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Don’t Count on China to Buy America’s Coal

It’s been one bumpy ride for America’s coal producers, to say the least.

The hydraulic fracturing and advanced drilling revolution continues to pump out record amounts of natural gas and drive its price to new lows. Additionally, new Environmental Protection Agency rules designed to limit carbon-dioxide emissions from new power plants have effectively halted the construction of coal-burning plants and made natural gas even more attractive for power companies.

Mines are being closed, earnings remain poor and some operators, like Oxford Resource Partners (NYSE:OXF) and Cliffs Natural Resources (NYSE:CLF), have recently cut dividends in a bid for survival.

And just when the International Energy Agency gave the industry some hope, things have once again turned sour for coal producers. It seems that investors betting on rising export demand to keep the sector going may be sadly mistaken.

Short-Lived Gains

As environmental regulations and cheaper natural gas diminished domestic demand for coal, international markets picked much of the slack. Lots of those exports have been bound for China, where coal-burning has skyrocketed. However, coal firms and investors thinking China’s continued hunger for all things energy will keep the coal cars rolling may need to think again.

A new study by consultancy IHS CERA throws plenty of cold water on that idea. Called “Coal Rush: The Future of China’s Coal Market,” the report represents some of the most comprehensive research to date on the Chinese coal market — and the results aren’t pretty for U.S. producers.

IHS CERA predicts that Chinese coal imports will peak by decade’s end and enter a prolonged period of decline through 2035. The combination of moderating demand and increased domestic production will reduce the need for China to import coal. IHS believes its imports have already peaked at 145 million tons of standard coal equivalent (SCE) last year. Overall coal demand in China will peak around 2025 at about 5.1 billion metric tons, according to the study.

IHS suggests the Chinese import boom that has supplied much of enthusiasm for U.S. coal producers will be short-lived. Ironically, many of same reasons why coal usage is on the decline in the U.S. will ultimately play out in China as well.

First, China has spent more than $250 billion revamping its own mining industry. The nation has added new railways to bring down shipping costs and remove bottlenecks, and it has fast-tracked new mine approvals. That’s helped push up its own coal production capacity for all types of coal, including metallurgical/steelmaking ore, nearly four times over the last five years.

Second, coal’s mortal enemy — natural gas — has a role to play also.

The nation’s use of piped natural gas from Russia and points west has risen over the last few years. That will take a big bite out of coal demand. Perhaps more damaging will be China’s own shale gas production. It has some of the largest known reserves of natural gas trapped in shale rock on the planet, and those unconventional resources could begin getting developed as early as 2020. Already, Royal Dutch Shell (NYSE:RDS-A, RDS-B) has begun drilling test wells. Add in China’s growing adoption of solar, wind and nuclear power, and coal could be on its way out.

Adding insult to injury, The U.S. Department of Interior recently announced that it was investigating whether coal mining companies are skirting royalty rules as they increase exports to Asia. So far, no violations have been issued, but a new report says audits of overseas sales have just begun for years when coal exports from federal lands grew substantially. If found guilty, producers could be on the hook for millions in fines and royalties just as their export gravy train could be ending.

Cut and Run?

Given IHS’ dour long-term estimates for U.S. coal producers, the question remains whether investors should just head for greener pastures. Perhaps.

While the U.S. exported roughly 4 million tons of coal to China in 2011, it’s just the third-biggest market in Asia. According to the U.S. Energy Information Administration, coal producers actually sent more fuel to both South Korea and Japan. Since Japan’s Fukushima nuclear disaster, it’s ironically turned to “dirty” coal to meet its growing power needs.

Then there’s Europe. While it’s the bastion of solar and wind energy, it also buys the bulk of U.S. coal. The Netherlands alone received roughly 8 million tons of U.S. coal in 2011.

So, does the IHS report matter? Quoting it gives us the answer. “Some international suppliers will be able to compete effectively, but others will struggle to find a competitive edge as China’s market becomes ever more liquid.”

China is still a huge market for U.S. coal producers, and losing that could be detrimental to smaller producers like James River (NASDAQ:JRCC) or Oxford Resources. Which is why investors should continue to focus their efforts on the big boys like Peabody (NYSE:BTU).

The coal producer shakeout is ongoing, and the idea that China’s imports may be dwindling will only push that trend harder. If you’re going to play coal over the long term, you have to do it with the bigger firms that will survive.

As of this writing, Aaron Levitt is long RDS-A and RDS-B.

Article printed from InvestorPlace Media, https://investorplace.com/2013/02/dont-count-on-china-to-buy-americas-coal/.

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