*New Coal Economics*http://www.energycentral.com/site/newsletters/ebi.cfm?id=614

* December 24, 2008* by Lee Buchsbaum

http://www.energyblogs.com/site/blog_this.cfm?article_type=4&article_id=614

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A perfect storm of rising world coal demand and falling international supplies is creating higher prices for U.S. producers who can sell into the export markets instead of domestically.

Utilities are also facing rapidly escalating railroad transportation contracts as shippers take advantage of their pricing powers. Major utilities such as AEP, Duke, TVA and others are either raising rates or weighing their options while they struggle to contain their fuel costs, develop new procurement strategies and re-evaluate alternatives.

Driving international demand for both coking and thermal coal are rising global electrical demand and coal consumption throughout Asia and India, and production shortfalls in South Africa, Australia and China itself. Throughout 2008, China has purchased as much Australian, Indonesian and Vietnamese coal as they can acquire -- even as less is exported from those producers because of their own growing domestic demands. South American coal, particularly from Colombia, is finding buyers who will purchase at higher rates than U.S. utilities, especially Western Europeans.

With the falling dollar, selling to Asia, Europe or South America is giving coal producers a higher return than selling into the United States. "If I were running a coal company and I looked at what's happening on Capitol Hill and the states, I'd be very inclined to send my marketing team overseas," said Michael Morris, AEP chairman, president and CEO. "That's where it appears the growth market is going to be, not here domestically."

In 2007, the United States exported almost 60 million tons of coal. This year, many expect that figure to be between 80 and 90 million tons. Estimates for 2009 are even higher at 100 million tons. Through June of this year, producers sent 40.4 million tons overseas, up 57 percent from 2007.

With dollar devaluation, the "United States is on sale right now," said James River CEO Peter Socha. Most of what's heading overseas originates in Central Appalachia (CAPP) where some of the world's best remaining coking and thermal coal lies. However, after a century of extraction, much of CAPP's reserves have been depleted.

Prices for coal have remained relatively high. According to Michael Quillen, Alpha Natural Resources chairman and CEO, those prices continue to escalate and production remains flat. "Even with dramatic increases in prices, we've not been able to match it with production. If we could, we would," confessed Quillen. "The CAPP basin is on an unstoppable downward slope of shrinking production, and higher prices don't necessarily imply that production can be re-stimulated. Higher prices are merely having the effect of extending reserves."

*Fierce Competition*

With fierce competition to get into the lucrative export market, producers are selling as much as possible overseas and shortening their contracts. "It's been a recent trend to leave more market pricing open as part of a producer's portfolio," said Chuck Zebula, AEP's new senior vice president and treasurer. Zebula, whose portfolio still includes fuel, contrasts the current market with years past. "Producers today want as many options as possible. They don't want to lock up their coal prices for five years anymore."

With eastern coal moving into the export market, coals that would normally be sold elsewhere are filling the CAPP void. Northern Appalachia (NAPP) and Illinois Basin (IB) coals, while garnering higher pricing and being shipped overseas as well, are more expensive domestically, too. Utah, Colorado and PRB coals are also traveling further and, recently, are being shipped in increasing amounts to the West Coast for deep-pocketed Asian customers.

Consequently, fuel managers of major utilities are seeing their costs escalate. Mike Hendon, senior manager of coal acquisitions at TVA said he's "never seen prices as volatile as they are now." TVA generates 60 percent of its energy from coal, burning from 45-47 million tons per year. "We're in a period of dramatic increases." To cover its costs, TVA is increasing its rates by 20 percent.

To insulate themselves from transportation disruptions, many large utilities are expanding their coal sourcing, buying from different basins and blending. With costs rising for CAPP coal, TVA may increasingly turn to the Illinois Basin as several new and independent producers emerge, particularly in western Kentucky and southern Illinois. "We're happy to see the competition. It's always welcome," said Hendon.

AEP is also mixing and matching. "We're in a unique position because we own a 600-unit barge fleet," Zebula said. "In this tightly priced market, we owe it to our shareholders to optimize our system."

Rail is an effective but expensive option. While their rail service has improved, CSX is now demanding steep haulage prices, says Pat Cummings, fuel supply coordinator for Rail Transport at Seminole Electric in Florida. "We're facing huge increases in our rail rates that aren't economically justifiable in my opinion. But the railroads control the destination point. For any plant or entity that is served by only one carrier, you're captive and have no alternative."

In today's marketplace, coal increasingly no longer wins economically. "If coal stays at $100-$150 a ton, and if natural gas remains as low as it is or continues to fall in price, a lot of utilities will look at gas instead," said Hendon. It's going to be interesting to see what pressure that puts on the coal market: $120 coal versus $7 gas. "We're at that point now with CAPP coal. Gas is becoming a viable alternative."

Like it or not, coal is part of a global economy. The railroads and the producers understand that. And they are looking to the highest bidder, which is increasingly overseas.