In December 1952 a dense, smoky fog descended upon London–not an unusual occurrence. While living in London, my favorite variety was freezing fog, a light mist that would freeze to your car instantaneously, creating traffic hazards and jams throughout southeast England.

But the fog of 1952 was nothing like what London experiences today. In 1952 many Londoners still burned coal in their homes for heat; the particulate matter, sulfur and nitrous oxides mixed with water vapor to produce a thick, toxic soup. Meanwhile, unusually light winds and cold temperatures prevented these pollutants from dispersing into the atmosphere. 

It’s estimated that more than 4,000 people died during the dense fog of 1952, primarily from respiratory ailments. Poor visibility prompted school closures and train cancellations, while abandoned cars sat on the streets for nearly a week.

Although weather patterns dictate that London is still a foggy city, the dense, smoke-filled fogs for which it was once known are a thing of the past. This is also the case throughout much of the West.

Modern coal plants are fitted with advanced scrubbers that remove more than 90 percent of the sulfur dioxide, nitrous oxide and particulate emissions produced by combustion. The pollutants released from these facilities bear little resemblance to the unscrubbed emissions belched from London homes and factories fifty years ago.

But these air-quality concerns still prevail in emerging markets. Some cities in China still experience the dense smog that once enveloped London’s streets. This is largely due to the prevalence of smaller coal-fired plants and coal-burning facilities that do not employ scrubber technology.

But investors shouldn’t assume that coal will go the way of the dodo because of its dirty effluence.

The Chinese government is aware of the pollution problem afflicting certain cities and is taking steps to ameliorate the problem, closing down many small, coal-fired facilities that had operated without a license.

To replace this capacity, the government has encouraged the construction of modern coal plants that are equipped with scrubbers. In 2007, for example, Chinese authorities announced a plan to replace 50-gigawatts worth of older generation capacity with modern power plants.

And despite its air-quality issues, China is leaping ahead of the developed world in terms of its energy infrastructure. In the US, stiff resistance from environmental groups makes it difficult to build new coal-fired facilities, forcing utilities to rely on older plants that are far less efficient.

Because of these impediments, the average coal-fired plant in North America is more than 35 years old.

Meanwhile, China, India and other emerging markets are rapidly putting up state-of-the-art plants to replace older facilities and expand generation capacity. Based on current trends, the average Chinese coal plant will be more efficient than the average US plant within a few years.

Carbon dioxide (CO₂) emissions complicate matters further. The technology exists to remove CO₂ from coal plant emissions but hasn’t been tested and perfected on a commercial scale. At present, these technologies aren’t economic.

But carbon capture and sequestration technology isn’t alone in that regard: Alternative energy sources such as wind and solar aren’t economic without government subsidies.

Don’t believe the common fallacy that green energy will replace coal-fired plants over the next three decades–such a transition remains unlikely.

China has committed to holding coal’s contribution to the country’s energy mix relatively steady. But coal already accounts for roughly 80 percent of China’s power generation, and the nation’s rapid economic growth will increase actual consumption.

Meanwhile, India and other fast-growing economies have also committed to a large-scale build out of coal-fired capacity in coming years.

Natural gas–not alternative energy sources–is the one fuel that’s likely to take share from coal in the intermediate term. Natural gas-fired facilities emit far less CO₂, and the rapid development of shale-gas fields in North America eliminates any supply concerns. I discussed the prospects for natural gas in the Aug. 23, 2010, issue of The Energy Letter Natural Gas: The Realistic Choice.

But coal enjoys key advantages over other power sources, particularly in developing nations that lack access to America’s abundant gas supplies. In particular, coal-fired power is less expensive, and the feedstock is relatively easy to source.

Expect coal to remain a key energy commodity for decades to come.

Short Term Coal Outlook

Broadly speaking, there are two major coal markets: thermal coal and metallurgical (coking) coal.

Thermal coal is burned in power plants to produce electricity. This variety tends to have less energy content per ton and typically trades at a lower price.

Metallurgical coal contains more energy and is used in blast furnaces to produce steel.

