Coal Stocks Set to Soar, Part 1By Chris Nelder | Wednesday,...

Coal Stocks Set to Soar, Part 1
By Chris Nelder | Wednesday, August 20th, 2008
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.

Next week, we'll explore exactly how that's going to work, and the implications it has for grid power and many other commodities.

And of course, how to profit!

Until next time,