Coal has an image problem. Casual observers of energy markets view coal as an anachronism more at home in a 19th century factory than in modern developed economies.

And environmental groups consider coal an anathema. Compared to most other power plant fuels, coal produces more of every imaginable pollutant–from suflur dioxide (SOX) and nitrous oxide (NOX) to mercury and particulate matter.

As I write this article, world leaders are preparing for a UN Climate Summit in Copenhagen, ostensibly to hammer out the outline of a new global pact to reduce carbon dioxide emissions. It’s no secret that addressing global warming and climate change are cause célèbre for environmental groups and a top legislative priority for the Obama administration.

Coal-fired power plants produce roughly 45 percent of the world’s energy-related carbon emissions, far more than any other fuel. That makes it impossible to discuss climate change without addressing coal.

Several countries around the world have passed legislation to control emissions. And although the timing and severity are far from certain, the US will likely pass some form of legislation that limits emissions. The bill in the Senate isn’t likely to pass muster as it’s currently written, but the US House of Representatives has already passed a measure that aims to reduce US carbon emissions 17 percent by 2030 and 83 percent by 2050.

Whether you believe global warming is hyperbole or the biggest crisis of our era, it would be foolish to ignore the potential impacts of new regulations, laws and public sentiment concerning carbon dioxide emissions.

And don’t forget that coal is the world’s most important and fastest-growing fossil fuel.  In the US, coal-fired power plants produce roughly half the nation’s electricity. The most recent projections from the Energy Information Administration (EIA) forecast that total electricity output from US coal plants will jump 18 percent by 2030 and coal plants will retain a 47 percent share of the US electric grid.

Although laws governing greenhouse gas (GHG) emissions might slow the construction of new plants, existing plants would likely continue to run because of their low operating costs. And don’t make the mistake of assuming that there are no new coal-fired power plants being built in the US. Despite efforts to halt or disrupt projects, there are a total of 83 power plants in various stages of construction and permitting whose total capacity would be in the neighborhood of 47,000 megawatts (MW).

Most of those plants will never be constructed or put into service. According to EIA data, in 2002 utilities had announced plans to construct 36,000 MW of new coal-fired capacity by 2007. Of that total only around 4,500 MW actually made it into service. However, plants near or already under construction are far more likely to be built than plants that have simply been announced; 25 coal plants with 15,000 MW of capacity are currently under construction, and companies are close to breaking ground on facilities that would add another 882 MW of capacity.

Bottom line: Even assuming a significant cost attached to carbon emissions, coal plants will remain a relatively low-cost source of power for decades to come. Further, coal plants represent a reliable source of baseload power.

And coal may shed some of its dirty image over the long-term. Modern scrubber technology can remove more than 90 percent of SOX and NOX emissions from coal effluence. Technologies also exist to remove carbon from plant emissions, though the cost of implementing these carbon-capture technologies on a commercial scale is still the subject of significant debate. In the near term, modern coal gasification plants are far more efficient at converting coal into electric energy; simply replacing older coal plants with more modern designs can cut carbon emissions by more than one-fifth. 

And the House-passed climate bill contains significant incentives for the development of clean-coal technologies. Don’t forget that there are several Senators on both sides of the aisle that hail from major coal-producing states. Don’t buy the hype that America’s coal industry is on the rocks.

While the US coal market is far from dead, the international coal market is positively booming. Coal accounts for 42 percent of global electricity generation and that share should grow over the next two decades. The developing world is the primary driver of this growth; China and India produce 80 and 70 percent of their power from coal, respectively. And both countries are building out their coal-fired power capacity at a breakneck pace.

Source: EIA

Asian countries outside the Organization for Economic Cooperation and Development (OECD) currently generate roughly 70 percent of their power from coal. Coal-fired generation in the region is expected to soar more than 176 percent by 2030.

Although the media tends to focus on China, India is a market that gets far too little attention from investors. But India is also a major consumer of coal and needs to build considerable capacity to meet growing demand for electricity. Indian officials state that the nation will need to import as much as 200 additional tons of coal over the next five years, making the country the world’s fastest growing importer.

