Selling A Survival Put Option On Patriot Coal

May.21.12 | About: Patriot Coal (PCXCQ)

I've written about selling puts on Walter Energy, (NYSE:WLT) in the past. On 3 occasions, I've done this and made good returns twice. In this piece, I will describe a way to play the medium-term survival of Patriot Coal for an annualized return of close to 60%. It should go without saying that the following trade idea is high risk.

Before reading further, please note that it may be easier to simply buy shares of Patriot, (PCX), Peabody, (BTU), Arch Coal, (ACI), Alpha Natural Resources, (ANR), Consol Energy, (NYSE:CNX) or Walter Energy, to articulate a bullish view on the coal sector.

Patriot Coal is down 87% from its 52-week high and 96% from its all-time high of $75 per share in June, 2008. Will Patriot make it through this downturn? If one believes that Patriot will survive at least until January 18, 2013, then the following trade may have some appeal.

If one sells Jan-2013 Put options on PCX with a strike price of $2.50, one would get paid about $0.70 per contract. If the Company muddles through the downturn and lives to fight another day, then one's annualized return would be ~59%. The calculation is $0.70 premium divided by ($2.50 strike minus the $0.70 premium = $1.80) times 1.51. That's $0.70/$1.80 = 38.9% x 1.51 = 58.7%. The 1.51 comes from annualizing the 38.9% return, 365 days divided by 242 days remaining until the option expires (hopefully worthless) on January 18, 2013 = 1.51.

On paper, this looks pretty good. But there's no such thing as a free lunch, or a free option premium, in this case. Patriot announced a few weeks ago that they had lined up $625 million of financing to retire a convertible bond maturing next year and refinance its revolving credit facility. However, the market now fears that this deal will fall apart. Early last week, the Company announced that a significant customer is defaulting on a contract to take 1 million tons of Patriot's coking coal. This will have a materially adverse impact on earnings.

Importantly though, there's no explicit trigger for Patriot to be forced to file for bankruptcy before January 18, 2013. In thinking about this trade, consider that as long as PCX stock is trading at or above the strike price of $2.50 at contract expiration, one would earn that 59% annualized return; nothing more, nothing less.

However, the $2.50 strike is only 24% below Friday's closing price of $3.30. There's a real chance that the stock will be trading at say, $2.00 per share on January 18th, 2013 if things at Patriot continue as they are. In that case, one will still have made a small profit of $0.20 per contract, but PCX shares would be put to you at $2.50 per share. The profit of $0.20 is calculated as ($2.50 strike minus $0.70 premium collected = $1.80, which would be the effective cost of the shares) vs. the prevailing stock price of $2.00 in this particular example. $2.00-$1.80 effective cost = $0.20 profit.

The worst case scenario is that one could lose $1.80 per contract, (but not more than that), if Patriot were to file for bankruptcy on or before January 18, 2013. A more likely bad outcome would be Patriot stock trading at say, $1.00 per share on January 18, 2013. In that case, one would have lost $0.80 per share, a pretty bad outcome considering that the best case outcome was a gain of $0.70 per share.

One might contemplate this trade if one believes that the coal stocks, and PCX in particular, will bounce along the bottom, perhaps plus or minus as much as 25%, over the next 9 months. However, if one believes that Patriot is way oversold and due for a big bounce, then buying the stock outright may make better sense. I believe that until and unless Patriot addresses next year's bond and bank debt maturities, the stock will be stuck at depressed levels.

Operationally, Patriot is doing a decent job at cutting costs and preparing for a fairly long downturn. In the Company's annual report, the CEO clearly states that domestic thermal coal demand will be weak for at least the next year and most likely longer. With that as management's base case, they will preserve cash at every opportunity, continue to close or idle coal mines, sell coal reserves and/or seek co-investment in new projects to offset the capital burden. Importantly, Patriot is actively pursing export opportunities for its thermal coal. This could be the Company's savior.

Despite the doom and gloom, Patriot's management team is cautiously optimistic longer term, as can be seen in the Outlook section of their latest 10-q filing. The following are direct quotes:

While the domestic market remains difficult, international thermal coal markets continue to be open to U.S. coals. We expect to ship between six and seven million tons of thermal coal oversees in 2012, including cargoes to both Europe and Asia. This represents nearly a doubling in thermal exports from the 3.8 million tons we shipped overseas in 2011...

Based on recent market activity and spot pricing, metallurgical coal markets appear to be back on an upward trend. U.S. metallurgical coal exports are expected to remain at historically high levels, in part due to supply disruptions in Australia...

Longer-term, coal market fundamentals remain intact. The construction, infrastructure development and demand for electricity associated with population growth and urbanization in China, India, and other developing countries are expected to contribute to significant long-term growth in both thermal and metallurgical coal demand. Additionally, the replacement cycle for infrastructure and automobiles in developed countries should drive further growth in metallurgical coal demand.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in (WLT), (ACI), (ANR), (BTU), (CNX) over the next 72 hours.