in mind that this was happening even as blackouts enveloped the country.) But then as international prices fell in early July, exports fell by a third from June volumes.

Now, with thousands of factories temporarily shuttered for a lack of grid power, there is an enormous amount of pent-up demand for coal.

So much demand, apparently, that China is not only planning to increase both production and imports, but also to further curb coal exports deliberately.

China announced two weeks ago that it would impose an export tax of 10 percent on thermal coal, and raise the export tax on coke to 40 percent. It also raised taxes on coking coal.

"The move will greatly reduce exports on the spot market. Besides the term contracts, there will be very little exports," said Judy Zhu, an analyst at Standard Chartered Bank in Shanghai.

Since China exports over half of the world’s coke, and since coke and coking coal are essential elements in making steel, we should expect higher prices worldwide for both the fuels and for steel.

Rising Prices

As international coal prices shot up this year, US coal prices tripled too, in a hockey-stick pattern that by now should be all too familiar. This chart from the EIA tells the story plainly:

Historical Average Weekly Coal Commodity Spot Prices (Dollars per Short Ton), Business Week Ended August 22, 2008. Source: Energy Information Administration

As Asian production and consumption of coal fell, its local suppliers suffered. The loss of Chinese coal exports indirectly translated to higher demand for US coal, driving its price skyward.

Flagging output from foreign producers and record prices have called more of Appalachia’s coal to buyers on the continent and in Asia, as we shall see in a moment.

In turn, this created more demand for coal from Wyoming’s coal-rich Powder River basin. Despite high transportation costs, even coal from the Powder River is now making its way to buyers in Europe and Asia.

I hasten to point out that since coal accounts for about 50 percent of US power generation, our grid prices are bound to follow coal upward. Dozens of utilities across the nation have recently announced price hikes of up to 30 percent, and I expect that many others will soon follow suit.

It could be a very expensive winter for those who rely on electricity for heating this year…

US: The Coal Exporter of Last Resort

With Chinese and Indian coal exports down sharply this year, one would normally expect major eastern exporters like Australia and Russia to fill the gap. But severe flooding in Australian mines and power shortages in South Africa have cut sharply into their exports. As of August 14, some 29 ships were reported to be waiting to load at Australia’s biggest coal export harbor in Newcastle.

Russia cannot make up the export shortfall either. On August 7, Deputy Prime Minister Sergei Ivanov told Russian coal exporters to prioritize domestic needs over exports, because coal stocks at Russian power plants are extremely low, and hydropower reserves are lower than they have been for decades due to low rainfall. Nor are there sufficient rail cars to move coal for both domestic supply and exports. To avoid power outages, Russian state rail monopoly RZhD halved the number of rail cars used to export coal from the Kuzbass in Siberia.

Likewise, Reuters reported two weeks ago that coal exports from Vietnam, a key supplier to China, are likely to drop by a third this year due to cyclone damage to three out of four cargo-loading facilities at its largest coal hub in the northern Quang Ninh province. In addition, Vietnam is cutting back on fossil fuel exports in order to ensure sufficient supplies for its own industries.

The loss of Vietnamese coal exports caused the price of Australian steam coal, an Asian benchmark, to rise to $163.90/ton after five straight weeks of declines from a record $195/ton in early July.

Indonesian coal exports have also been reduced. On August 12, six coal miners were ordered to stop exporting because their prices were too low, and police stopped output from a mine in Borneo claiming that the operator lacked a forestry permit. To my ears, this sounds like a Russian approach to resource nationalization, using legal technicalities to tamp down exports.

Like a cascade of dominoes, China’s renewed appetite for coal has now made the US the coal exporter of last resort for the entire world. And since the US holds the world’s largest coal reserves, that situation may never be reversed.

Stifel Nicolaus analyst Paul Forward expects U.S. coal exports to jump a full 39 percent this year, to 82 million tons.

Consider Alpha Natural Resources (NYSE: ANR), the largest US exporter of coking coal, with 22 percent of the domestic coal export market. Since the beginning of this year, the stock shot up 200 percent!

US Coal Stocks Are Now Cheap Investments

Fortunately for smart investors like us, the news hasn’t quite yet sunk in on the Street.

The stocks of most US coal producers have declined 40 percent or more from their July highs, and are now testing support levels last seen in April when they broke through the previous resistance level set in January.

 

By comparison, for those interested in investing in Chinese coal, China’s coal producers have corrected even more:

My read of the charts suggests that coal stocks may have bounced off a classic double-bottom last Friday, making coal ripe for another charge upward. The shares have already gained 9-10 percent since then.

For investments in coal, I like Peabody Energy (NYSE: BTU) and Arch Coal (NYSE: ACI), but for those who prefer to play a basket of shares, the coal ETF (NYSE: KOL) works too.

I’m not the only one who sees a boom time ahead for companies like Peabody. Analyst David Khani of Friedman Billings Ramsey believes the stock will more than double in a year, largely due to foreign markets which account for more than half of Peabody’s profits. He believes that demand will outpace supply for at least another two years, and that prices could double again next year.

The domestic outlook is bullish too, with some 30 new coal-burning power plants under construction in the US.

Takeover Targets

Aside from the strong market fundamentals for the black stuff, there is another angle that makes coal a promising sector right now, and that’s mergers and acquisitions.

Billionaire Wilbur Ross, chairman of the International Coal Group, told Bloomberg that he anticipated "an unprecedented amount of both domestic and cross-border mergers and acquisitions" in the coal sector, as China seeks to secure enough energy to keep its economy going.

The reason is simple: Compared to China’s top coal company, the top U.S. coal producers are hugely undervalued, at $2.11 a ton for Peabody Energy Corp (NYSE: BTU) vs. $15.52 for China Shenhua Energy Co.

With a huge store of US debt on its balance sheet, the dollar still dragging the bottom, and an insatiable need for more energy, China is on an aggressive campaign to secure energy supplies from the US by hook or by crook.

According to the New York Times, 9 out of 10 unsolicited hostile bids launched by Chinese firms on foreign targets since 2005 were focused on natural resources. The Asian nation has recently made several hostile bids for foreign steel makers.

Likewise, smaller coal companies are takeover targets for larger companies with better operational efficiencies.

Rail Benefits Too

There is another investing angle on the China coal crisis that we must not forget: the railroads. Norfolk Southern (NYSE: NSC), one of the industry’s largest coal shippers, stands to benefit handsomely, as do Burlington Northern Santa Fe (NYSE: BNI) and Canadian Pacific Railway (NYSE: CP).

Although the rail sector got hit along with everything else in the June-July selloff, shares have recovered to May levels or better, and look ready to make another run up now.

On the whole, I see no direction but up for coal prices and coal stocks, and the profits will come quickly. This looks like an excellent entry point for the group.

Now, don’t get me wrong. I am deeply concerned about carbon emissions, and it gives me no joy to announce a new boom for King Coal. In time, I am hopeful and confident that carbon emissions will come with a price, and coal producers and coal-burning power plants will have to pass those costs on to the consumer, which will ultimately benefit renewable energy.

The transition will take a long time though, because you don’t just put up thousands of wind turbines and solar arrays and miles of transmission lines overnight. Nor will the billions in capital committed to coal production and distribution and coal-fired power plants just get up and walk away.

If you have an agnostic approach to investing, coal is a clear investment winner for the near to medium term.

Until next time,

Chris