I have seen the fuel of the future.It's not natural gas. That was the fuel of the future in 2000. It's not uranium. That might be the fuel of the future in 2015, if the new generation of nuclear plants turns out to be as good -- once someone builds one and operates it for a while -- as their proponents hope. It's not solar or wind or fuel cells, either. But they could give nuclear a run for its money by 2015 -- if government subsidies produce enough of a market to drive costs down further. Nope. The fuel of the future is coal. For the next five years anyway. My prediction is based on nothing more or less grand than this: Coal is cheap, and the coal supply is stable. I think investors can count on coal stocks, such as Peabody Energy ( BTU) and Arch Coal ( ACI), to continue to outperform the stock market -- on average -- for the next five years. An even better bet, however, are the shares of the companies that make the steam turbines that allow utilities to turn coal into electricity. I'd put General Electric ( GE), Germany's Siemens ( SI) and France's Alstom in that group. And, of those, Alstom would be my favorite. Exactly how cheap is coal? Really, really cheap when you compare it with other fuels used to generate electricity. In December, according to the investment bank Natexis Bleichroeder, U.S. coal sold for the equivalent (taking into consideration the different energy content of the two fuels) of natural gas priced at $3 to $4 per million BTUs. In December, the spot price of natural gas hit $15.50 per million British thermal units. On Jan. 19, after a monthlong selloff, natural gas sold for $8.59 per million BTUs. Even if the price of natural gas falls further -- to, say, $7 per million BTUs -- coal will still be about half as expensive as natural gas.
Building SteamThink utilities may have noticed? Last week, GE, Siemens and Alstom, which are three of the world's big makers of turbines for electricity generation, told The Financial Times that they were seeing a shift in their orders to steam turbines for coal-fired utility plants from natural-gas turbines. According to the three, coal-powered units will make up about 40% of all orders for electricity turbines in the next 10 years, with the share for natural-gas-fired turbines falling to 25% to 30% of orders.
And this isn't just a projection. In the past year, 30% to 40% of orders for new electricity turbines were for coal-fueled generators; 20% to 30% were for gas-fired turbines. The projections for the next decade would be a huge shift in the market. Between 1997 and 2000, the peak of the move to natural gas for electricity generation, natural gas accounted for 60% to 70% of new electricity power plants. Coal's share was just 20% to 30%. That shift means big growth for coal demand. The U.S. Department of Energy's Energy Information Administration projects that coal consumption in the U.S. will climb 73% to 1.9 billion short tons in 2030, from 1.1 billion short tons in 2004. I think that projections of the growth in coal demand are likely to be low, too. They underestimate the appeal of stable supplies to utilities planning their next generation of projects. Hey, if you want to believe that energy supplies are stable in a world where Russia, Iran, Venezuela, Saudi Arabia and Nigeria are major sources of energy, be my guest. Utility executives making decisions on $1 billion capital investments are having nightmares about supply disruption from sources like those. The European countries are as adamant about reducing carbon emissions as any on earth, but coal is making a comeback even there. In Germany, RWE started construction on a 2.2 gigawatt coal plant last year. I think there are two ways for investors to play coal as the fuel of the future: You can buy the shares of coal producers, or you can buy the shares of the companies that make coal-burning power plants.
The ProducersMy top three picks among coal producers are, in alphabetical order, Arch Coal, Consol ( CNX) and Peabody Energy. Arch Coal has the most exposure in the coal sector to improvements in pricing and supply in Wyoming's Powder River Basin. This November's selloff among U.S. coal stocks was a result of falling prices for the low-sulfur coal produced from this region and disappointing production volumes caused by the need for repair and maintenance work at mines in the area. Powder River Basin coal prices have stabilized recently, and with stockpiles at utilities low because of past production problems, sales growth should be healthy in 2006. Prices could well move up sharply as customers move to lock in supply for delivery in the second half of 2006, when production could again be constrained by maintenance work at the mines. A reasonable target price for December 2006 is $95 a share.
