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Kings of Clean Coal

Elliott Gue
Elliott Gue
Who are the surprise winners and losers in today's market reality? Click here to find out!

When it comes to energy, oil, natural gas and nuclear power are the headline grabbers. But in most corners and avenues of the world, King Coal reigns.

Despite a building wave of more than 100 gigawatts of natural gas plant capacity during the 1990s, US coal still generates half the nation's electricity, and that share is rising.

The profit margin for selling electricity produced from various fuels is fat, while the spread for gas is negative. Even if gas fell by half, coal would still have the advantage. That's why major utilities and industries are planning to use more, not less, coal in coming years.

King Coal's biggest long-run advantage for US consumers is its domestic abundance. At current usage rates, it would take at least 200 years to run out.

The key disadvantage is it emits harmful pollutants.

Chief of these is sulphur dioxide (SOX), the cause of acid rain and respiratory diseases. SOX forms when sulphur, which naturally occurs in coal, burns and combines with oxygen.

The Clean Air Act of 1990 allowed coal plant owners to emit SOX and its companion, nitrous oxides (NOX), provided they purchase credits from companies that release less than the legal limits. But with the price of credits rising 300 percent this year, that option is considerably less attractive. So is buying low sulphur coal, up 90 percent (see graph "High Energy).

In contrast, coal liquefaction and gasification eliminate SOX, NOX and other pollutants with a series of chemical processes to convert coal into an ultra-clean diesel-like fuel or natural gas.

And coal's economic advantage is wide enough to cover the cost with room to spare. That means fat profits for the companies profiled here and in the table "Coal's Bulls."

New Old Tech

The Germans used coal liquefaction during World War II when their wartime supplies of oil wore thin. So did apartheid South Africa in the '80s and '90s when it was under global embargo. Yet today's liquefaction movement is firmly rooted in favorable free market economics.

In China, the Majiata plant is expected to economically produce 50,000 barrels a day of low polluting diesel fuel and gasoline by converting local coal economically, even when oil is at $20 a barrel. Other major projects are on tap in Australia, Japan and the US.

America's champion of coal liquefaction is Montana Governor Brian Schweitzer. One reason is the state's coal reserves are equal to one quarter of Middle East liquid reserves. But Schweitzer has also made coal conversion a cornerstone of his run for the presidency in 2008.

Coal gasification was once widely used by US utilities. Most sites now are shuttered, but rising gas costs have increased potential for rebirth. Gasifying coal removes particulate matter, SOX and NOX targeted by clean air laws. It's even cleaner than natural gas.

India's abundant coal, scarce gas and growing air pollution have made it a leader in coal gasification. So are China and the US.

Motivated Miners

Coal technology players are a mixed bag. After two decades of depression in the energy patch, the miners are primary developers and motivated investors.

Peabody Energy has gone the furthest. Specifically, the company's Alabama coal gasification facility can produce pipeline quality gas at a cost of roughly $5 to $6 per million British thermal units. And it's building a coal-to-diesel plant in China at a cost equivalent to $35 to $40 per barrel oil.

Peabody is the world's largest mining company with more than 10 billion short tons located mainly in the US. It's the single largest player in the Powder River Basin (PRB), where coal is typically found close to the surface and can be strip-mined at relatively low cost. In contrast, coal mined in the eastern US comes from deep underground, where costs are much higher.

Most of Peabody's reserves are classified as either low sulphur or ultra-low sulphur. And it has plenty of unsold production to boost sales further, whether it's processed conventionally or with new technologies.

Most output is sold under four-year contracts to utilities, rather than on the spot market. Some were priced in the $7.50 to $8 per short ton range, the prevailing market price for PRB coal in early 2005.

In contrast, new contracts are more than double that level, near $18 per short ton. And as more old ones come due, earnings will surge. Though it's expensive, buy Peabody under 90.

Arch Coal is Peabody's closest rival, with 4 billion short tons of reserves. Reserves are mainly low sulphur, with a major presence in the PRB. The company has nearly a quarter of 2006 and half of 2007 production unsold, leaving plenty of upside.

More intriguing, it has a growing stake in KFx, a small company with a technology that drastically reduces pollution content in coal. KFx's K-Fuel Technology heats coal under extreme temperature and pressure to remove water.

By getting the water out, K-Fuel produces coal that's lighter and easier to transport. It also strips out sulphur and mercury from the coal, eliminating the need to clean up emissions with expensive scrubbers.

By 2008, its new plant should be able to produce about 8 million tons of ultra-clean coal per year. Of the two, Arch is the more conservative play but it is pricey; buy under 85. Speculators can pick up KFx below 17.

Penn-Virginia Resources (PVR) is our income pick in the sector. It's a limited partnership that collects royalties on low sulphur coal and natural gas produced from its properties. It has no labor costs or health liabilities and pays a dividend of nearly 5 percent. Buy PVR up to 55.

The Innovators

Large engineering firms are also set to grab a big piece of the pie. Last October, Growth Portfolio stalwart Siemens bought Pittsburgh-based Wheelabrator, a leading designer and developer of air pollution reduction products for coal-fired power producers and other industries.

Wheelabrator's rapidly growing backlog of sales includes wet and dry scrubbing systems, fabric filter systems and dry and wet electrostatic precipitators. The acquisition adds to the German giant's growing presence in this business, which has tremendous potential on both sides of the Atlantic.

Siemens' sales surged during the past year but earnings slumped in the face of restructuring and unloading unprofitable units, such as communications. With restructuring complete, 2006 is looking good and the dividend was raised 8 percent as well. Buy Siemens up to 93.75.

A small but profitable play, Headwaters is a leader in coal liquefaction technology. The company has licensed its proprietary coal-to-diesel technology for commercial use in China; and commercial approval in India is pending.

In China, Headwaters is constructing a $2 billion coal-to-liquids plant with state-owned Shenhua Group that will output more than 50,000 barrels of high-quality diesel and gasoline per day by 2008.

Headwaters is also a major player in plant construction and the disposal of ash residue from plants. Sales rose 92 percent in the third quarter, doubling profits. Headwaters has been volatile, but it's a buy under 37.50.

Electric utilities are the country's biggest users of coal and are strongly motivated to develop technologies that make it more efficient and less polluting. Cinergy is the leader, with a wide range of investments including a venture to convert an existing 600-megawatt coal plant into an integrated gasification combined cycle (IGCC) process.

IGCC plants first convert coal to gas, removing most pollutants. The gas then powers a combustion turbine generator to generate electricity.

At the same time, exhaust gases heat steam, driving a steam turbine generator to produce power. The result is an ultra-efficient process, which turns virtually all inputs into energy and emits only a fraction of the pollutants released by today's conventional plants.

When Cinergy completes its merger with Duke Energy early this year, it will have the heft and expertise to expand in IGCC, and will be profitable overall. Buy Cinergy up to 42.

Elliott Gue will be available to take your questions until Monday, January 23. Please use the form below to submit your questions.

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