The return of old King Coal

Last weekend was a watershed moment for Japan. For the first time in four decades, none of its 50 nuclear plants were operating, sending the country's power grid back to the pre-nuclear era. The question now is, how long will it stay that way? The answer largely boils down to politics. Since the Fukushima plant was damaged in last year's earthquake and tsunami, opposition to nuclear power has grown. As plants have shut down for new safety checks, pressure from local communities has prevented central government from turning them back on again.

Given the tragic circumstances, the opposition is understandable. Yet this leaves the Japanese government in a tricky situation. Japan has few indigenous energy resources and has had to replace the lost nuclear output with extra imports of oil, coal and gas, resulting in Japan posting its biggest-ever trade deficit earlier this year. Without nuclear power, the country is going to have to spend a lot more to keep the lights on in future.

This dilemma is by no means unique to Japan. The security of power supplies across the globe is being threatened by declining reserves of fossil fuels, concerns over environmental effects and in the wake of Fukushima opposition to nuclear power. The problem is particularly acute in emerging economies, where demand for electricity is rising fast. America's Energy Information Administration (EIA) expects total global energy demand to grow by 50% between now and 2035. This is all good news for one fuel in particular: coal.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Why coal is making a comeback

Coal might seem an odd choice as a fuel of the future'. It is more normally associated with the past, with steam ships and the industrial revolution. Indeed, for much of the 20th century it seemed like old King Coal was on his way out. After World War II, coal was increasingly replaced by oil in factories and power plants. By 1965, oil had overtaken coal to become the world's most used source of energy.

Meanwhile, growing fears over climate change in the last 20 years seemed set to consign coal to the annals of energy history. Driven by concerns that greenhouse gases such as carbon dioxide are warming the planet, European politicians have set up binding legislation to curb such gas emissions. That puts coal firmly in the firing line, as the dirtiest fossil fuel it emits twice as much carbon as natural gas. As a result, a host of older coal-fired plants are scheduled to shutdown in the next few years. Those that remain are trying to reinvent themselves. For example, Drax, Britain's largest power plant, has started burning biomass as well.

Yet despite all this, coal has not become less popular in recent years. In fact, its total share of the world's energy consumption is currently 30%, up from 25% five years ago. "Coal, which preceded oil and carried onward in a reduced role during the oil age, has been making a comeback over the past decade," says American energy analyst Gregor Macdonald. By contrast, oil's share of global energy use peaked at 48.5% in 1973, and has now slipped back to 33.5%. "Oil held a unique supremacy for over 50 years. But the king of fossil fuels was, is, and will remain coal."

Coal's main strength? It's cheap cheaper, per unit of energy produced than any other fuel apart from US shale gas. It is also abundant, with enough left in the ground to supply current demand for over 120 years. Because it is well spread out, importers are less worried about security of supply or having to deal with cartels such as Opec. Take China. As its economy has grown, energy demand has gone through the roof. It has overtaken America as the largest global energy consumer. Unfettered by European regulations or strong environmental opposition, China has opted for the cheapest, most reliable source of energy it can find coal.

China has vast coal reserves, as does neighbouring Mongolia, making it a secure energy supply. In the last eight years, China's coal use has doubled: half of the coal burned in the world is now burned in China. Its miners churn out three billion tonnes of the stuff a year, making it the world's largest producer. Yet its demand for energy is so great that last year it overtook Japan to become the world's biggest importer too. The country might be heading for an economic slowdown, or even a hard landing, but in the longer run its energy demand will continue to grow, even if at a slower rate.

India's coal use is also growing fast, doubling in the last 12 years. Like China, it has huge domestic reserves the fifth-biggest in the world and is the world's third-largest producer. With 300 million people still without a power connection, India is desperate for more electricity and is expected to triple the number of coal-fired plants in the nation over the next decade. It has also cut coal-import tariffs, opening up a potentially valuable new market for producers.

