How Coal Could Stay Profitable

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There are few certainties in the world outside of Cleveland professional sports struggling and U.S. dominance in the fast food industry, but another apparent given is this: coal will slide as a leading energy source. And that may be true – in the United States. Elsewhere, the industry looks poised to soar, and UCG (Underground Coal Gasification) will play an enormous role.

UCG allows companies to convert the coal into usable energy before it leaves the ground. All of the mining companies (smartly) take the easiest coal first. But geological positioning makes it extremely difficult to extract some of the remaining coal, often making it almost unprofitable to unearth it. UCG – along with its lower environmental footprint and efficient extrapolation of 80% of available energy – could lead a coal revolution.

In the U.S. and Canada, the coal industry could continue to struggle. With U.S. natural gas prices finishing at $4.01 per MMBtu (million British Thermal Units) in 2011 and industrial prices still at $3.52 toward the end of 2012, UCG’s $6 per MMBtu poses little threat to the natural gas revolution – unless natural gas prices keep climbing. But it’s a different story elsewhere. In Japan, LNG (liquefied natural gas) prices soared to $14.73 per MMBtu at the end of 2011, while the UK and EU saw prices of $9.03 and $10.61, respectively.

Regardless of whether coal prices rise, the cap on coal-powered energy sits at $6 per MMBtu, the current price of UCG power. And with non-U.S. coal prices range primarily between $100-$150 per tonne (the equivalent of approximately $4-$5 per MMBtu), UCG may not become necessary for some time yet. If you’re looking to capitalize on U.S. markets, it’s probably smart to run away from coal. But if you look at the global picture, you’ll want find a company that can capitalize off of what the IEA (International Energy Agency) thinks will be a 1.2 billion tonne increase in annual coal consumption by 2017.

China Shenhua Energy (NASDAQOTH: CSUAY) could easily capitalize well beyond its current 6% yoy revenue growth. UCG production is still developing, leaning heavily on universities and privately owned companies such as Australia’s Linc Energy, which has already made inroads with a few joint projects in China. But as the biggest company in the world’s biggest coal market, Shenhua should be able to adopt the new technology whenever it becomes necessary. Although its 6% yoy earnings decline does signal a red flag, the company also enjoys a 21% profit margin and holds more cash ($9.87 billion) than debt ($9.55 billion).

If it does move to UCG, potential Chinese partnerships abound. For example, GCL-Poly Energy Holdings (3800.HK), already boasts a partnership with Linc. It suffers from a debt/equity ratio of 197.96, including almost five times as much debt as cash, but its foresight could pay huge dividends – perhaps more to its partners in China than to itself.

In the meantime, global coal trends and the $6 per MMBtu price cap UCG provides could deal a blow to U.S. natural gas companies hoping to export. Dominion Resources (NYSE: D) stated in early December that it saw exporting opportunities in the mid-Atlantic, responding to a study that the entire U.S. economy could benefit. Now, it’s trying to launch an exporting arm of up to 1 billion cubic feet of LNG per year. Although potential exists, U.S. natural gas companies will struggle to compete. Natural gas – ironically – is helping UCG become increasingly efficient. By the time natural gas companies export, they could very well be competing with $4-$5 UCG coal, even more dangerous considering that natural gas prices may rise in the upcoming years.

U.S. coal companies seem to recognize UCG’s potential as well. Giant Peabody (NYSE: BTU) recently purchased 29 Wyoming mines that would seem ideal for UCG. Even oil titan BP (NYSE: BP) launched projects to increase UCG reach via Ergo, GasTech, and more. For both Peabody and BP, these savvy forays could provide the difference if U.S. coal production bows to natural gas, giving them a leg up on smaller companies unable to invest in the technology today.

For Peabody, investments in UCG technology might be necessary. Although it still boasts revenue growth of 3.9% yoy, its quarterly earnings recently plunged 84.3% yoy. The result: margins are getting dangerously thin, and Peabody desperately needs to reverse the trend. BP, on the other hand, is mostly expanding their reach via investment. The move will probably not affect the company's bottom line drastically, at least in the near future. Investing in cleaner coal technology could certainly help BP repair its still-damaged reputation from the oil spill. As BP tries to maintain its earnings increases - even as revenue slides - by improving efficiency, this foray could be a low-cost contributor to BP's continued success.

5 years down the road, in early January of 2018, there are a few bets that seem pretty safe. McDonald’s will probably be thriving, and sports will support billions in revenue. With coal, nothing seems completely certain. But investors interested in the energy sphere need to continue to watch not just prices, but innovative methods that could be game-changers down the line. Ultimately, UCG probably needs a bit more progress to turn the energy world upside down – but maybe only that little bit.

Will Chavey (willchavey) has no position in any stocks mentioned. The Motley Fool recommends Dominion Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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