And don’t forget that there are two main types of coal: thermal coal and metallurgical (met) coal. Thermal coal is used primarily in electricity generation.

Higher quality, more expensive met coal is used to make coke–a dense, nearly pure form of carbon that burns at an extraordinarily high temperature. It’s made by burning met coal at a high temperature in a sealed environment. Coke is in turn used in steel production and other industrial applications.

The main difference between thermal coal and met coal is that met coal contains more energy. Met coal also typically produces far less ash when burned than thermal coal.

Demand for met coal is sensitive to the health of the steel industry. China is the world’s largest steel producer and has been forced to import significant quantities of met coal in recent years to supplement locally produced coal.

The Coal Recession

Although the long-term outlook for coal remains bright, the recent global downturn took its toll, particularly on US operations. Total US electricity demand fell sharply in the final months of 2008 amid the financial crisis and is only beginning to show some signs of recovery.

Source: EIA

This graph compares US electricity generation from different types of plants in the first eight months of 2009 against the same time period in 2008.

As the chart shows, total US electricity demand is down 4.9 percent in the first eight months of 2009, and coal generation declined 12.6 percent. Coal-fired generation was off more than total US electricity demand due to the precipitous drop in natural gas prices from mid-2008 through summer 2009. Falling natural gas prices prompts fuel switching; generators with the capability to burn both coal and gas to produce power opt to burn cheap gas.

The biggest winner on my graph is non-hydroelectric renewable energy sources, up 8.4 percent year-over-year. While that’s impressive in percentage terms, consider that non-hydroelectric renewable sources accounted for just 3.4 percent of US energy generation in the first eight months of 2009.

As a result of the severe drop-off in US thermal coal demand, stockpiles of coal at US power plants are glutted. US coal stocks stood at 194,145 short tons in August, down only slightly from 198,215 in June; based on average coal consumption so far this year, that’s more than 70 days of coal supply. A more normal historical range is 30 to 40 days’ worth of stored coal.

Due to glutted inventories, utilities have stopped buying coal on the spot market. US coal mining firms have attempted to cut back production by shuttering plants or scaling back operations. Over time falling mine output, coupled with the recent recovery in electricity demand, will normalize coal inventories, but even the most optimistic analysts estimate that this process likely will take much of 2010.

On the plus side, the recent rally in natural gas prices may help to reverse some of the fuel switching that occurred this year. Moreover, the summer of 2009 was unusually mild in the US; the El Nino current in the Pacific that contributed to America’s cool summer is likely to fade by the summer of 2010. This should bolster energy demand as Americans fire up their air conditioners.

The most obvious fallout from the Great Recession for the coal industry has been lower prices for its black gold. The average pot price for coal from Central Appalachia (CAPP) reached highs of over $130 per short ton in summer 2008 amid strong US demand and a surge in coal exports.

In the middle of last year China’s demand for coal rose so quickly, the nation was forced to step up imports. With China taking in most of the world’s exportable coal, European generators scrambled to secure supply; many decided to import more coal from the US.

But the collapse in US demand for coal this year saw prices for CAPP coal fall all the way to $45 per short ton. Lately they’ve rebounded to $50 to $55 per short ton.

Due to the drop in US steel production, met coal prices also fell from over $160 per ton in mid-2008 to lows under $110 this year. Met coal demand appears to be recovering faster than demand for thermal coal. In the US, steel plants that had been idled have resumed operations in recent months, helping boost US demand.

More important, the Chinese and Indian economies have recovered more quickly than many pundits expected this year, powering strong global growth in demand for steel. The Chinese economic stimulus package has further bolstered demand for steel used in construction industries. Since the US is an important met coal exporter, rising demand has begun to pull met coal prices higher globally.

The picture for the US coal markets remains murky, but demand and prices are on the rise and reduced mine output should help tighten the market. A rapid recovery in demand outside the US, particularly in developing Asia, is also helping to power exports and push global coal prices higher.

