Decade-Low Natural Gas Prices Lead to Coal Glut
In a recent article in the Financial Times ("Miners hit by coal glut as prices slide to new lows"), Javier Blas noted that "pure play" coal miners Arch Coal, Inc. (ACI), Alpha Natural Resources (ANR), and Peabody Energy (BTU) have suffered as decade-low natural gas prices have prompted electric utilities to burn more natural gas and less thermal coal. Blas quoted a striking statistic from the US Department of Energy: the share of electricity produced by burning thermal coal has dropped to its lowest level in nearly 40 years. Emblematic of glut, according to Blas, was the recent decision by GenOn Energy (GEN) to invoke a force majeure clause (normally used in the event of disasters such as hurricanes) to get out of contracted coal purchases. In GenOn's case, there was no disaster; it simply had no space left to store any more coal.
A Look At Hedging Coal Miners
For investors in the three pure play coal miners mentioned above who are concerned about limiting downside risk, the table below shows the costs, as of Wednesday's close, of hedging those stocks against greater-than-24% declines over the next several months, using optimal puts. In addition to those three pure play coal miners, I've also included CONSOL Energy Inc. (CNX), which produces natural gas as well as coal. Possibly because it isn't a pure play coal miner, CNX happened to be the least expensive of the four coal producers to hedge. Two of the pure play coal producers - Arch Coal and Alpha Natural Resources - were extremely expensive to hedge. Recall that we've observed examples in the past of stocks with higher optimal hedging costs underperforming stocks with lower optimal hedging costs.
For comparison purposes, I've also added the SPDR S&P 500 ETF (SPY) to the table. Below the table is a reminder about what optimal puts are, and an explanation of the 24% decline threshold. Then, a screen capture showing the current optimal put to hedge the comparison ETF, SPY.
Hedging Costs as of Wednesday's Close
The hedging costs in the table below are as of Wednesday's close, and are presented as percentages of position values. As we noted above, the costs of hedging a couple of these stocks are extremely high. If you own these stocks as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk - but are still concerned about market risk - you might consider hedging your market risk by buying optimal puts on an index-tracking ETF such as SPY.
|ACI||Arch Coal, Inc.||17.3%**|
|ANR||Alpha Natural Resources||19.5%*|
CONSOL Energy Inc.
|SPY||SPDR S&P 500||1.18%*|
*Based on optimal puts expiring in December
**Based on optimal puts expiring in January
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).
Often, I use 20% thresholds when hedging equities, but one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so the algorithm indicated that no optimal contracts were found for it). The smallest decline threshold for which there were optimal puts for all these securities was 24%, so that's the threshold I've used for all of the names in the table above.
The Optimal Puts To Hedge SPY
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the SPDR S&P 500 ETF SPY against a greater-than-24% drop between now and December 21st. A note about this optimal put option and its cost: To be conservative, the app calculated the cost based on the ask price of the optimal put. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table above).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.