How coal can power your portfolio in 2008

“Coal-fired power plants are being built from Shanghai to Berlin to Wichita, Kan. The International Energy Agency expects demand for thermal coal to rise by 2.2 per cent a year – more than either oil or natural gas. The reason is simple. Coal is cheap – it can generate a million British thermal units (Btu’s) of energy at less than a third the cost of natural gas, and less than a sixth of the cost of fuel oil."

Coal companies had a huge year in 2007. The Stowe Global Coal Index, which includes firms that source over half of their revenue from the coal industry, jumped by 104 per cent this year. Compare that to the 4 per cent the S&P 500 returned.

To some this big move in coal stocks means the party is already over. But don’t bet on it.

There are two ways to look at coal: as a feedstock for the steel industry, so-called coking coal, and therefore a play on infrastructure; and as a source of cheap power. Thermal coal is what is burned in coal-fired electricity plants.

Patricia Mohr, commodities market specialist at Bank of Nova Scotia is calling for coking coal prices to jump by 49 per cent in 2008. UBS sees a similar gain. That’s because of problems getting the coal used in steelmaking out of Australia and into Japanese and Chinese furnaces.

On the other side of the coal ledger Ms. Mohr expects thermal prices to climb too.

“They’ll probably be up by double digits,” she said. That’s largely because coal-fired power plants are being built from Shanghai to Berlin to Wichita, Kan. The International Energy Agency expects demand for thermal coal to rise by 2.2 per cent a year – more than either oil or natural gas.

The reason is simple. Coal is cheap – it can generate a million British thermal units (Btu’s) of energy at less than a third the cost of natural gas, and less than a sixth of the cost of fuel oil.

Of course if you are going to play some of the names below you have to be comfortable with the environmental cost of the black stuff – even the most efficient coal-fired plants produce twice as much carbon dioxide as natural gas.

Consol Energy Inc (US$44.61/CSX–NYSE)

One of the giants of the space. The coal miner’s stock has already doubled in the past 12 months, but it’s still the top pick of analyst David Khani of Virginia-based brokerage Friedman, Billings Ramsey & Co. “Consol has one of the highest margins in Northern Appalachia, and it’s only getting better.” The high-sulphur, and therefore, cheaper coal from that area is now back in vogue as tighter environmental standards mean most plants now have scrubbers. Mr. Khani also likes the fact Consol owns its own terminal in Baltimore, giving it a leg up on competitors in taking advantage of demand in Europe and Asia.

Foundation Coal (US$53.25/FCL-NYSE)

Analyst Pearce Hammond of Houston-based brokerage Simmons & Co. likes Consol, but for his money FCL is a better play because of its cheaper price-to-earnings ratio. FCL trades at 8.5 times and seven times 2008 and 2009 earnings before interest tax depreciation and amortization, while Consol is up at 10.2 times and 7.9 times, respectively.

FCL also mines in Northern Appalachia and Mr. Hammond says stockpiles of Northern Appalachia (NAPP) coal are below average for utilities – he expects that to change. Mr. Hammond also likes FCL’s mining presence at Powder River. Rio Tinto is selling assets in the Wyoming basin, and Hammond believes those will fetch a higher price than many expect, “showing the value of the space.”

Massey Energy Co. (US$34.38/MEE-NYSE)

Of the big U.S. coal plays, Massey is benefiting from demand from steel makers and the expected rise in coking prices. Massey has about a quarter of the domestic market and recently inked a deal with Essar group, which has steel operations in India and Latin America.

Massey is the top pick of Ann Kohler analyst at New York brokerage Caris & Company, “The upward pricing pressure on coking coal could certainly be a long-term trend,” she said.

China Shenhua Energy (63.94 yuan/Shanghai - 601088)

With China undergoing a massive expansion of its coal-fired electricity capacity – some reports claim the nation is building a plant a week – China Shenhua is an intriguing opportunity for the adventurous investor.

The stock is one of UBS’ top-two Asian mining picks. UBS likes Shenhua’s strong presence in the domestic thermal market, its ownership of transportation infrastructure and its coal-liquefaction project, which UBS expects will generate 6.8 million barrels of oil equivalent by the end of the year.

FreightCar America (US$34.98/RAIL-Nasdaq)

The few bears on coal all point to one problem – the rising cost of getting the black-stuff above ground. Analyst Michael Gallo of New York–based brokerage CL King says one way to make money on coal, even if the miners don’t, is to try RAIL.

The company is the largest manufacturer of coal-carrying freight cars in the U.S. – with about 80 per cent of the market.

With more than 150 coal-fired plants due to come on-line in the U.S. between 2009-2012 Mr. Gallo expects 26,000 new coal-cars will be needed. He also says half of the 269,000 cars in use are older models and need to be replaced.

“This could make FreightCar a good second-half story”.

MarketVectors Coal ETF

And, finally, coming in the new year a new exchange traded fund will provide investors with yet another way to play the commodity thanks to Van Eck Global. The ETF will aim to replicate the return of the Stowe Coal Index and is expected to hit the market in the first two months of 2008. The fees and the expense ratios have yet to be set. Van Eck is still working on a ticker symbol – here’s hoping it’s as much fun as “MOO” – the ticker for Van Eck’s agribusiness ETF.

Special to The Globe and Mail