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The Rude Awakening

Wall Street, New York

Thursday, December 02, 2004

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*** It pays to be dirty...turn coal into diamonds!

FOUL IS FAIR
By Eric J. Fry

Coal is dirty. Coal is messy. Coal is politically
incorrect. But coal is also drop-dead gorgeous...as an
investment. The price of coal has tripled over the last two
years, as has Bloomberg U.S. Coal Stock Index. But now that
this perennial ugly duckling of the financial markets has
become a runway model, should investors continue wooing
her?

Let's begin addressing this nettlesome question by
examining the recent past. In the early 1990s, American
utility companies started migrating away from coal usage
toward natural gas and other "clean" energy sources. As a
result, profitability migrated away from the coal
companies. Throughout the 1990s, the coal industry
inhabited a gloom as dreary as Oliver Twist's London. Those
that managed to stave off bankruptcy, labored under
mounting pension and health care liabilities. As recently
as two years ago, many publicly traded coal companies were
still producing losses.

But then something changed; global demand started to swamp
supply. The politically incorrect fuel source started to
enjoy brisk demand from almost everywhere. But the demand
was particularly acute from - you guessed it - China. Last
year, the Asian juggernaut consumed nearly one third of the
world's coal production - more than any other country. By
comparison, the U.S. consumed only about 22% of global
production. And China's demand continues to swell. Chinese
coal imports surged a stunning 62% in the ten months ended
October 31, according to the Tex Report, an industry
newsletter.

This breakneck rate of coal consumption is unlikely to slow
dramatically over the next few years. Here's why: China
uses coal to power more than three quarters of its
electricity production. Hence, as Chinese electricity
demand goes, so goes demand for coal.

"China's total energy demand surged 13.8% in 2003,"
according to the Asia Times. "Increase in electricity
demand in China last year accounted for 50 gigawatts of
total global growth of 70GW (a gigawatt is 1,000 megawatts,
a megawatt is a million watts)." Looking ahead, China will
need to add about 30GW of generating capacity per year for
the next 16 years in order to satisfy its growing energy
demand. This rate of addition is roughly double the recent
rate of capacity expansion. Coal will almost certainly
power the majority of these planned capacity expansions.

Coal investors are not blind to the delightful fundamental
trends underpinning the bull market in this sooty energy
source. As the nearby chart illustrates, industry bell-
weather, Peabody Coal (NYSE: BTU) has handily outpaced the
XNG Index of natural gas stocks over the last couple of
years.



And the frenzied buying of coal stocks continues...

"Anything coal," a Canadian stockbroker informed your New
York editor last week, when asked what his institutional
customers were buying. "Anything coal, or coal anything.
That's what my customers are asking for. They want to buy
anything with the word 'coal' in it. It doesn't matter if
it's small-cap or large cap, they'll buy it. Did you see
Fording? That Canadian coal trust? That thing has tripled
this year."

Just maybe, we would surmise, coal stocks have become a bit
too popular for their own good. Certainly, they carry
loftier prices now than they did two years ago. But the
question remains whether they might become even pricier
over the next two years. For insight, we turned to the
"experts" on Bay Street and Wall Street.

"We expect North American coal markets to remain robust
next year," predicts BMO Nesbitt Burns coal analyst Jay
Turner, "and recommend Peabody Energy as the most
attractive investment vehicle due to its diversification,
industry leadership position and attractive exposure to
international metallurgical coal markets."

Legg Mason analyst, Paul Forward, shares Turner's optimism.
"After two years of coal demand outstripping supply," says
Forward, "we project a third consecutive supply deficit in
2005 and sustained high coal prices for the next few
quarters." Nevertheless, he cautions, "The remarkable rise
in coal miner equity valuations over the past month causes
us to be sensitive to valuation concerns."

We will consider ourselves forewarned...certainly, the
heady performance is cause for concern, especially for
those investors who remember the recent dismal history of
the coal-mining sector. Even so, the coal industry's long-
term prospects suggest that this ugly-duckling-turned-swan
might remain photogenic for several more years.

"Over 100 new coal-fired plants are currently being
planned," the Legg mason analyst observes, "after more than
a decade of almost no new coal-fired power projects, and
the last major wave of new coal plants (in the late 1960s
and 1980s) helped drive the double-digit coal price growth
rate over that period."

Okay, so it seems, on balance, that we investors should
regard coal stocks with a mixture of terror and optimism.

"So what's the best way to play the next leg of the bull
market in coal?" we asked Kevin Kerr, contributing editor
of Outstanding Investments.

"Why not buy some of the stocks that are RELATED to the
coal business?" he replied. "I'd give you some specifics,
but I'm actually writing up the ideas for the upcoming
issue of Outstanding Investments, and I don't think my
readers would be too happy if I gave you the ideas first.
I'll give you a hint, though. One of the companies makes
surface-mining trucks and different types of excavators for
the coal industry.

"We issued a pretty timely buy on CONSOL Energy a couple
months back, and like most coal stocks, that one has
soared. But in today's market it's probably a good idea to
err on the side of caution. So I'd recommend indirect plays
- also known as backdoor plays - in the coal sector."

"Any examples?" your editor inquired.