Profit from the decline of Big Coal

Every two weeks I contribute something at the intersection of Economics, Finance, and Space or Environmentalism. This is often takes the form of exploring an investment opportunity. This week, I’m taking a slightly different approach and showing how savvy investors can profit from the decline in stock price of a beleaguered coal miner faced with shrinking demand for its product.

The coal mining industry in the United States is more or less doomed. While the current administration is friendly to polluting industries there is a growing movement especially among Millenials to put an end to any industry that is dirty. Punitive regulations could return as soon as the 2020 election. At the same time, the industry is becoming economically obsolete. Coal used to be the cheapest way to produce electricity. There are multiple cheaper alternatives today. First, the fracking revolution unlocked vast reserves of cheap natural gas in the United States. That fuel is now cheaper (and cleaner) coal. It is also logistically simpler to hook into a natural gas pipeline than it is to maintain a supply chain of rail cars to bring your fuel in. At the same time, costs for solar and wind have fallen dramatically in the last decade. The Energy Information Administration (EIA) is now reporting that it is less expensive to install new renewable electricity to the grid than to build a new coal plant. Soon, it will be cheaper to build new renewable capacity than to maintain an existing coal facility. Domestic demand for thermal coal is in a state of terminal decline and this spells opportunity for those are of a mind to kick a dirty dog while it is down.

Coal is a commodity product. No one company is able to produce “better” coal than another or achieve premium pricing based on more effective marketing. The miners are price takers and not price setters. With demand in decline, the market price for coal is tumbling. Miners tend to have large fixed costs that cannot be avoided and weak pricing can quickly lead to weak or negative margins and rapidly deteriorating stock performance. The entire domestic coal space has taken it on the chin in the last couple years and there is no sign of a turnaround. In fact, the basic economic realities noted above ensure that demand and pricing will continue to fall for the foreseeable future. A lot of coal miners are going to go bankrupt (some already have). Later, I will detail some strategies that allow an investor to profit from the decline in a stock price.

I have been looking high and low for a juicy target in the coal space to bet against. I believe I have found that in industry giant Peabody Energy Company (BTU). Peabody has recently went from a position of profit and cash flow strength to producing losses. Revenue is in steady decline and this is weighing heavily on performance. The company already once had to voluntarily file Chapter 11 to reorganize itself to avoid bankruptcy in 2016. That may buy some time but this company is destined to go to zero and cease to exist in its current form. I’ll be showing you how to profit from its inevitable decline. The stock is already down from 30.48 to 9.05, year to date and with more downside ahead.

There are multiple ways to benefit from the decline of a stock. The simplest is to directly “short” the underlying stock. This concept might be foreign to many investors. It is not complicated or difficult though. Instead of buying low and hoping to sell high, you start by selling high and hope to buy later at a discount to lock in your profit. This is done by borrowing shares through your broker. For most brokers, this is as simple as entering a sell order (even though you own no shares). You will end up with a negative amount of shares in your account and receive cash proceeds for the sale. This cash is yours to hold or invest however you like.

There is a non-zero cost to borrow shares to short in the market. Firstly, there is the borrowing fee. At my preferred broker, Interactive Brokers, that rate is currently 0.59% per year. If the stock pays a dividend or other distribution as BTU does, you will also have to make payments in lieu of dividend to the counter party your broker borrowed the shares from. For BTU, the current yield as of today’s close is 5.99%. Your total cost to borrow shares is thus 6.58% per year and you will need the shares to decline at least that much to earn a profit. I’ll show you later how to mitigate these cost. I also want to note that this is a margin trade and is not allowed in tax advantaged accounts. If you have never used margin before, you will need to apply for permission at your broker. You may have to change your declaration of your investing intent to include “speculation” before your broker will allow you pull the trigger.

This is not a free lunch. The shares are not yours to borrow forever. You eventually must buy the shares back on the open market and return them to your counter-party. The intent here is to buy them back from the open market after a price decline so you secure a profit. For example if you short today at 9.05 and buy shares back at 7 dollars in a year, you will profit 2.05 per share less the total borrowing cost of 6.58%. That would leave you with about 16% profit. There is a risk that shares could rise and you would forced to buy back at a loss.

The total borrowing cost of 6.58% per year is a high hurdle to clear for profit. A savvy investor can use the cash received from the sale of the borrowed shares to offset this cost. To do this, you will create what is known as a “pairs trade”. That is, you will use the cash received to buy shares in another company or fund. In this case, the focus will be on safety and earning a cash yield sufficient to cover most or all of the borrowing cost. Earlier I recommended a green energy financing company as an investment “Armstrong (HASI)“. That investment is currently above my buy up to guidance and only yields 4.67%, not enough to cover the borrowing costs of BTU. It might still make a good pairs trade as HASI is likely to continue growing. You do not necessarily need to make money on the actual short if your pair partner does well. One only needs the short shares to under-perform the long shares to make money. Short shares with a dollar value no more than 4% of your portfolio to diversify your risk.

I’m going to go out on a limb here and recommend a steady, stable, boring closed end fund that is invested in bonds, including convertible issues. I have personally owned this fund since 17OCT2016. The price is 0.33% higher than when I bought it. Nothing to write home about. But with this price stability comes a 9.19% cash distribution. I’m up 26.19% after these payments. I am speaking of Advent Claymore Convertible Securities and Income (AVK). The fund is currently very low risk in that it is trading at a 7.08% discount to its Net Asset Value (NAV). That is, if management decided to close the fund today and return all funds to investors, you would make an immediate 7.08%. If all prices on the pairs trade stay the same, the pair will earn 2.61% annually without needing to pony up additional investment capital.

Since this trade is not possible in a tax advantaged account, I will offer a option that is. You can profit from the decline in a stock with a “put” option. This is a contract for the right to sell 100 shares of BTU at a predetermined price and time. You pay a fixed price for this right. This is more risky than the pairs trade as there is the possibility of losing 100% of your cash invested. But it is a leverage trade that can make you many times your money in the event of a strong move downward. In this case I recommend buying the 17JUL2020 put with a “strike” of 9 dollars. Bid no more than 1.75 for these puts. You will need for the stock to finish 1.75 or more below the strike of 9 at the time of expiry to earn a profit. This makes your price target 7.25 or lower. Because of the binary nature of an options trade and the potential for 100% loss of capital, put no more than 1% of your investable capital in this trade.

Lizard King

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