Profit from coal's rebound

Demand for coal has slumped recently, with prices down sharply. But things are not as bad as they look, and there are good reasons to believe that coal has reached a bottom. Eoin Gleeson investigates the sector, and picks the best way to play the rebound.

Everyone knows China cooks the books. Ever since Beijing decided that the economy must maintain an official growth rate of 7% to stave off social unrest in the wake of the 1997 financial crisis, economists have maintained a healthy disrespect for the government's growth data. Still, when those economists picked up on a catastrophic collapse in China's electricity output in November, it was a real shock. A fall of 6% for the year, from annual growth of 15%, raised fears that China had slipped into outright recession. Had Chinese industry suddenly suffered a complete meltdown?

One group, however, was entirely unsurprised by the reports Australia's coal miners. With heavy industry grinding to a halt in China, it had been months since Queensland's coal terminals had received anything like a steady stream of traffic. There were no ships docking for coking coal to meld the steel girders of China's skyscrapers. And no ships loading up with thermal coal to fuel Japanese power stations. Australia's coal miners were bracing themselves for some very ugly contract negotiations with their trade partners in the months ahead.

The first of those annual negotiations came last month. It certainly wasn't pretty. In early deals that set the tone for the rest of the industry, steel firms managed to wrangle a 60% discount for coking coal on last year. In the thermal market, mining giant Xstrata and Chubu, the Japanese power firm, agreed a price of $70 a tonne for this year down 44% on the price Xstrata commanded last year. The deals brought a dramatic end to six consecutive years of price increases, says Jonathan Soble in FT. Demand for steel and power have well and truly slumped.

But it's not as bad as it looks. In fact, there are good reasons to believe that these deals signal the bottom of the cycle for coal. Because the truth is that at $70 a tonne, coal producers can still make very good money, says Tom Bulford in his Right Side letter. In fact, $70 a tonne for thermal coal is still double the price that coal producers were receiving two years ago before super-cycle fever sent commodity prices into orbit.

And there is good news from Queensland. The last month has seen a sudden recovery in coal traffic to China with the Hay Point and Dalrymple Bay terminals posting their strongest results since November as shipments surged 21%. Has China's heavy industry suddenly sprung into action? Well, no. This is partly about stockpiling. Chinese utilities are loading up on coal while it's cheap.

China also needs to make up for serious shortfalls in energy supply. Shandong, for example the nation's second-most populous province produced 135 million tons of coal last year, while provincial demand was for 270 million tons. So the local authorities are rushing to build facilities to hold between 80 million and 120 million tonnes of coal equal to several years of US exports. And stockpiles are being run down in Chinese terminals after a spate of deaths in the northern provinces forced the government to close small mines in the region.

But it's the use of coal as substitute for oil that will really kickstart its recovery, says energy analyst Gregor McDonald. At current prices, the 5.8 million British Thermal Units (BTU) in a barrel of oil will set you back $60. But for $45 you can get yourself as much as 25 million BTU in a ton of coal a fact not lost on power utilities from California to Shandong. We have a look at the best ways to play the rebound in coal below.

Peabody Energy triples its profits

China may be running down its coal supplies (thermal coal inventory at its largest coal terminal, Qinhuangdao, has fallen 54% since the February peak) but coal miners are still cutting production. Industry titan Peabody Energy (NYSE: BTU) has been shedding most of its high-cost east coast mines in America as global steel demand fell 23% in the first three months of this year.

437_P08-peabody-energy

Yet the low-cost coal producer recently reported that its first-quarter profits tripled to 63 cents per share. Peabody now expects to produce 185 millions to 190 million tons in the US and 20 million to 23 million tons in Australia this year. So as the world's largest pure-play coal producer, with a significant position in the Australian export market, it's in a great position to benefit from a rebound in demand for coal across Asia. It has $527m in cash and trades on a forward p/e of 11.6.

For a higher-yielding option, go for Anglo Pacific (LSE: APF), says Tom Bulford. Last year the firm received £22m in royalty income from its ownership of mines operated by BHP and Rio Tinto. As long as you can take a long-term view, says Bulford, this commodity play looks a good bet at the current level, with a historic dividend yield of 5.9%.

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