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A Lump of Coal

Richard Croft
July 10, 2011
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6 minutes read
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Some of the world’s largest coal reserves are tucked away in the arid wastes of Mongolia. The Tavan Tolgoi coal deposit, for example, holds about 6.4 billion metric tons. That’s the world’s second largest coal deposit after China’s Shengli field.

Recently, the Mongolian government arranged for a US/Chinese/Russian consortium to develop the deposit, which includes both thermal and coking quality coal. The latter being particularly valuable as it is used in many industrial processes such as the manufacture of steel. According to www.wikipedia.org, “coking coal is heated to produce coke, a hard, grey, porous material which is used in blast furnaces for the extraction of iron from the iron ore.”

China, of course, is the target market, and its insatiable demand for both energy and steel will ensure a market for Mongolian coal for a long time.

Interestingly, a Canadian company has been operating in Mongolia for some time, and has interests in operating mines that already produce not only coal, but also copper and gold. Ivanhoe Mines Ltd. (TSX: IVN, recent price $24.92) is the brainchild of one-time stock promoter and now billionaire miner Robert Friedland.

Ivanhoe operates mines in joint ventures with SouthGobi Resources (in which it has a majority interest) and global mining giant Rio Tinto Ltd. It’s recent price is not far from the company’s 52-week high of $29.29, and is well above its 52-week low of $12.75.

For option traders, this company is interesting from the perspective that it is quite volatile and will likely remain so for some time. I say that because; 1) the company has a volatile earnings stream which translates into a volatile stock price. The company broke even in its second quarter reporting zero earnings per share. And 2), the company is located in the Far East which often raises concerns about reporting standards and quality control. Not to mention making the company’s shares ripe for short sellers. Just ask Sino-Forest how that can affect your share price!

The question is how does one play this story. On a longer term basis, you can make a bullish case based on demand from China. Demand can only grow and IVN will be a supplier. However, over time, one would have to discount potential competition from the Tavan Tolgoi coal deposit in which IVN does not have a stake.

Shorter term there are concerns about the company’s cash position and more importantly, a slowing of China’s economic growth. The Chinese central bank is trying to reign in demand by tightening credit, and there is the general global “soft patch” which could spread into a sluggish second half. In that scenario, there would be further softening of commodity prices, especially as demand for industrial materials like copper and coal fall off.

If you fall into the bullish camp, you might look at strategies that take advantage of the higher than average option premiums by looking at longer term option writing strategies. For example; covered call writing where you buy the shares at $24.92 and write the IVN December 25 calls at $2.85 per share. The six month return if exercised is 13.3%, return if unchanged is 12.9% and the downside breakeven is $22.07.

You could also look at writing cash secured puts. In this case, selling the IVN December 24 puts at $2.45. With the sale of the IVN December 24 puts you are obligated to buy shares at $24 per share until the December expiration. Your cost, should the puts be assigned, would be $24.00 per share less the $2.45 per share premium received from the sale of the put. Meaning that the net cost to buy IVN shares would be $21.55 per share.

To structure a cash secured put, you must deposit the net purchase price ($21.55 per share) into your brokerage account. If the shares are put to you, you simply buy them with your cash deposit plus the premium from the sale of the puts.

If you fall into the short term bearish camp, you could look at IVN September bear calls spreads. In this case, you would sell the IVN September 24 calls at $2.40 while buying the IVN September 30 calls at 45 cents. With this trade, you take in a net credit of $1.95 per share. If IVN is below $24 per share at the September expiration, both options would expire worthless and you simply retain the net credit.

The risk is that the stock rises over the summer. If the stock closes above $24 per share, the September 24 calls will be in-the-money and subject to an assignment. You risk is capped by the purchase of the September 30 calls, which means that the most you can lose is the difference in strike prices ($30 strike less $24 strike = $6.00 per share), less the net premium received ($1.95), for a maximum risk of $4.05 per share.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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