FORDING CANADIAN COAL TRUST $39 (Toronto symbol FDG.UN; Aggressive Growth Portfolio, Resources sector; SI Rating: Extra risk) is a leading producer of metallurgical coal, a key ingredient in steelmaking.

It gets 98% of its revenue from its 60% stake in Elk Valley Coal Partnership, which owns six mines along the Alberta-B.C. border. Teck Cominco owns the other 40%. At 2005 production rates, these reserves should last at least 25 years. With further development, the reserves could last 100 years.

Unlike most commodities, coal does not trade on a futures market. Instead, Fording must negotiate supply contracts directly with its major customers, mostly steelmakers in Japan and China. About 95% of these are long-term deals that require the customer to buy minimum amounts of coal. However, the two sides negotiate new prices every year.

Coal prices still near all-time highs

In the coal year ended March 31, 2006, Fording received an average price of $122 U.S. a tonne, more than double its 2005 coal year price of $53 U.S. This year, average prices will drop to $107 U.S. That’s because many steelmakers, fearing a shortage, stocked up on coal last year and are still using up their excess inventories.

Higher prices also prompted steelmakers to switch to cheaper coal. However, that’s a false economy. Cheaper coal does not burn as hot as Fording’s coal, so steelmakers must use more of it.

Thanks to the strong coal prices, Fording’s earnings in the first quarter of 2006 jumped to $1.12 a unit from $0.44 a year earlier. Cash flow per unit grew to $1.39 from $0.51, while revenue rose 64.5%, to $485.2 million from $294.9 million.

Higher prices for fuel and labour are starting to squeeze Fording’s profit margins. Equipment shortages, particularly for mining truck tires, could limit Fording’s production in the next year or two.

Rising costs hurt distributions

Consequently, Fording recently cut its quarterly cash distribution, from $1.60 a unit to $1.40. The new annual rate of $5.60 yields 14.4%. Fording may have to cut the rate again soon. Even if the annual rate drops to $4.00, the units still yield 10.3%.

Fording will likely earn $4.80 a unit in 2006, and the units now trade at just 8.1 times that estimate. They’re also attractive at 7.0 times Fording’s forecasted cash flow of $5.60 a unit.

New structure should broaden appeal

Unitholders just approved a plan to reorganize Fording, from an open-end mutual fund to a royalty trust structure. This will not change the way Fording operates or its distributions. However, it will remove the 49% limit on foreign ownership.

That should make it easier for Fording to raise new capital. It could also turn Fording into a takeover target. As always, investors should treat any takeover possibility as a bonus, and not the sole reason to buy.

Fording is a buy.