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Should Coal Company Investors Breathe Easy After Copenhagen?

Green Energy Investing For Experts, Part V

Tom Konrad, CFA

A global climate deal in Copenhagen would have been bad for coal miners, and coal companies have been rallying as the economy recovers, but it may not be clear skies for the black rock.

In the battle to reduce greenhouse gas emissions, coal is enemy number one.  The global disarray in Copenhagen can only be good for coal mining companies, and they duly rallied when the climate talks ended with little to show for it. 

Yet carbon emissions are not the only black mark on the coal industry's record, and investor relief may be premature.  

None of this is to say that coal mining stocks have to fall anytime soon.  Rather, I'm pointing out that there are large and significant risks that coal investors ignore at their peril.  The polarization of climate debate is such that many conservatives seem unable to see these risks because of their preconceived notions.  Climate deniers may crow in anticipation about their impending victory in the climate change debate, but this is a debate they cannot win because the facts simply do not support their case, no matter how many careless emails they are able to dredge up.  

Investors usually have to operate in a realm of uncertainty.  We don't know what next years earnings of any company will be, we only hope that our estimate is better than the rest of the crowd.  The climate debate, on the other hand, is a rare opportunity where we know the outcome with near certainty, and yet there is a large contingent of climate deniers willing to put their money down on the other side of the bet.

Today, with recent polls showing fewer Americans supporting action on climate change than last year, it's easy to become discouraged about the chances of real action to confront climate change.  As an investor, it is dark moments like these when courageous investors put their money down and are rewarded when the pendulum swings back, as it always does.  

Betting Against Coal: A Green Lottery Ticket

I'm not one of those courageous investors.  I prefer to take small risks that still have the potential for large rewards.  Since I don't know if the pendulum of public opinion on climate change will begin to swing back today or ten years from now, I'm not ready to start shorting coal companies.  However, I am ready to make a few small bets that change might be sudden and soon.  I've bought a couple cheap, long-dated puts on coal companies.

The Market Vectors Coal ETF (NYSE:KOL) has exchange traded options, but only with expiration dates going out six months.  In contrast, many of the large coal mining companies have exchange traded options that go out two years.  This situation is similar to the one I ran into when shorting the Mexico ETF and shorting airline stocks.  In particular, I chose to buy January 2012 $30 puts on Consol Energy (CNX) and January 2011 $25 puts on Peabody Energy (BTU.)  I chose these two because, as with airlines, they are the top two holdings of KOL.  Furthermore, both of these came near the bottom of Newsweek's Green Rankings, and BTU scores badly on quantitative valuation measures.

To be sure, these are long-shot gambles.  Coal will be with us for decades to come, and coal companies have an annoying habit of getting politicians to do their bidding.  On the other hand, these bets could pay off even if there is no real action on climate change, because of another stock market collapse (both of my puts would have been in the money at March 2009 lows,) or from some company-specific problem.

Where else are you going to buy a lottery ticket that is so environmentally sensitive?

DISCLOSURE: Short BTU, CNX.

DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.



was posted on AltEnergyStocks.com.


       

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Comments

I agree in concept with your reasoning and action regarding coal stocks. However, my guess is that your entry in these trades is early. Both are still trending higher in a sector that is trending higher. I'll wait, perhaps until a Fib retracement point. There is no need to rush into this position.

While the 30 strikes certainly could work, unless these stocks take a severe pounding in the next two years, there is now fairly good support well above 30. I'd probably use the 40 strikes.

I suspect that delaying entry into this trade and using the 40 strikes will result in trade costs relatively similar to entry now at 30 but with somewhat better risk/reward. I may also structure this trade as a put spread to somewhat further reduce risk (at the cost of capped reward).

Fundamentally this is a bet against the global economy improving or for passage of "cap and trade" or some similar legislation.

Part of the reason for my "caution" in entering this trade is the broad feeling that coal will continue in substantial use for an extended time, regardless of legislation.

Further, as with any "investment", there is the potential for "black swans". One example that I like is a bilateral US/China deal to replace/update inefficient / polluting Chinese coal fired generating plants. Particularly interesting would be a technology agreement based on coal fired solid oxide fuel cells operating in a combined cycle configuration, presently in development in the USA. On the other hand, while there is optimism about expanded coal production, one of the lessons of the 2008 peak was that coal (as with many other things) hit multiple production and logistic bottlenecks. Granted, a number of these have been resolved. However, a number of them are still issues and will likely remain so.

Also, while both of these are "large coal companies", they are quite different from each other. One is essentially a USA play but has a substantial amount of shale gas production. The other has substantial international production and trade with China (and other countries. A more pure play might be someone like Arch (ACI).


Mike,
Since I got into these trades over a month ago, you're definitely right that I'm too early.
But you're also right that they are a bet against the global economy... I see them as a hedge against the long position in my portfolio. I'm bearish, so if I had not gotten into these trades, I would have gotten out of some long stocks... I'm trying to stay market neutral at this point.

You're also right about Black Swans being part of my reasoning. I have puts such as these scattered around the energy-intensive sectors of the economy, in the hopes of benefiting from Black Swans. That's why I'm using such low strike prices... I wanted to choose price points where it was difficult to imagine the companies falling to, so that I would not have to pay much for my lottery tickets.

As for Arch Coal, thanks for the suggestion. If you're particularly focused on the evils of coal mining, that sounds better than CNX. I'm not focused, and I like that Peabody and Consol are very different companies, though... this allows me to spread my bets: I only need one of the lottery tickets to pay off to be quite happy.

There;s nothing certain about Shale Gas, either:

Tom,

I just re-read your shale gas post. Certainly I agree that nothing is certain. But, not all shale gas companies are "the same". As a specific example I note that operating costs range from $0.73 to $2.13 per mcfe. Finding and development costs are similarly broadly spread. I believe this sector still has some good long term investment potential. XOM apparently agrees.

I feel similarly about gas pipeline companies. Less potential for capital improvement, but nice long term distributions (especially if one bought last March).

But I am biased, with long positions in these areas, notably HK and ETP.

By the way, speaking of Black Swans, the recent issue of Science published a peer reviewed report that concluded: "Considering environmental impacts of MTM/VF (mountain top removal/valley fill), in combination with evidence that the health of people living in surface-mining regions of the central Appalachians is compromised by mining activities, we conclude that MTM/VF permits should not be granted unless new methods can be subjected to rigorous peer review and shown to remedy these problems. Regulators should no longer ignore rigorous science."

If attention is paid, could this be the end of this type of coal production?

Mike,
Agreed that not all shale gas is the same... the real question is which players are most open to nasty surprises. If you believe Dr. Berman, non e of them have costs that can be believed, so if he is right, which will fall farthest? The ones that currently appear to have low costs, or the ones that appear to have higher costs.

Exxon Mobil believes in a lot of things I don't. I don't have an opinion on shale gas (except that it's riskier than it appears.) The XOM purchase both lowered the added credibility to Shale Gas and means that contrarians can place their bets at lower prices. Big banks were wrong about the MBS and CDO markets in 2007.

Why couldn't XOM be wrong about Shale gas in 2009?

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