March 2012

Cheaper ‘Toxic Rock’ May Present an Opportunity for InvestorsDespite statistics released by the U.S. Energy Information Administration (EIA) supporting an increase in the long term usage of coal as a form of energy, both delivered coal prices and coal stocks have experienced declines over the past year. This article explores the potential investment opportunity presented by cheaper ‘toxic rock’. It reflects not only the challenges and potential benefits of investing in coal but also aims to inform investors how exposure to the coal industry can be achieved.

By Yasin Ebrahim

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A ROCKY RIDE for coal demand in the past year has lowered prices to attractive levels. Several factors are exerting downward pressure on the average delivered coal price.

These include; lower electricity demand, lower natural gas prices prompting utility companies to switch from coal to natural gas power plants, and concerns regarding an energy cap that seeks to limit carbon emissions.

However, coal is cheap, easy to extract and ample in supply. Coal currently provides 29.6% of global primary energy needs and generates 42% of the world’s electricity according to the World Coal Association. Population and income growth are the main drivers of energy demand. Demand for the coal in the long term is supported by current statistics released by the U.S. Energy Information Administration (EIA) which expects coal consumption to increase from 139 quadrillion Btu in 2008 to 209 quadrillion Btu in 2035 (Figure 1).

Primary drivers for an increase in expected demand of coal are Asian countries, more significantly China – the world’s largest energy consumer which uses close to half of the world’s coal. China’s annual coal demand is expected to reach 3.9 to 4.3 billion tonnes by 2025.

Despite China’s attempt at adopting a more diverse energy mix – investing heavily in renewable energy resources such as hydro, wind, solar and biomass power – it still relies significantly on coal fired powered plants to provide approximately 80% of its electricity.

However, China is not alone in its preference for coal as the main provider of energy. Australia, Poland, India and South Africa use coal as a major generation fuel. India is expected to increase it’s use of coal-fired power plants from 99 GW in 2008 to 172 GW by 2035, an increase of 60%. South Africa, the world’s fifth largest coal producer, relies on coal

to produce 93% of its electricity needs and coal is the country’s third largest source of export revenue.

Environmental conservation efforts such as the proposed U.S. Waxman-Markley Energy Bill [aka the American Clean Energy and Security Act] has given rise to the use of clean-coal technology.

Clean-coal technology seeks to reduce harsh environmental effects by using multiple technologies to clean coal and contain its emissions.

Acceptance of this bill will increase preferences towards the use of clean-coal technology, inevitably raising coal demand.

These facts point favourable towards coal demand and are supported by analysts at UOB-Kay Hian Ltd– the largest listed securities company in Singapore – who believe China’s “strong demand and supply tightness should continue to support coal price uptrend in 2012”.

‘Stuck Between a Rock & a Hard Place’China relies largely on domestic energy resources

to develop its economy. Coal is China’s largest energy resource and the Chinese domestic market is more than three times the entire international coal trade. As a result, a minor shortage in supply of coal leads to increases in world coal prices.

On the domestic front, this shortage could be

Coal currently provides 29.6% of global primary energy needs and

generates 42% of the world’s electricity

World Coal Consumption (Quadrillion Btu)

Source: EIA

209 Btu by 2035

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March 2012

COAL

In addition to the factors limiting supply, the vast reserves of the world’s coal are mainly of the lower-quality bituminous variety, more difficult to mine in terms of time and cost, further giving rise to the importance of a long term investment in coal.

The ‘Pure Play’‘Pure play’ involves investing in a company devoted to one line

of business or a company whose stock price is highly correlated with a specific business. For example, investors seeking exposure to coal markets could purchase shares in Peabody (the US’s largest coal mining company) thereby making a pure play in the coal mining business.

An exchange traded fund (ETF) can also be used as a pure play on coal. These are typically passive investments that trade on an exchange. And ETFs can be purchased via a single transaction. The advantages of this include cost effectiveness since there is only one transaction per trade. Furthermore, ETFs require minimal management as their aim is to track an index rather than outperform it; therefore, risk and management fees are lower.

An ETF such as Market Vectors Coal ETF (KOL) or PowerShares Global Coal ETF (PKOL) provides investors with exposure to a global universe of listed companies engaged in the coal industry, including Peabody Energy, Alpha Natural Resources and CoalCorp Mining. Coal ETFs not only provide exposure to the industry but help investors achieve diversification.

Standing the Test of TimeGiven that last year was difficult for coal stocks –

as evidenced by dramatic falls in a number of coal mining company stocks – it may be the entry point for investors with a long term outlook on the sector.

The challenges the coal industry faces in the long term will be determined by the expansion rate of environmental conservation efforts, improvements in the production and mining in the coal industry, and the adoption rate of renewable energy resources.

Despite these challenges, the benefits of coal – ample supply, cheapest form energy, ease of extraction and contribution

towards the labour market – should not be underestimated.

The expected tightening of supply and rising demand for coal, coupled with a more positive macro outlook, only strengthens the appeal of

coal as a long term investment.In any investment portfolio, an allocation towards a stable

investment should always be considered – and commodity investing is no different. Investors seeking a stable commodity that will stand the test of time may ‘call to coal’ as a way to maintain some stability in a portfolio. •

caused by China’s inadequate rail capacity, resulting in a dramatic increase of road transportation which is costly and already strained. This is likely to increase production costs and remain a constraint to further expansion.

Australia – the largest exporter of coal – has recently approved the use of a carbon tax, to be implemented in mid-2012, with a smooth transition within three to five years to a cap-

and-trade system. As a result, any coal mine expansion plans are expected to be axed, further pressuring coal supply.

The notion of a shortage of coal is frowned upon given the widely held misconception that current coal reserves will last for another century.

The US – the ‘Saudi Arabia of coal’ – has experienced peak extraction of high quality coal such as anthracite since the early 19902. Higher quality coal produces more energy and is easier to mine. The Energy Watch Group – a German organisation that undertakes studies about worldwide availability of fossil and nuclear energy resources – has estimated that China will experience peak coal by 2015.

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Energy Watch Group ... has estimated that China will experience peak coal by 2015

Yasin Ebrahim is an investment professional.His background is in Risk and Investment Management coupled

with leading industry qualifications; Financial Risk Manager (GARP), Chartered Alternative Investment Analyst (CAIA); and

Investment Management Certificate (CFA UK).