Jan-2013 Call Options in Coal Stocks Offer 2 Attractive kickers
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Twice in the past four years Queensland, Australia has experienced, "100-yr" flooding events in the first quarter. In both cases, benchmark coking coal prices spiked. That's because more than 50% of the seaborne coking coal market comes from Australia. Back in 2008, the spot price spiked to $400 per metric tonne and annual contracts were struck at $305 per tonne. More recently, upon flooding in Queensland in January of last year, the benchmark price reached $330 per tonne in the April-June period. Prices above $250 per tonne for a few quarters next year would be more than enough for my favorite coal stocks, Alpha Natural Resources, (NYSE: ANR) and Walter Energy (NYSE: WLT) to generate strong cash flows.
Off course none of that matters now with spot coking coal prices of $180 per tonne and the next quarterly benchmark likely to be $200 per tonne, plus or minus $10. Or does it? The next coking coal settlement is for Oct-Dec. If Australia gets hit again by moderate-to-severe flooding, it will occur in the Dec 12 - Feb 13 time-frame. That would almost certainly cause a big up-tick in the Jan-March 2013 price. Have I become so desperate for good news in the coal space that I'm doing rain dances? No, I'm not predicting the weather down under. However, buying Jan-13 Call options on a favorite coal stock offers a free shot at another weather-related incident.
The second kicker worth mentioning is a takeout of Walter by a global miner. Recall that last year speculation that Anglo American and BHP, were looking at Walter sent the stock price up 20% on September 7, 2011. I've posted my thoughts on a WLT takeout, I think it makes perfect sense for a company like Anglo, BHP, Teck Resources, (NYSE: TCK) Rio Tinto, (NYSE: RIO) or I think that if a takeout were to occur it could easily be in the $60's-$70's per share.
Walter is easily digestible for a number of majors. The majors have access to incredibly cheap debt financing. Teck Resources just issued over $1 billion in new corporate bonds, some of which with a 2.5% fixed coupon for 6 years. TCK would greatly benefit from diversification away from it's Canadian only coking coal operations. As the largest producer of iron ore in the world, Vale would benefit from greater diversification into coking coal. Vale has a large base of operations in Brazil, a country that Walter has a clear and sustainable shipping advantage to.
To be clear, if one is bearish on commodities, China, Europe, the stock market in general, then this trade may not be for you. But, if you've been watching the coal stocks get hammered or you're thinking of doubling down, Jan-13 Call options might be a good way to go. If coal fundamentals don't recover somewhat by January, coal stocks will likely continue to under-perform and owning them outright could be painful.
The advantage of a Call option is that an investor can deploy far less capital to control the same number of shares. This is a high risk way to articulate a long position as time becomes the enemy. However, if one believes there's a decent chance that coal markets will recover, five months is a reasonable amount of time for that to play out. While anything can happen in the next five months, bad weather in Australia could be a catalyst to get the coal stocks moving in the right direction.
Let's take an example. I'm long the Jan-13 Call options of Walter. My options have a strike price of $45 per share. To go long these Call option, the premium costs $1.6. The break-even share price is therefore $45 + $1.6 = $46.60, which is 26% above the current stock price. At a price of $48.2 I would double my money, and at $49.8 I would triple it.
A move to the upper $40's within five months is a BIG move. However, as recently as June, 20, 2012, the stock was at $48.15, and in the first half of May, 2012, the stock was in the low-to-mid $60's. In addition to the weather in Australia, a pick-up in China's demand for industrial materials in the 4th quarter could move the needle. Reports of this happening are common. In Europe, if member countries kick the can further down the road, demand could pick up there as well.
No matter what the contemplated scenarios, this is a risky bet. However, if one wants to be long WLT anyway, why not the Jan-13 Call options? For $1,600 an investor can control 1,000 shares through mid-January. By that time, the weather, (or lack thereof) in Australia should be known to the market. Combined with the probability of Walter being taken over, even if just a 5% chance between now and January, I like my Call options on Walter.
MockingJay2011 owns shares of Alpha Natural Resources and Walter Industries. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.