Unstoppable Asian demand

"Across Asia, from Bangladesh to the Philippines, the drive for more coal-fired power seems unstoppable," says The Economist. "Renewable energy sources, such as wind and solar generation, do not offer affordable electricity on a big enough scale. Production of natural gas, which emits less carbon, will boom but not supplant coal." While the new growth is coming from emerging markets, the developed world is also proving reluctant to give up coal.

America still relies on coal for 40% of its electricity demand. That's down from a 60% peak in 1985, a trend that most industry watchers had expected to continue, especially as cheap American natural gas was substituted for coal. But the slide in coal's share of the market recently seems to have stalled. JP Morgan analyst John Bridges believes that the trouble is that even if utilities want to switch from coal to gas, in many cases they can't because the power grid simply is not yet up to scratch. "In order to increase gas-fired power generation, additional investment in the grid is required."

Another factor that might reduce the rate of switchover is that natural gas prices, currently at a decade low, are likely to rise when liquefied natural gas (LNG) export terminals are built. These terminals, which are already under construction, will allow American producers to sell to Asia where gas is five times more expensive and reduce the glut of gas in America. That will make coal more competitive.

Even Europe needs coal

Even in Europe, coal use will prove surprisingly stubborn, says Charles Butcher in Power magazine. Indeed, a recent study by Ecoprog, a German energy consultancy, found that coal plants are set to enjoy at least a short revival in Europe. According to the firm, the loss of old coal-fired plants and Germany's decision to close down its nuclear plants by 2020 will create a supply shortage. That shortage could be made worse by falling subsidies for renewable energy sources, combined with volatile gas prices. The result? Another 50 gigawatts (GW) worth of new coal plants will need to be built in Europe between now and 2020. That would be a big increase on the 10GW of coal-fired plants built between 2003 and 2011.

The environmental vote in the European Union is strong, especially in Germany. But the fact is, when it comes to keeping the lights on, there are no easy choices, says Butcher. "The years up to 2020 are forecast to see many new coal power plants being built in Europe, even as coal's share of the generating mix continues to shrink and its perception as a dirty fuel becomes more firmly fixed in the minds of the public Europe's citizens do not like coal, but for the moment they cannot do without it."

Despite the hype renewables are still nowhere near ready to replace fossil fuels. Wind and solar power in particular have made huge advances in the last ten years, yet still provide less than 2% of the world's total energy supply. Even if theybecome a major source of power there is another problem. Renewable energy is intermittent and weather-dependent. Improvements in electricity storage would mitigate this fact but, for the foreseeable future at least, renewables still need to be backed by plants that can create power on demand.

So what will power those plants? Oil is becoming too expensive, and perhaps too scarce. Natural gas has a lot of potential. But the shale gas' revolution driven by new drilling techniques has yet to spread from America to Europe and Asia, where gas remains more expensive than coal per unit of energy produced. As for nuclear energy, it's reliable and efficient, but, as Fukushima has demonstrated, it has the potential to go horribly wrong.

Even those countries that want to invest in nuclear, such as Britain, are struggling to do so. Although uranium the fuel source is very cheap, nuclear plants themselves are incredibly expensive to build, accounting for around 60% of the total cost of power produced, compared to about 14% for a gas plant. Over a long life, nuclear plants can often work out cheaper, but the need for lots of cash up front is a challenge in the heavily-indebted West. All of this means that coal is likely to be with us for some time to come.Below, we look at the best ways to invest in this unfashionable fuel.

The best ways to invest in coal

One way to play the long-term rise in coal prices is to invest in a top producer. One of our long-time favourites is US miner Peabody Energy (NYSE: BTU). When we tipped it in June 2009 it traded at $30 a share before rising to $68. Since then the slump in the coal price has dragged the share price down to $30. Yet Peabody's earnings have risen by about 70% since then and it now looks good value on a forward price-to-earnings (p/e) ratio of 7.9.

Peabody also has Australian coal mines that allow it to serve the fast-growing Asian markets and benefit from demand in the region. Indeed, Australia now accounts for half of its earnings, up from 17% in 2007. These mines produce thermal coal, used for power generation, and the metallurgical coal needed for steel making. The latter business will struggle in a Chinese downturn, but we'd argue that this is reflected in Peabody's share price.

