Consolidated Energy (CNX)

[frenchee]

On to coal. What's to like?

Coal has a promising future. Last year was kind of a perfect storm for the coal industry. There was a warm winter and a cool summer, strong hydroelectric and relatively low natural-gas prices. Demand was weak and in response to the strong coal prices in 2004 and 2005, supply was in the process of really ramping up. Inventories exploded, prices collapsed and stock prices collapsed. Coal is now in the process of reversing the ugly 2006 trends.

What's changing?

There are three main regions of the coal industry: the Powder River Basin in the West; the North Appalachian area; and Central Appalachian, which is the high-cost area in the U.S. Under current conditions, Central App is shutting down capacity. They are about 20% of U.S. production. Year to date, Central App production is down about 20 million tons, and we think it will be down about twice that for the entire year. More Central App capacity will shut in 2008 because most coal contracts are multiyear.

At the end of this year, a whole new set of contracts will roll off that were priced two, three, four years ago when prices were better, and they will be facing the new lower prices of today and therefore there will be further shutdowns. Overall U.S. production is down almost 3% year to date and so it's under very good control. On the demand side, we are assuming a normal summer and electricity generation in general will be up roughly 4% this year. Inventories are slowly moving back to a lower level and supply and demand will be more balanced in 2008.

What about China?

China is exploding. They are adding a coal-power plant a week, and China has now crossed over to become a net importer of coal in 2007 for the first time.

What about pricing?

Coal is extremely cheap on a BTU basis. At $7 natural gas, on a comparable basis, coal should be about $70 a ton for high-quality steam coal. Today, the price is about $45. That cost arbitrage is going to narrow over time.

Which region and what companies should benefit the most from developments in the industry?

You could throw a dart at the industry. All companies will benefit from the closing of the price gap between natural gas and coal. But Northern Appalachia is the area specifically that will benefit the most. Central App prices will probably move up the most, because they have the biggest swing capacity. And the PRB is the low-cost growth area. But Northern Appalachia has the most going for it now because the sulfur-emission restrictions mandated by the government will result in the amount of scrubbers installed at coal plants almost tripling in the U.S. by 2010.

Northern App coal is very high-sulfur. Before scrubbers, they were significantly disadvantaged and had to sell their coal at a discount to lower-sulfur coals elsewhere. But with scrubbers, they can operate on a more equal footing with the low-sulfur coals. We see Northern Appalachian coal prices moving more in line with the lower-sulfur coals.

Any particular company that stands to benefit?

Consol Energy [CNX]. And Consol Energy owns 80% of a public company called CNX Gas [CXG], which represents about $20 a share of Consol Energy's stock price. CNX Gas is a terrific low-cost player with long-life reserves. It is a nice property in its own right.

If you consider the earnings that Consol could generate if gas trades on a BTU-equivalent priced with coal, they could earn over $6. If it were to occur, it would be a ways away. There are really only two cost-effective power options: nuclear and coal, and the United States has 250 years of reserves of coal, while new nuclear plants won't be available until at least 2016.