Coal MLPs

Longtime readers of MLP Profits know that even among our Aggressive Portfolio holdings, we tend to look for MLPs involved in businesses that generate steady, reliable cash flows over time. After all, ample distributions are primary attraction of these securities, and steady cash flows make those payouts possible.

One of the hallmarks of our Aggressive Portfolio relative to the Conservative and Growth allocations is that we’re willing to take on some commodity price risk. The payoff for that higher risk: Our average Aggressive holding offers a yield that’s a full 3.2 percent higher than our average Conservative Portfolio holding.

As we’ve cautioned on several occasions in this newsletter, do not be tempted to buy MLPs that offer the highest yields. Higher yields usually involve higher risk: yield-chasers who bought sell-rated K-Sea Transportation Partners (NYSE: KSP) for its sky-high yield took a hit when the company slashed its payout and the stock cratered more than 50 percent.  When choosing Aggressive Portfolio holdings, we carefully select MLPs with higher–but no unmanageable–risks which offer yields that are sufficient to compensate for those risks.

At first glance, it might seem that the volatile and economy-sensitive coal mining business I just described would be completely unsuited to the MLP structure. After all, volatile mining earnings aren’t exactly a firm foundation for attractive distributions.

But MLPs involved in the coal mining business take a relatively low-risk approach that allows them to protect revenues amid a volatile and unpredictable market.

Coal MLPs don’t mine an ounce of coal; instead, these firms are in the business of collecting royalties. MLPs own property in coal-producing regions and lease those properties out to mining firms under long-term contracts. The beauty of this arrangement is that the MLPs do not incur any operating costs associated with the mines located on their properties.

In other words, these firms do not face the rising costs associated with new mining safety and environmental laws. Nor do the MLPs have to worry about the rising cost of hiring experienced miners or fuel costs associated with running mining equipment. This is a huge advantage because one of the biggest impediments coal mining firms in Appalachia have faced in recent years is the rising cost of complying with ever-changing government regulations.

A typical lease provides several different sources of revenue for a coal MLP. First, coal MLPs normally take a guaranteed minimum fee whether the firm leasing their properties mines coal or leaves its mines idle.  Even in weak coal markets, this minimum contractual fee means that the MLP is guaranteed some base level of cash flow.

On top of those contract minimums, coal leases generally provide for a fixed fee per ton sold and a percent of the gross sales price generated by coal mined from their properties. This offers the coal MLP multiple layers of protection.

First, per-ton fees are based on volumes of coal mined, not the value of the coal; fluctuations in coal prices don’t necessarily impact an MLP’s cash flows. However, the percent of sales royalties offers the coal MLP an upside cash flow bonus in periods of high coal prices. In effect, the MLP takes on relatively limited downside in exchange for significant upside potential.

Of course, as noted earlier, weakness in coal prices and demand spells lower output from mines and falling coal volume fees. However, this effect is limited somewhat by the fact that most mining firms contract with utilities in multi-year deals. These contracts typically force the utility to accept delivery of some coal each year, regardless of current mining conditions; the nature of the coal contracting business helps to mitigate the risks of fluctuating coal output from an MLP’s mines.

That being said, it’s extremely important to note that these factors mitigate but do not eliminate risk; coal MLPs still carry significantly more commodity and economic risk that the straight fee-based midstream MLPs we recommend in the Conservative portfolio.

The Coal Universe

Penn-Virginia Partners (NYSE: PVR), Natural Resource Partners (NYSE: NRP) and Alliance Resource Partners (NSDQ: ARLP) are three MLPs in our coverage universe that operate in the coal industry. Here’s a look at the business for all three MLPs and the rationale behind our ratings.

Natural Resource Partners (NYSE: NRP) owns roughly 2.1 billion short tons of proven and probable coal reserves. Roughly 78 percent of production volume and 70 percent of total coal royalties come from thermal coal–the rest comes from met coal.

