A New Energy Opportunity

Robert Hsu, February 01, 2008

As oil prices climb higher, cheap alternative energy has become a big topic of interest. While investors talk about solar, wind and nuclear energy alternatives, they tend to do so from a pie-in-the-sky perspective. We've been able to make money with one solar play -- Suntech Power (NYSE: STP) -- but when it comes down to it, these technologies are still too expensive and underdeveloped to deploy on any meaningful scale. The truth is that good old-fashioned coal remains one of the cheapest and most efficient ways to produce energy.

Coal has been around for hundreds of years and was the main energy source for the Industrial Revolution of the early 19th century. Despite its widespread usage over the past few centuries, there is still enough coal in the world to supply energy for at least the next 100 years -- more than twice as long as oil or natural gas. This supply is one of the reasons why the price of coal has remained low and why it now has some room to run.

The Future of Coal

The use of coal is the standard across China. The country is the world's biggest producer and user of coal, which accounts for 61% of its power generation. I expect China to keep the title of world's biggest producer and user of coal in the years to come. China's energy demand grew by a staggering 8% in 2006, nearly four times the 2.4% annual growth rate for the rest of the world. Because of China's vast coal reserves, the fossil fuel was the natural choice for the main source of energy to run Chinese power plants and drive its economy.

In order to fuel its fast-growing economy, China must increase its number of power generators. Every week, the country builds the equivalent of two 500-megawatt coal-fired plants. By 2030, China's coal-fired electricity generation will more than triple. It's going to require a huge amount of coal to fire all of these new power plants, so you can see how important coal is to China's economic development. And we haven't even talked about all of the other industries in China that use coal -- the country's sizzling-hot steel industry is also a big coal consumer. By 2020, China will account for 40% -- or almost half -- of global coal consumption, according to the International Energy Agency estimates. In fact, China's coal prices have increased almost threefold over the past five years.

Although China has a large reserve of coal, its main coal production sites are concentrated in several regions: Shanxi, Shaanxi and Inner Mongolia. However, a shortfall in railway capacity resulted in a shortage of coal in major faraway cities like Beijing, Shanghai and Guangdong, where economic growth is thriving.

As a result, China became a net importer of coal for the first time in the first-quarter of last year. The country imposed a 5% tax on coal exports to help secure domestic supplies. In addition, taxes on coal imports were cut to zero on June 1, 2007. As a result, the imbalance between supply and demand led to higher coal prices. For example, coal prices at Qinhuangdao, China's biggest coal port, have increased 35% from a year ago to a record of 564 yuan or $75 per ton.

Right now, the best way to profit from China's rising energy demand is to own a major Chinese coal producer, which is why I'm recommending one this month. Let's get right to the details on how this company is going to profit for us.

New Buy: Visit our China Strategy website to find out the details and get in on the action.

Our stock pick is a leading coal miner in Eastern China that not only supplies coal, but also owns a large stake in railroad assets. The company is organized into two operating divisions -- coal mining and coal railway transportation. It has six coal mines in China, as well as a regional railway network that links these mines with the national railway grid.

The company's main products are high-quality clean coals, which are suitable for use in large-scale power plants. Domestic sales of its coal products are concentrated in Southern China and Eastern China -- especially in Shandong Province. Twenty-one percent of its total sales are from exports, mainly to East Asian countries like Japan and South Korea.

In 2006, China increased the price of coal for Japanese and South Korean utility companies because international prices were rising. According to the country's new agreements with Japan and South Korea, China will export 5 million tons of coal to Japan at $67.90 per ton, up 28% from $52.97 per ton. The price of coal for South Korea is even higher at $73 per ton. These deals will benefit Chinese coal miners, including our company of choice.

Clearing the Air

Earlier we talked about the role that pollution could play during the Beijing Olympics. Much of the pollution in China is due to years of using coal as a fuel source. On the scale of heavy-polluting energies, coal is at the top of the list. The Chinese government recognizes this problem and has vowed to crack down on its air pollution. Over the next three years, China aims to cut harmful sulfur dioxide emissions by 10% from 2005 levels.

In order to reach this goal, the country will continue to close down its smaller coal mines. By 2010, 70% of China's small coal mines will be shut down. These closures will have a significant effect on China's coal industry -- large- and medium-sized coal mines will need to grow their productions by nearly 20% to meet surging demand and a decreasing number of suppliers. I expect our pick, which is one of the largest coal miners in China, to show strong production growth over the next couple of years as it shoulders the burden of meeting the exploding coal demand.

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