It seems that King Coal can’t catch a break.
The advances in hydraulic fracturing and new drilling techniques have dropped natural gas prices down to decade lows, making it the preferred choice for utilities. Currently, natural gas can be had for around $2.06 per million BTUs. Already, older coal-fired power plants have been shutting down across the country, as electricity producers switch to the cheaper and greener fuel. Couple this with slowing demand from China — the world’s No. 1 consumer and dwindling electricity demand across the U.S. and Europe — and you have a recipe for lower stock and coal prices.
So it’s no wonder why the coal sector recently sold off when the EPA and the Obama administration announced sweeping rules designed to limit carbon-dioxide emissions from new power plants. This effectively blocks the construction of new coal-burning plants and makes natural gas an even more attractive option for generating electricity. Some analysts are now calling the fossil fuel dead money and saying investors should stay away.
However, nothing could be further from the truth. While the EPA’s rules are simply reinforcing the existing trend in power generation — that cheap natural gas is No. 1 — the rest of world still runs on coal. For American producers, that could mean a bigger piece of the export pie.
For investors, that spells opportunity.
While the EPA’s announcement came as a shock to the coal sector, the actual piece of legislation was first created in 2009. The regulation, which was scheduled to be released last July, stems from a 2007 settlement with environmental groups and states. The EPA already controls global warming pollution at the largest industrial sources, but now is working on regulations to reduce greenhouse gases at existing power plants and refineries.
The rules essentially state that new power plants will be limited to emissions of 1,000 pounds of CO2 per megawatt-hour of electricity produced. Existing power plants and the 15 that currently are under construction will not be affected by the rules. This was the first move by the U.S. to regulate the gas blamed for contributing to global warming, though many other nations have implemented similar rules with regards to power plant construction.
The EPA estimates that the overall health benefits and reduced medical costs will outweigh any increases to the potential higher energy costs. Coal-fired plants currently produce around 44% of U.S. electricity.
As expected, the new rules, which won’t finalized until November, already have sparked a fierce political backlash. The EPA’s plan faces serious opposition in Congress and has fueled Republican complaints of regulatory overreach by the Obama administration. The legal underpinnings of the law are being challenged in court.
A spokesman for Oklahoma Sen. James Inhofe perhaps best summed up the Republicans’ stance on the rules, saying, “At a time when the Obama administration should be working to lower the price of gas at the pump, it is alarming that they have put forward more global warming regulations. Republicans are committed to ensuring that the Obama-EPA is finally reined in.”
What the Rules Really Mean
Odds are the EPA’s new standards will get passed and enacted. At their core — much to the Sierra Club’s chagrin — the rules really aren’t that strict and are just enforcing what is already going on: A shift toward more natural gas power generation. Again, the proposed rule will not apply to existing power plants or new ones built in the next year. The regulation also gives future coal-fired power plants years to meet the new standard.
Eventually, the plants will be required to capture and store that carbon pollution underground. That technology is not yet commercially available. Utility American Electric Power (NYSE:AEP), one of the biggest coal users in the U.S., pulled the plug last summer on a pilot program to capture emissions from one of its plants in West Virginia because of rising costs.
While some utilities have expressed concerns that the impact of the regulations will raise electricity rates in areas where coal is a big part of the generation mix, the new rules by themselves shouldn’t have a huge impact on prices. Record-low natural gas prices have ensured there are few new coal-fired plants on the drawing board.
So where does that leave U.S. coal producers and (more importantly) us investors?
Overall, these stricter emission rules most likely will force coal companies to make up for that lost domestic demand by exporting more to countries in Asia. Despite being the world’s largest producer of coal, China still is the largest importer and more than 80% of electricity generation comes from the fossil fuel. Likewise, India receives about 70% of its electricity generation from coal. Worldwide, there are plans to build more than 1,000 new coal-fired plants, most of them are located in emerging Asia. The U.S. Energy Information Administration predicts that Chinese coal demand will rise by 2.4% annually through 2035. That’s 10 times faster than U.S. demand.
The key for U.S. producers is getting access to these markets. The U.S. is without a West Coast coal port, and the closest one (in Canada) is not viable for U.S. producers. However, that could be changing. Leading coal producer Peabody Energy (NYSE:BTU) is in talks with a developer to build a port in Washington state that could handle 25 million tons of coal. That would allow the firm to ship coal exports from its rich Powder River Basin mines in Wyoming. Likewise, Cloud Peak Energy (NYSE:CLD) holds significant acreage in the region.
Perhaps some of the biggest beneficiaries to this shift towards exports would be the railroad firms. Both CSX (NYSE:CSX) and Norfolk Southern (NYSE:NSC) receive about 30% of their total revenue from coal shipments, while Union Pacific (NYSE:UNP) receives around 22%. There are plenty of adequate rail lines in and out of the Powder River Basin, and any export plans would benefit the three firms.
Ultimately, the EPA’s rules can be seen as another way the United States can increase its energy dominance. By switching to an exporting coal future rather than using it domestically, the U.S. now is in position to be the world’s major energy supplier.
For investors, Peabody and the three railroads offer a great opportunity to play that new reality.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.