Caterpillar Believes that Coal is “Here to Stay”

Coal is a relatively dirty fuel source, and that has increased the scrutiny it has faced in the United States. In fact, some believe the Environmental Protection Agency's (EPA's) new electricity plant rules are materially biased against coal. However, there are worldwide demographic trends in place that make Caterpillar (NYSE: CAT  ) confident enough in coal-fired electric power's future to say that coal is "here to stay."

It's tough now, but...
At a recent investor presentation, Caterpillar highlighted the deep downturn in mining through which it is currently navigating. That's been tough on business, leading to more than a 40% drop in second-quarter earnings. However, the company sounded anything but downbeat despite having to lower full-year estimates.

Shifting demographics is the reason. According to the company, the world is growing by 6.5 million people a month. That should continue for the next three decades or longer. Putting that in perspective, "every 36 days the world population is [growing] the size of the Boston metropolitan area." At the same time, there's been a population shift toward urban living. Essentially, Caterpillar believes the future holds more people and bigger cities.

At a recent presentation, Caterpillar challenged the audience to think about "what that means in terms of demand for energy, for roads, for hospitals, for bridges, for rail, for airport..." Its mining customers, though pulling back right now, provide the products needed to support increased demand for all of these things. So the company believes it has a bright future despite the current troubles in its mining division.

More than coal
Coal, meanwhile, has a bad image. That's particularly true in the United States. In fact, Caterpillar highlights that the U.S. Department of Energy expects coal to lose two percentage points of worldwide electric market share by 2040. However, demand for electricity is expected to nearly double over that same time period. So, even with a slightly smaller piece of the pie, coal is looking at notably increased global demand. And that also means more demand for the minerals needed to build coal-fired electric plants.

Global and diversified players like BHP Billiton (ADR) (NYSE: BHP  ) , Vale (NYSE: VALE  ) , and Rio Tinto (ADR) (NYSE: RIO  ) will see the benefits of this across their product offerings. For example, a new coal-fired electric plant leads to more coal use, but it also requires steel and copper -- among many other mined materials -- to build.

Coal represents about 10% of Rio's sales, iron ore 44%, and copper 12%. Iron ore represents about 31% of BHP's revenue, copper 18%, and coal 16%. Vale generates about 70% of its top line from iron ore, 4% from copper, and 2% from coal. Clearly, this trio is highly leveraged to increased investment in the world's electricity infrastructure.

To add some perspective, Vale highlights that almost half of the copper consumed in China in 2012 was used in the electrical-power industry. Although Chinese growth may slow as the nation matures, this statistic shows just how important copper is to the electric market in that country and, by extension, others. Steel may be more widely used, but clearly walls don't go up without it. Coal, meanwhile, is used to create steel and power the resulting electric plant.

While pricing and demand may be weak now, this trio is working hard to reduce costs and has the financial strength to survive until demand and pricing recovers. In fact, all three companies were profitable in the second quarter, unlike many coal-focused players. That could make these diversified miners of particular interest if you are a conservative investor who can imagine a future with increased demand for everything from energy to hospitals.

Just a lot of coal
If you are a little more aggressive, however, you might consider a coal-focused player like Peabody Energy (NYSE: BTU  ) . While it is focused exclusively on coal, it has material operations in both the United States and Australia. That gives it a worldwide footprint that allows it to go toe to toe with the diversified giants above, at least with regard to coal.

In the United States, it has leading positions in the cheapest thermal coal basins. That gives it a solid domestic position, but also puts it in a good position to export U.S. coal to foreign markets, another industry shift that is starting to take shape. And while the coal market has been difficult of late, Peabody turned in a profitable second quarter, thanks in part to the falling Australian dollar.

While the rest of 2013 will be touch and go, Peabody has the financial wherewithal to make it to brighter days. And when the skies brighten, it will be more leveraged to a coal rebound than the diversified miners above.

And back again
Of course, Caterpillar and rival Joy Global will also see improved results from this increased demand for infrastructure, notably for electric power. Only they will be selling the equipment needed by the miners. That should, eventually, be a good business again since mining equipment is heavily used and requires new parts on a regular basis.

So, it's easy to see the negatives in the mining industry today, particularly for coal. What's harder is to envision a more positive future. The interesting thing is that Caterpillar is still betting heavily on that vision despite today's detractors. If it's right, Rio, BHP, Vale, and Peabody will also benefit from the fact that coal and the energy it produces is "here to stay."

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