U.S. Future in Coal Burns Bright

Includes: JRCCQ, KOL
by: Jake Taylor

The future of U.S. coal is burning bright and long-term options may be the best way to capitalize on the trend. Growing demand in China combined with higher comparable valuations abroad will create a catalyst for the U.S. coal industry, according to many experts. The environment may also spark an unprecedented number of domestic and cross-border mergers and acquisitions. Investors looking to take advantage of these trends with leverage and limited risk should consider purchasing LEAPS options.

China is expected to generate the majority of demand for coal over the next decade. The fast-growing developing market economy requires coal to supply 80 percent of its energy needs, which makes it the largest consumer of coal in the world. The country may also be the largest producer of coal, but it may still become a net importer within the next couple of years. The increased demand in China has helped jumpstart global coal prices, which have risen substantially over the past year.

Investors looking for a safe way to play these increases in coal prices may want to consider purchasing the Market Vector Coal ETF (NYSEARCA:KOL) for a diversified portfolio of companies. The most actively traded calls options are the September 50 calls followed by the October 48 calls. However, the January 35 puts have the largest open interest, indicating that at least some investors remain bearish on coal over the next year despite the bullish news. Notably, this ETF contains international companies as well.

Those investors looking for more direct exposure to U.S. coal plays may want to check out James River Coal Company (JRCC), which is one of the more volatile players in the industry operating out of Kentucky and Indiana. The firm is trading down after reporting wider-than-expected losses thanks to bad weather, higher costs, competition for skilled labor, and detrimental hedging contracts. To make matters worse, the pricing increases of 2008 weren’t yet realized because of the way futures work.

Luckily, these are problems that are either temporary or can be solved. Investors should expect strong pricing through the remainder of 2008 and even stronger pricing throughout 2009. Meanwhile, the pricing of 2009 to 2011 contracts came in at $125, which is higher than expected. Pressured profit margins from struggling coal prices and higher costs are also set to recover thanks to lower oil prices and continuously strengthening demand from China for worldwide coal supplies.

Investors looking for other potential U.S. oil plays should look at how long their contract obligations go out. Those selling more to the spot markets stand to benefit more quickly and directly from higher coal prices. Additionally, those dealing exclusively in the United States may hold greater potential because of the higher coal quality and lower valuation relative to others thanks to the lower value of the U.S. dollar. Long-term options can also help increase leverage and help diversify through multiple companies in the sector via a lower total cost per position.