Shorting Coal on Extraordinary Short-Term Demand

Coal stocks were sitting at 52-week highs before a downgrade by Goldman on Friday. On Wednesday, I discussed a potential trade in shorting coal with my father, who is a registered investment adviser. He discouraged the idea, so I didn't do anything immediately in any real-money account, but in my paper account I shorted both CNX (Consol Energy) and KOL (the new coal ETF).

My reasoning: Extraordinary circumstances have caused a temporary bubble in coal demand. Snowstorms in China and floods in Australia caused production to cease from many mines, and a combination of legitimate supply concerns and speculative fears drove the price of coal skyward.

There's one problem with coal getting this expensive this fast - there's so much of it in the ground. Unlike oil, which might have 50-100 years left, or natural gas, with a slightly longer timeframe, it's common knowledge that there are hundreds, if not thousands, of years of coal consumption left in the ground.

According to simple economic theory, what happens when the price of a good increases? Producer surplus increases, and producers become even more motivated to bring goods to market. As they record huge profits (as they may in the coming quarters), coal producers will surely ramp up production.

Then, when the snow melts, the waters retreat, and the coal dust settles, there will be more production capacity than there will be demand.

Big coal companies like CNX are trading at valuations of about 50-70x TTM earnings and 15x forward earnings (which take into account higher prices). But if prices fall (or even stabilize), these valuations will be unjustifiable. Look at big oil/gas companies - Exxon, Chevron, Conoco, Marathon, BP, and most others trade at multiples of less than 10.

So when the coal companies tanked Friday, I made nice 5% one-day returns on my newly-shorted shares. If only I would have done it with real money...

Comments

[guntherd20:]

Must be something wrong with my charting softwares - all show the coals up very nicely today. Should I sell now?

2008 Feb 19 03:33 PM

[Dawson Lodge:]

Your logic is flawless Stephen but I think your timing is premature.

I believe the recent rallies just highlight a
supply demand imbalance (thats what moves markets) that was hidden until the crunch.

It's not like we're going to run out of coal (or oil either). It's just that we can't get it out and shipped to where it's needed fast enough.

This is a demand pull, supply push is at capacity.

This cycle looks to be a bit bigger than a couple of months. But your point is well taken, and the scale will tip towards oversupply (or reduced demand) soon enough.

Besides, coal in the yard is better than dollars (US) in the bank. That won't change for awhile either.......

2008 Feb 20 02:11 AM

[Long-Short Guy:]

I love this idea -- this is gutsy, original thinking.

However, I'm also not sure about your timing. Specifically, the transmission mechanism you specify (increased price => increased suppy) takes a while, potentially years, to kick in. In that time, you can lose a lot of money on a short.

2008 Feb 21 03:41 PM

[nicholas.co...:]

Good article and good Comments. My question to Stephen...if you had used real money on Friday...to short...what was is your price target and over what time frame? e.g., down 10% over 3-months or 20% over 6 months from the highs. Using your thinking (more of a secular decline will be in the works) some of your gain has already been reversed (if you are taking a longer term view) - unless you would have sold before the Friday close (which is what GS and other trend Traders likely did). That said...what is your NEW price target and holdilng period from here? Also, does KOL have options and assuming they do...which contract and expiration would you take?

2008 Feb 22 11:08 AM

[weldona:]

I tend to agree with you over the recent extraordinary circumstances in China and Australia causing a short term bubble in coal prices. However, from a long term perspective global energy consumption is expected to grow. Because coal is so essential in the production of energies like electricity a lot of these multiples for companies like CNX are at least in part a reflection ofT long term growth prospects.

2008 Feb 23 11:50 AM

[fat tail:]

I agree with the short term rationale, but then why the long-term fundamental overlay? Also, why short a northeast USA company when the supply events described are in Asia/Aust? When I look at MACD, RSI, FStoc, for example, there is some confirming data for these shorts. But KOL (heavy weightings in China) and other individual Chinese producers will trade at those multiples for the unforseeable future. What near term solution do the Chinese have (certainly not nuke or alternatives) to satisfy their level of demand? I'd also get ready to short these around 8.8.8 when athletes cant breathe (boycott) in Beijing, major headline risk to come... Aside: There's so much smog there that they have to light up their buildings at night with neon to see them...kind of a vicious, non-green circle. For the glory, A fellow Penn Stater.

2008 Feb 26 11:13 AM

[JP Azzopard...:]

I agree with you reguarding the panick priced into the price of coal. But one must also follow that coal is a cheaper alternative to oil and one should follow coal as a dervative of the price of oil. This has been stated by the CEO of Bumi Resources some time ago.

2008 Feb 27 05:17 AM