Why Coal Is Part of China's Pollution Solution

China's pollution problems are well known. Recently the city of Harbin saw levels of fine particulate matter 40 times the recommended levels by the World Health Organization. While coal is a big part of the problem, it can also be part of the solution. Thanks to coal-to-gas conversion technology, polluting facilities can be moved away from cities and China can diversify its energy mix.

Coal-to-gas conversion
It was not until 2009 that China became a net coal importer. The nation has huge coal reserves that are easy to assess. By building coal-to-gas plants like the Datang Keqi Project, China can use coal to create natural gas.

Refining coal far away from cities and then shipping natural gas to power plants lets China reduce pollution levels close to populated regions. Some criticize coal-to-gas conversion as simply moving pollution from one location to another, but the technology deals with China's fundamental problem. As China industrialized and more coal was burned close to city centers public health has fallen. Lung cancer has become the leading site of new cancer. By refining coal far away from population centers Beijing can help save lives and keep its cities powered.

Good news for U.S. coal exporters
U.S. coal exporters like Peabody Energy (NYSE:BTU) and Cloud Peak Energy (NYSE:CLD) have a bright future in China. The nation is trying to shut down small domestic mines and decrease the use of low-quality coal. Peabody's Australian mines are in good position to enjoy increased market share as Beijing considers limiting low quality imports from countries like Indonesia. Also, Peabody's port access on North America's Western Coast gives it additional export capacity.

Cloud Peak is much smaller than Peabody and it has had a great deal of success in Asia. Between 2008 and 2012 it grew its Asian exports from 0.7 million tons to 4.4 million tons. While its assets in the Powder River Basin are farther away from China than Peabody's Australian mines, Cloud Peak still has good access to U.S. export facilities.

In the face of falling domestic demand Peabody has been forced to shut down some assets, helping to make losses from its discontinued operations in Q3 2013 large enough that the company posted an overall loss of $26.1 million. When its lower-quality U.S. assets are completely shut down Peabody should not have any problem returning to profitability, however. While it has posted negative quarterly net income in the past year, its quarterly earnings before interest, depreciation and amortization (EBITDA) have consistently remained at or above $237.7 million

Over the past year Cloud Peak's EBITDA has been consistently positive. While the company only mines in a limited region it managed to post EBITDA of over $200 million over the past four quarters. The company is optimistic that in the coming years its export sales will continue to grow. Its Northern Powder River Basin assets mine coal of significantly higher quality than Indonesia.

The loser
By now it is well established that U.S. miners with old mines far away from the coast have a very difficult time in the international market. Arch Coal (NASDAQOTH:ACIIQ) is a good example. It has a number of mines in the older Appalachia region, and its EBIT margin of -17.4% is noticeably worse than Peabody's EBIT margin of -6.6%.

Thanks to growing natural gas production in the Marcellus region Arch Coal is facing stiff competition on its home front. Its total debt-to-equity ratio of 1.97 is very high, making it a company best left for another day.

Instead of doubling down on coal CONSOL Energy (NYSE:CNX) decided to do the opposite. It recently sold five longwall coal mines in Virginia and shifted more assets into natural gas drilling. CONSOL actually has a small positive profit margin of 1.4% and a relativity strong EBIT margin of 8.3%, while Arch Coal is holding on to U.S. coal assets and facing big losses. 

Bottom line
Coal-to-gas conversion will let China move some coal use away from cities and reduce air pollution in populated areas. Peabody Energy and Cloud Peak Energy are both in good positions to benefit from this trend thanks to their strong export facilities. At the same time CONSOL Energy's recent asset sale shows how far the Appalachia region and traditional miners like Arch Coal have fallen.