The Saudi Arabia of Coal

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Last year, something important happened in the coal markets. China actually imported coal for the first time. As recently as 2001, China exported 90 million tonnes. But in 2009, China imported around 86 million tonnes. That’s a huge shift in less than a decade.

Overall, that import total is just a drop in the bottle. China alone burned about half the world’s total demand for coal last year, about $2.8 billion tonnes. Over the next five years, China may well need another billion tonnes of coal annually.

While 86 million tonnes is not a big deal overall, it is a big deal in the coal trade. So China’s demand has helped prop up prices.

Power generation is the big slice of the pie. The reason is simply that China has lots of coal, enough at minable depths to last for hundreds of years at current mining rates. Meanwhile, China lacks natural gas reserves. Hydropower is possible, but difficult, given the water strains that exist in the country. Nuclear power is a clear priority, as we’ve discussed before. But that’s going to take some years before it makes a dent in China’s coal demand.

Coal usage by China’s power industry has nearly tripled in the last decade. That’s an average growth rate of about 11%. The International Energy Agency estimates that China and India will account for 80% of the increase in demand for coal over the next two decades. These markets are obviously important to think about if you are going to invest in coal.

But to stay with China, what opportunities are there in satisfying China’s demand for coal?

Leaving aside the coal producers that export coal to China, there are a number of Chinese coal miners. These include China Coal, China Shenhua, Fushan Energy, Hidili Industry and Yanzhou Coal. As a group, they have lots of coal and big growth potential as they start to unlock those reserves.

The biggest growth, though, may be just outside of China, in Mongolia. Yes, Mongolia.

Mongolia is a big country, the 19th largest in the world, at over 600,000 square miles. It’s also one of the emptiest countries in the world, with fewer than 3 million people. It has the lowest population density in the world. About 40% of that population lives in Ulan Bator, the capital city, which lies on a flat table of earth amid high mountains. It is the coldest capital in the world. Temperatures swing wildly and can drop 50 degrees in a single day.

Mongolia, though, is rich in resources – iron, tin, copper, gold and silver…and coal. Lots and lots of coal. Mongolia has 10% of the world’s coal. Indonesia is currently the largest exporter of coal. Mongolia has double the amount of coal Indonesia has.

Total coal reserves are around 125 billion tons, according to AME Mineral Economics. This spans the full spectrum of coal, everything from high-grade coking coal (used in making steel) to low-grade lignite.

Yet Mongolia currently produces only around 10 million tons a year. AME reports only 40 of the 200 known coal deposits have active mining going on. There isn’t the infrastructure in place to get the coal to market. But that’s changing.

Already, about 64% of all of Mongolia’s exports go to China. For China, this is like having the Saudi Arabia of coal right across the border. For Mongolia, China is a meal ticket. Trade with China has created an influx of cash in the country. There are new cafes and bars and hotels in Ulan Bator today. Mining, it seems, is Mongolia’s economic future.

The only publicly traded Mongolian coal company is SouthGobi Energy, which trades in Toronto under the symbol SGQ. It seems to be quite a gem, too. SouthGobi has low mining costs and high-quality coal – better than many Chinese companies.

SouthGobi has one producing mine, Ovoot Tolgoi, and two other coal projects. Its producing mine is only about 25 miles from China’s Ceke port, where the coal is then shipped by rail into China. This is a big advantage because sparse infrastructure in Mongolia can make it challenging to get coal to China.

SouthGobi plans to boost production from about 4 million tonnes per year currently to 14 million tonnes by 2013. China Investment Corp. (CIC), the state-owned wealth fund that manages China’s bulging reserves, put a big slug in the company and now owns 14%. (It would own 26% if it exercised certain options.) Temasek Holdings, the Singapore state-owned fund, owns 2%. Ivanhoe Mines owns 57%.

So there are lots of insiders here who have just put fresh money in the deal. The CIC deal is important because it will surely help open doors for SouthGobi in China. Plus, I’m sure that the CIC would love to buy SouthGobi whole someday. SouthGobi, with prize assets, is an obvious goldfish among much larger fish.

Currently, the stock seems a bit rich, even given the potential growth here. The stock sells for about 30 times this year’s estimated earnings. But if growth comes through as expected, earnings could nearly triple in 2012. So this is a high risk, high reward opportunity.

SouthGobi may be the first significant public company to capitalize on Chinese coal demand, but it won’t be the last.

Chris Mayer
For Daily Reckoning Australia

Chris Mayer
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.
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