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New EPA Rules Are Money in the Bank for These Coal Stocks

by | published September 18th, 2014

On the face of it, it sounds like a major miscalculation by the Environmental Protection Agency (EPA).

The agency’s latest rules requiring that power plants reduce emissions are actually increasing the use of higher sulfur content coal.

The EPA is requiring that all coal-fired generating facilities introduce sulfur scrubbers to decrease the amount of sulfur dioxide pollution entering the atmosphere.

However, the effect of requiring and installing scrubbers has been to encourage the use of “dirtier” low-grade coal from the Illinois basin at the expense of the higher-grade Appalachian coal.

At the center of this counterintuitive result is a combination of price and heat content.

That, in turn, has improved the short to medium-term prospects for this niche of coal stocks…

Why the Market Loves “Illinois Coal”

Thanks in part to new regulations, companies emphasizing the Illinois basin like Foresight Energy, LP (NYSE: FELP) – along with a range of smaller privately-held coal producers – are now experiencing a resurgence in demand from power plants. As a result, plans to increase production in these areas are quickly following.

Sulfur dioxide is one of three non-carbon standards the EPA is working to strengthen. The other two involve reducing mercury and nitrous oxide emissions. Both of these objectives can also be accomplished using the same scrubbers as those introduced for sulfur.

That means the initial wave of interest in higher sulfur content coal is likely to continue as more scrubbers are introduced.

Of course, all of this still needs to be placed in perspective.

According to a study by consultant Wood MacKenzie, around 217 gigawatts (GW) or some 72% of U.S. coal plants already have scrubbers. And by 2025, 252 GW or 100% of the national capacity will be using them. According to the U.S. Department of Energy (DOE), 1 GW satisfies the needs of over 708,000 homes.

Nonetheless, by 2020 the consultant estimates that 67 GW of coal-fired electricity will have been taken off line as utilities work to comply with the EPA rules. That, taken in combination with over 90 GW of coal-fired capacity nationwide closing due to the age of facilities, is producing a major boon to the rise of natural gas as the primary source of electricity generation.

As a result, coal’s share of the country’s power generation will fall to 33% in 2020 and 30-31% in 2030 under the new standards, compared to 41% under existing rules, according to EPA projections.

Even so, according to latest DOE estimates, the U.S. will still burn 616 million to 636 million tons of coal to produce power in 2020.

As a consequence, lower grade Illinois coal is flourishing. In a May report, the DOE’s Energy Information Administration (EIA) forecast that 2015 production from the Eastern Interior, the area including the Illinois basin, will increase 9.4% over 2014.

In contrast, volume from Northern Appalachia is projected to decline 1.9%, while Central Appalachia will take a 14% hit.

And Illinois is not the only area producing lower grade coal to feel this effect. Wyoming’s Powder River basin (PWB) will increase production 4.4% year-over-year.

However, while Illinois basin coal costs almost four times the price of PWB production ($44 vs $12), its heat content is 34% higher.

That is a decisive advantage, since coal demand for the generation of electricity is forecast to increase by 2.8% to 882.2 million tons over 2013, according to the August 12 EIA “Short-Term Energy Outlook.”

What’s more, the pricing differential versus higher-grade Appalachian coal is also significant.

Illinois basin coal is 22% cheaper than Central Appalachia and 30% less than Northern Appalachia. Higher-grade (and more expensive) metallurgical coal is still in demand for steel production. But it is the thermal coal that fuels the production for electricity and heat that is driving the Illinois coal renaissance.

Investing in Coal Stocks

Overall, coal usage will continue to rise at a small rate for the remainder of the decade, but the longer-term outlook shows that it will plateau, giving way to the alternative largess of domestic natural gas supplies.

Still, there will remain niche plays in the coal sector for some time to come.

The Illinois basin play, at least for now, provides one opportunity based on location and cost. Production in this area also benefits from the level agricultural land found there. Unlike the more hilly mining locations of Appalachia, Illinois coal is simply cheaper to produce.

The other opportunity for investing in coal stocks involves companies that are able to consolidate operations at several locations, preferably combining better cost thermal production with ready access to end-user markets.

A good move in this direction is Westmoreland Coal Co. (NasdaqGM: WLB), a company that has combined production of low-cost coal grades with control over electricity generating plants.

Not surprisingly, WLB is up 103% YTD and 246.5% since August of 2011.

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