Thermal and metallurgical coal of varying qualities and properties is mined throughout the world, but this simplified view of the coal industry is still instructive.

Equally important are geographical considerations. The US has the world’s largest coal reserves and is the second-largest producer of the commodity. However, US producers traditionally have focused on meeting domestic demand for thermal coal. Australia and Indonesia are the world’s largest exporters of thermal coal.

The US and Canada both export metallurgical coal, but Australia should remain the leading exporter of coking coal for decades.

Prices for US thermal coal depend on domestic supply, demand for electricity and utilities’ stockpiles. Bloated inventories have weighed on US prices in recent quarters, a product of weak electricity demand during the 2007-09 recession.

But there are reasons to be optimistic about the US market for thermal coal. Electricity demand has recovered from the depressed levels that prevailed throughout the recession, and a hot summer provided further relief. US coal miners also helped their cause by reducing production in response to elevated inventories at power plants.

With supply declining and demand on the rise, these stockpiles are beginning to diminish. In May, the most recent month for which the US Energy Information Administration (EIA) provides detailed data, inventories were off 3 percent from a year ago. And the EIA projects further declines.

Source: Energy Information Administration

As you can see, coal inventories (“stocks”) moved from extremely lean levels in 2005 and 2006 to an outright glut in 2009. The EIA expects stockpiles to decline gradually to average levels in 2011. This forecast appears at least directionally correct and should put a floor under US thermal coal prices going forward.

There’s an important distinction to make between the US coal and natural gas markets in recent months. Although demand for both commodities has been strong this summer, gas producers have continued to drill aggressively despite weak prices. We examined the reasons for this frenzied activity in several recent issues of The Energy Letter, including Pugh Clauses and Shale-Gas Activity and Why Some Natural Gas Is Worth $7.28.

In contrast, US coal producers reined in production during the recession to match falling demand. And many operators in Central Appalachia–the nation’s oldest coal-producing region–have reported difficulties maintaining their output because of depleted seams. New safety regulations that impact underground mining on the East Coast compound this challenge, rendering many smaller mines uneconomic.

The combination of stronger demand and falling production means that US thermal coal prices will recover more quickly than natural gas prices in the short term.

But investors spend too much time analyzing coal supply and demand trends in the US. The truly exciting story is taking place in Asia. Consider the following facts:

• Chinese electricity generation is up 19 percent in the first six months of 2010, compared to the same period one year ago;
• Vehicle sales in China are up 48 percent this year, and steel production is up 22 percent;
• China’s steel intensity–steel use per capita–is at half or less than that of Japan, South Korea and the US, but will ultimately be higher than in the US because Chinese cities are growing up (high-rise, steel structures) rather than out (suburbs);
• Coal exports to India soared 22 percent in the first half of 2010 and are expected to be up 15 to 20 percent for the full year; and
• Japanese steel production is up 20 percent this year, and imports of thermal coal have increased 13 percent through May–both signs of a recovery from the 2007-09 recession.

Even as demand for coal in most developed countries gradually recovers, Asian consumption of both thermal and metallurgical coal continues to grow at an impressive pace. Companies capable of exporting coal from Australia stand to benefit handsomely.

Over the past few years, China has moved from being a net exporter of coal to a country that’s likely to import more than 130 million tons of coal in 2010.

India may offer even more compelling growth over the long term. The country continues to rapidly build its coal-fired generation capacity as it seeks to meet fast-growing power demand. Whereas China produces a sizable amount of domestic coal, India’s low-quality reserves increase its dependence on imports. In fact, the nation is expected to be the fastest growing coal importer in the world over the next five years.

I’ll cover global coal markets in my Sept. 22 Webinar, highlighting a pair of US-focused names that yield nearly 8 percent and top growth-oriented plays on the Asia-Pacific boom. Equally important, we’ll take a look at some names to avoid–primarily companies with exposure to rising costs and falling production in Central Appalachia. 

Best of all, attendees will receive ongoing coverage of all of these stocks through a free 90-day trial subscription to The Energy Strategist. Click here to sign up for my upcoming Webinar.