While 30 percent met coal might not seem like a high percentage, Natural Resource Partners actually has more exposure to met coal than most coal-focused MLPs–an advantage because the met coal market is strengthening more quickly than the market for thermal coal thanks to strong demand from emerging markets.

Geographically, Natural Resource Partners’ largest area of operation is Central Appalachia (CAPP), a region that includes West Virginia, Kentucky, Virginia and Tennessee. Roughly 70 percent of Natural’s total coal royalties are generated in the area.

CAPP is the oldest coal mining region in the US and, for most of the nation’s history, was also the largest source of coal. In recent years, rapid growth in output Montana and Wyoming–a region known as the Powder River Basin (PRB)–has overtaken CAPP on a volume basis. The disadvantage of operating in CAPP is that many mines are underground and, therefore, have higher mining costs, require better-trained laborers and are subject to more stringent safety regulations than surface mines in the PRB. In Natural’s case, 85 percent of its properties are mined using underground mines.

But there’s also a bright side to CAPP: Coal from the region is of a high quality. Met coal from CAPP generates more energy per ton and produces minimal ash waste; it’s among the most in-demand grades of met coal in the world. Met coal fetches far higher prices than thermal coal on a per-ton basis, and much of Natural’s met coal volumes come from CAPP. This is one reason why the MLP’s per-ton coal royalties from Appalachia are the highest of any of its operations; Natural earned an average of $4.34 per ton of coal mined from CAPP in 2008.

Natural also generates about 10 percent of its production from the Illinois Basin and 5 percent from the PRB. Coal from the Illinois Basin is generally cheaper to mine than CAPP coal but contains a higher percentage of sulfur; power plants burning this coal must use scrubbers to remove sulfur dioxide emissions generated by the plants. The market for Illinois Basin thermal coal is improving; many utilities along the eastern Seaboard have installed scrubbers in recent years, so Illinois Basin coal is a viable choice.

Coal in the PRB contains less energy but is extremely plentiful and cheap to mine. It’s the fastest growing coal-producing region of the US–a trend that’s projected to continue in coming years. Some exports have already happened and there’s considerable speculation that PRB coal will see a growing market in Asia in coming years, shipped out of America’s West Coast ports.

In addition to coal royalties, Natural derives a small amount of revenue from coal processing and transport. The MLP owns plants that prepare coal for sale and load the coal on trains for delivery to utility customers. This is a relatively new business for Natural but does generate attractive volume-based fees.

On top of that, Natural has entered the aggregate mining business. Aggregate is the stones and gravel used primarily on construction and mining sites. Just as with coal, Natural Resource earns per-ton royalties and a percentage of sales proceeds. All three of these new businesses combined make up around 10 percent of revenues; the coal royalty business remains the key to Natural’s distributions.

In the most recent quarter, Natural generated $30.1 million in distributable cash flow, down 44 percent from the same quarter one year ago. As you might expect, revenues were hit hard by the decline in price-based royalty fees as well as a drop in volumes mined from its properties. The MLP paid a distribution of $0.54 per unit–2.9 percent higher than a year ago. However, the company did not generate enough cash flow in the quarter to fully cover its distribution.

For the full year, distribution coverage looks tight. According to management’s most recent forecasts, Natural will generate $139 to $165 million in distributable cash flow for 2009. In 2008, natural paid out a total of $171.31 million in distributions to its limited and general partners; even at the high end of management’s guidance, the company doesn’t appear to cover its payout.

But there are a few offsetting factors. First, Natural Resource updated it guidance over the summer, and conditions in global coal markets have improved since then. In particular, the US steel industry is restarting capacity, pushing up demand for Natural’s met coal. Expectations are for a gradual recovery into next year; a modest recovery would push up Natural’s cash flows and put the MLP back into a healthy coverage ratio.

Moreover, the general partner has decided to forgo more than $7.35 million in incentive distributions for both the third and fourth quarter in an effort to shore up cash flow. Since these incentive distributions would normally be paid out of distributable cash flow, this is a major help in terms of allowing Natural to maintain its payout this year.

