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Commodities

The New Black Gold

As coal grows in popularity, three ways to stoke your profits.

With 27% of the world's reserves, the U.S. is the Saudi Arabia of coal. That was once a dubious distinction because coal is harder to transport than crude oil and doesn't burn as cleanly. But as crude has become increasingly expensive, coal has emerged from the dust as a viable energy alternative. And that, naturally, has stoked interest among investors.

Stocks of U.S. coal producers have handily outpaced those of Big Oil over the past two years. During that period, for example, shares of oil giant ExxonMobil gained 37%, while the stock of Peabody Energy, the world's largest private-sector coal producer, more than quadrupled. Does this mean the coal barge has sailed and it's too late to get on board? Not necessarily.

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Room to run

Just as oil stocks were slow to reflect the near tripling of crude prices since 2003, coal stocks are still catching up to the commodity's price gains. St. Louis-based Peabody (symbol BTU) announced early this year that it had sold 30 million tons of future production through 2010 for 150% more than the average of last year's prices. If it could sell its entire output at those prices, annual revenues could surge from last year's $4.6 billion to $11.5 billion. Much of that extra revenue, says Tim Guinness, London-based manager of Guinness Atkinson Global Energy fund, would fall straight to the bottom line as profit. "That's why, despite the substantial appreciation in Peabody's shares over the past four years, they could double or triple again," he adds.

Of course, it's not quite so simple. Peabody sells coal mainly through long-term contracts, so rising coal prices only gradually work their way onto the company's income statements. Most of next year's expected output and nearly half of Peabody's 2008 output are already under contract, according to estimates by investment bank Friedman Billings Ramsey.

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Several other factors could darken the short-term outlook. About 90% of U.S. coal production is used by electric utilities to fuel power plants. Mild weather or an economic slowdown could significantly dampen demand and depress prices. Bottlenecks also plague coal producers as railroads struggle to keep up with rising demand, particularly from the prolific mines in Wyoming.

Seller's market

But the long-term case is as solid as the black rock itself. After years of playing second fiddle to cheap oil and gas, coal producers are benefiting from a seller's market. "It takes a long time and a lot of capital to increase production, so it's not so easy for them to respond to higher prices," says Friedman Billings Ramsey energy analyst David Khani.

Although the price of natural gas, another major fuel source for power plants, has retreated recently, it remains high by historical standards. So utilities have announced plans for 140 new coal-fired plants. It takes years for these plants to clear regulatory and financial hurdles. But analyst David Gagliano, of Credit Suisse, says that even if only half of the announced plants are ever built, the additional demand for coal will be greater than the annual output of the second-largest U.S. producer, Arch Coal. Adds Gagliano: "In short, the long-term demand outlook for coal is arguably the strongest it has been in decades, while the reserves to satisfy this long-term demand story continue to shrink."

Don't expect to get significant exposure to coal stocks through natural-resources mutual funds and exchange-traded funds. Neither Energy Select SPDR (XLE) nor iShares Dow Jones U.S. Energy Sector Index (IYE) holds coal stocks. And coal stocks make up only 5% of Fidelity Select Energy fund and 4% of Vanguard Energy.

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If you want to load up on coal, you'll have to buy individual stocks, and Peabody is a good place to start. It is a dominant producer in the Powder River Basin area of Wyoming and Montana, which yields low-sulfur coal that is in high demand throughout the U.S. Peabody also has operations in Australia and Venezuela. By most measures, Peabody's shares are not cheap. At $52, they trade for 22 times expected 2006 earnings of $2.36 per share. But Peabody's reserves of 9.8 billion tons are more than twice as large as anyone else's, so the company stands to benefit most from the industry's favorable trends.

FBR analyst Khani thinks better value can be found in an Appalachian-region producer, Consol Energy. High-sulfur Appalachian coal produces more toxic emissions. But tougher air-quality standards will force more utilities to add emissions-reducing "scrubber" technologies by 2010, allowing them to use more high-sulfur coal. "We could see cash flow literally double from this trend," says Khani. He contends that shares of Consol (CNX), recently $39, have lagged as investors have focused more on western producers of cleaner-burning coal. Consol could be worth as much as $80 a share as demand for high-sulfur coal rises, he says.

Natural Resource Partners offers a different way to own coal. The Houston-based master limited partnership (NRP) owns two billion tons of coal reserves in the eastern, central and western U.S. but doesn't operate any mines. Instead NRP leases its properties to mining firms and collects royalties. Most of those royalties are passed directly to investors as dividends. NRP's payout has increased for 11 straight quarters, and over the past four quarters, it has distributed a little more than $3 per unit. The payout is not guaranteed, but the partnership boasts a strong balance sheet and can use its $67 million in cash to buy additional income-producing properties, as well as fund its dividend. NRP units, which sold for as much as $69 a year ago, recently traded at $53, giving them a yield of 6%. A.G. Edwards analyst Mark Reichman has a 12- to 18-month price target for NRP of $63. That's based on his assumption that the cash distribution will grow 12% annually over the next three years.