Despite Massive Sell-Off, Coal Stocks Won't Double Anytime Soon

| About: Alpha Natural (ANRZQ)

Coal Stocks On Sale, Invest Now, Double Your Money!

Investors in coal stocks may be hoping for doubles on their investments, perhaps as soon as this year. While it's human nature to envision huge gains from here, I don't believe it's likely. Outright long positions will have a hard time rallying by more than 40%-50% (on average) in the next 6 months. To be clear, I'm not suggesting that they will or will not rally that much, I don't know. I just don't expect home runs like the average 61% coal stock price surge in just 21 trading days from the October 3, 2011 to October 28, 2011. Now those were the days.

If we do get a significant rally, I think that Alpha Natural Resources, (ANR) and Walter Energy, (NYSE:WLT) are the most likely to return 40%-50% or more. With regard to Patriot Coal, (PCX) and James River, (JRCC) they could certainly have out-sized returns, but they come with substantially greater downside risk. Therefore, I place them in a different category, separate from ANR, WLT, Peabody Energy, (BTU), Consol Energy, (NYSE:CNX), Arch Coal, (ACI) and Cloud Peak (NYSE:CLD).

Investors Have A Much Lower Cost Basis

A concern I have with how the sector is trading is that there is a lot more short activity and volatility. Not exactly a news flash for those involved. I think it will be difficult for coal stocks to sustain a significant rally because investors (and increasingly traders) with a much lower cost basis are now in place. If buyers of ANR stock at $7.5 - $8.5 were to see a price of $11.0 or $12.0, a meaningful portion of holders would probably sell. And it seems likely that short interest would increase again at that point.

And There's Still Those Pesky Coal Fundamentals

In addition to the lower cost basis argument, fundamentals are still a mess. Readers of my articles should know the headwinds facing the industry, but I will name them again. Domestic thermal coal prices have not yet turned. April ending inventories at 203 million tons are very high and may not have peaked. Industry-wide costs per ton are increasing for those players forced to cut production. The spot natural gas price has moved substantially higher recently, but at $2.75 per mcf it needs to move above $3.50-$4.00 for an extended period to begin to reverse Appalachian coal-to-gas switching.

China's much anticipated growth spurt in the second half has stalled upon arrival. Robust exports year-to-date from the U.S. are at risk of slowing in the face of no shortage of exports from Colombia, Indonesia and Australia. India's weakening currency is making it difficult to pay even the lower prices of US dollar denominated coals. The only saving grace is firm demand for coking coal from still buoyant auto build rates and a bounce in the global coking coal index to $225 per metric tonne from $210.

Using The Leverage In Call Options To Pick Your Bottom

Using call options is the only real chance to achieve 100% returns, of course with greater risk. If one thinks coal stocks are near a bottom, one should consider In-the-money call options. Earlier this week when ANR was trading around $7.75 per share, one could have bought an August-12 Call option with a $7 Strike for $1.25 per contract. If ANR were to increase by 22.6% to $9.5 at expiration, those call options would have been worth $2.5 ($9.5-$7.0 strike = $2.5). Notice the leverage, a 22.6% increase the stock would generate a 100% gain in the option price.

Typically, investing for a 22.6% gain in a stock in just 2 months is an aggressive bet. But with ANR down 85% from its 52-week high, a rebound of 22.6% is not all that crazy. In the example above, for $1,250 one could have bought 10 contracts and effectively controlled 1,000 shares of ANR stock for 2 months. If the stock went to $9.5, an investor would have doubled his money. The alternative way in which to have gained $1,250 would have been to buy 715 shares at $7.75 per share for $5,541.

Options Trades Provide an Investor With ... Optionality!

At times during Wednesday's trading session, ANR was up 10% from the $7.75 price used in the example. The Aug-12 $7 Strike Call option was bid at $1.90, a gain of $0.65 (up 52%) or $650 on the 10 contracts. The underlying stock price, up 10%, registered a gain of $554 on the 715 share position. The investor would have deployed less than one quarter of the capital into the trade and would be up way more, 52% ($650) vs. 10%, ($554).

Before I get accused of cherry-picking a big move in ANR stock to illustrate a great option trade, I pose the question, is a 10% increase in 2 days on a stock as volatile as ANR really that unusual? And, since the bet going into the trade was that ANR was near a bottom, one presumably would have bought the shares anyway. The Call option trade would have been a superior decision in this situation.

Using a Call option in this manner would enable an investor to have cashed out today, locking in a 52% gain. Or, if the investor held on, and the stock were to hover around $8 per share, the investor would have the opportunity over the next 6-7 weeks to exit the trade without losing much or any of his premium. Buying the stock outright only to watch it trade plus or minus 10% from the entry point would not have allowed the option holder the opportunity to pocket a 52% gain.

If one is truly a long-term holder, then buying the stock outright at $7.75 is perfectly reasonable. However, I find that my best intentions of holding a stock long-term get derailed by things like European debt crises and rumors of changes in Chinese GDP and inflation. If in the end we are all forced to be traders, then using call options to articulate a speculative long position can be an attractive strategy.

Finally, for those looking to avoid the increased trading activity alluded to above, buy and hold is still alive and well in my favorite coal MLPs of ARLP and NRP. Please see my articles on these names here and here.

Disclosure: I am long ANR, NRP, ARLP, CNX, WLT.

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