Finally, Natural Resource Partners has around $278 million available on its credit facility and around $61 million in cash. Although much of this is earmarked for acquisitions, the cash and credit gives natural some flexibility in terms of maintaining payouts through a tough period.

Bottom line: It’s unlikely that Natural will reduce distributions–unless the global coal markets reverse recent gains and weaken yet again into mid-2010. And for aggressive growth-oriented investors, Natural represents a high-income way to play a recovery in the global coal markets; the current yield is around 9 percent, well above average for the MLP industry. Natural Resource Partners rates a hold in our How They Rate table, solely due to its lack of distribution coverage.

Penn-Virginia (NYSE: PVR) owns roughly 830 million tons of proven and probable coal reserves.

Much like Natural Resource Partners, 70 percent of Penn-Virginia’s reserve base is in CAPP and 20 percent in the Illinois Basin; the MLP receives royalties, minimum fees and volume-based payments for coal mined on its properties. Unlike Natural, however, most of Penn-Virginia’s reserves are steam coal.

Penn-Virginia also operates a midstream natural gas business. The MLP owns five natural gas processing plant as well as an extensive natural gas gathering system in the Panhandle of Texas and Western Oklahoma. We profiled the natural gas gathering and processing (G&P) business in the October 9 issue of MLP Profits, Upside for G&P MLPs, and in the November 9 issue, Commodity Tailwinds.

Suffice it to say that the G&P business has commodity sensitivity but has showed signs of improvement in recent months due to better processing margins. Management noted a significant improvement in volumes and processing spreads in the third quarter. The G&P business is actually more important to Penn-Virginia’s bottom line than coal; 76 percent of third quarter revenues came from its midstream business.

Penn-Virginia’s coal business is, like that of Natural Resource Partners, based on long-term leases (usually five to 10 years in duration). Since many of the companies mining Penn-Virginia’s properties have locked in long-term contract coal prices with utilities, volumes and sales prices haven’t been hit much by the recent contraction. Coal royalty revenues are down just 9 percent year-over-year.

Total distributable cash flow in the third quarter was roughly $37 million compared to its payout of less than $31 million in distributions. Even factoring in incentive distributions to the general partner, Penn-Virginia covered its third-quarter payout.

Although Penn-Virginia’s coal royalty and G&P businesses carry higher-then-average risk, its attractive near-10 percent yield and decent distribution coverage warrant a buy rating in How They Rate.

Alliance Resource Partners (NSDQ: ARLP) has total proven and probable reserves of 686 million short tons. Unlike the other two coal MLPs, Alliance is heavily focused on the Illinois Basin–about three-quarters of its reserves are in the region, while the balance are in CAPP and northern Appalachia.

As I noted earlier, most of the coal in the Illinois Basin is high in sulfur, so it’s only appropriate for utilities with scrubbers installed on their plants. Without scrubbers, utilities can’t burn high-sulfur coal and comply with clean air regulations.

But this market is growing rapidly. US power plants outfitted with this technology have the capacity to burn 220 million tons of coal per year, and that’s set to increase to around 390 tons by 2013. Since Illinois Basin coal is cheaper to mine than in CAPP, increasing scrubber capacity spells a growing, profitable market for Illinois Basin coal.

And unlike Natural Resource and Penn-Virginia, Alliance is the fifth-largest coal producer in the US.

From a stability standpoint, one major attraction of Alliance is that it has 100 percent of its planned 2009 production contracted under fixed price deals with major utilities. That figure drops to 90 to 95 percent of 2010 production and 80 to 85 percent of 2011 output. These deals lock in revenue for Alliance and make it less sensitive to shifts in commodity prices than the other two coal MLPs. This accounts for Alliance’s lower yield of 7.8 percent.

Alliance’s conservative contracting policy has allowed the company to raise its distributions steadily over the past year despite the weak environment for coal-mining firms and still maintain a healthy distribution coverage ratio. We rate Alliance Resource Partners a buy in How They Rate.