Consol is a supplier of high-sulfur coal, and that isn't as much of a disadvantage as you might think. With new scrubbers to reduce emissions coming on line in 2006, demand -- and prices -- for high-sulfur coal will pick up. Having already made the fixed investment in pollution-control equipment, the utilities can only reap the advantage in variable transportation costs by sourcing coal from nearby, high-sulfur deposits. Consol's production is overweighted to high-sulfur Northern Appalachian coal, and the company will benefit disproportionately from increases in the price of that type of coal. A reasonable target price for December 2006 is $91 a share. Peabody Energy gets the best of the low- and high-sulfur worlds. The company's Powder River Basin coal is low in sulfur even for coal from that region, producing about 70% of the sodium dioxide as average Powder River Basin coal. That will get Peabody Energy premium prices in any recovery in Powder River Basin pricing. The company's higher-sulfur Illinois Basin coal is close to a likely concentration of new power plants that will go into construction in the next decade. In addition, the area is a hotbed of coal-to-liquid activity. (This technology converts coal into diesel fuel.) That should also increase demand for Peabody's coal from the Illinois Basin. A reasonable target price for December 2006 is $99 a share.
Generating ReturnsI think you'll find even better pickings among the shares of the companies that make the steam turbines that will go into coal-burning power plants. (It certainly doesn't hurt, as Bear Stearns notes, that these companies are looking at exploding demand for all types of power plants in Asia and the need to replace about 40% of existing thermal power generation equipment over the next five to 10 years.) My favorite in this sector is not General Electric: The company is a big producer of natural-gas-fired turbines, so while it's picking up sales of coal-fired turbines, it will also be losing sales of gas-fired equipment. The stock is cheap after its recent earnings disappointment, and I'd certainly reconsider my position if the company wins out in its bid with Hitachi ( HIT) to buy Westinghouse, a major producer of nuclear power plants. The company is bidding against Toshiba and Mitsubishi Heavy Industries to buy Westinghouse from current owner British Nuclear Fuels. The winner will quickly become the leader in the race to build nuclear power plants in China. China has said it plans to build 320 nuclear power plants by 2020.
My favorite isn't Siemens, either. I owned Siemens from November 2005 through January 2006, for a 23% gain. The stock now looks like it's correcting from that rocket ride -- news of a bribery investigation at one of the company's subsidiaries hasn't helped -- and I'd prefer to buy these shares after the selloff is completed. My favorite in the sector is Alstom. The Paris-listed company has undergone a restructuring even more extensive than Siemens', and in 2005 the work started to pay off. The restructuring under CEO Patrick Kron, who joined the company in 2003, repaired a balance sheet that was seriously overleveraged. Orders have picked up -- climbing 66% in the third quarter of fiscal 2006, a number the company reported on Jan. 12. That in turn has stabilized operating margins in the power-turbine business -- at a projected 2.3% in 2006 -- and given credibility to projections of 6% to 7% operating margins by 2008. The company is highly leveraged to the power-generation market -- more so than either General Electric or Siemens -- with about 80% of earnings before interest and taxes coming from the power-equipment and service markets. And although the company sells equipment across all fuel types -- coal, gas and hydro -- it is much more leveraged to the coal-fired steam-turbine market than its larger competitors. Alstom holds the top market share in the steam-turbine market, according to Bear Stearns, which also projects annual average earnings growth of about 20% for Alstom over the next five years. Alstom is listed only on the Paris market -- it doesn't trade as an ADR, or American depositary receipt. Buying Alstom will get you foreign ordinary shares, exactly the same shares that trade on the Paris exchange. Be careful when you buy -- try a limit rather than a market order -- because the bid/ask spread can be high. It was almost $1 a share when I checked on Jan. 20. You may also have to pay an extra commission charge to buy the ordinary shares. An electronic brokerage firm I use regularly quoted me an extra $50 fee. Despite all those hurdles, I still think Alstom is worth it as the best pure play I've found on the trend toward coal.