Meanwhile, oversupply in the container ship market means that shipping rates are low. That allows Peabody to send its American production to Asia and Europe. Another strength is Peabody's quality reserves in low-cost basins. As a result it has a higher profit margin than other American-listed coal miners.

Another interesting coal producer is Consol Energy (NYSE: CNX). We like the firm because it also produces natural gas, making it a double play on the growth in power demand. Both coal and gas prices are low compared to their historical averages and should rise in the long term. Consol trades on a p/e of 14. That's not as cheap as Peabody, but JP Morgan thinks the growth potential of the firm's gas business warrants a higher multiple. "We believe the market is struggling to value the hybrid coal/gas company as it trades at a discount to the actual value." The firm's current price is $33 JP Morgan has a $60 target price for the end of the year.

Of course, getting coal out of the ground and into power stations is a difficult, messy business. One British company that helps miners and power firms handle the stuff is Fenner (LSE: FENR). It is the world's largest manufacturer of industrial conveyor belts. It also makes seals for the oil and gas industry and has a niche engineering services division. Fenner's strong network of existing clients makes it less cyclical than some of its rivals more than 60% of sales come from maintenance and repairs. Jeremy Browne at Fairfax notes that "a high % of group sales are resilient if there is another global recession, we expect sales to remain at least steady". The stock looks cheap on a forward p/e of 10.25.

When it comes to clean coal there are a number of small companies experimenting with ways to turn coal emissions into less harmful gas. Most are penny stocks listed in America. Make no mistake, investing in these firms is a gamble. You are betting on an unproven technology. But one firm that seems closer to achieving its goal than most is Clean Coal Technologies (OTC: CCTC). Its products treat low-grade coal (coal that has high levels of moisture and impurities) to produce cleaner coal. It has signed a partnership deal with Jindal Steel & Power, an Indian multinational with big reserves of wet, dirty coal. It also has a joint venture in China. Crucially, the firm claims that the process is energy neutral. If this is true, it means it would be a low-cost solution to the coal problem. Investing in this firm is a huge risk as it's not making any money, but it's worth keeping an eye on.

Cleaning up coal

Given that coal is abundant and cheap, the ideal solution to our energy needs would be to make it environmentally friendly too. The Holy Grail of clean' coal is carbon capture and storage (CCS). This pipes the emissions that leave a coal-fired plant into a large underground space, such as a depleted oil reservoir. That way we can burn coal without the unwanted side effects.

However, while the process has worked in the laboratory, it is yet to find commercial success. Aside from technical difficulties, the main problem is economics. For now, there is no economic incentive for coal plants to invest in such costly technology. The EU has tried to encourage investment by putting a price on carbon emissions. But carbon permit prices are trading at around €7 each, about a quarter of what advocates think is needed to encourage investment. Here in Britain the government is introducing a tax to raise the price of carbon emissions between 2013 and 2030, but CCS is a long way from being attractive.

Clean coal's best hope may lie instead with China. Carbon emissions aren't the only environmental hazard coal produces. Coal stations create solid waste, such as ash and toxic sludge, while mining the stuff can devastate landscapes and pollute water tables. Burning coal creates smog, soot, acid rain and toxic gasses. While modern scrubbers and filters have improved what comes out of chimneys, it is still hardly fresh air.

China's addiction to coal means it has some of the worst air pollution in the world. According to the World Health Organisation, 16 of the world's 20 cities with the worst air pollution are in China. Only 1% of China's 600 million city dwellers breathe air considered safe by European standards.

This has become a serious political issue in China: pollution is by far the biggest cause of protests. China may not be a democracy, but it wants to keep its middle class happy. So just as Chinese living standards are catching up in terms of TVs, cars and holidays, quality of environment should follow. That in turn could open up an exciting market for clean coal technology.

This article was originally published in MoneyWeek magazine issue number 588 on 11 May 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.