Coaling It?

“Coal” is a four letter word long demonized by the environmental lobby as the ultimate villain in pollution-creating carbon-based fuel. Even so, coal continues to be abundant, relatively cheap and a much needed source of energy for a world trying to reduce its dependence on oil.

Power grids in emerging Asia, especially China, are largely fuelled by coal. Moreover, according to International Energy Agency estimates, coal usage will grow 65% by 2035, replacing oil as the world’s prime energy source unless energy policies around the world trend away from fossil fuels – which is unlikely.

The demand for metallurgical-grade coal used for the production of steel, is expected to grow at a more accelerated clip, and shows no signs of losing momentum. Even with a downwardly revised GDP growth target of 7.5%, Chinese demand for metallurgical coal remains strong. The upshot is that coal will be with us for the foreseeable future, and improving technology will make it cleaner and far less of a pollutant than it is today. Which by the way, is far less pollutant than it was 30, 40, or 50 years ago.

What’s interesting in this debate is that while the global demand for coal is growing rapidly, there remains a glut of coal in the US. That domestic supply overhang is being blamed for weakness in the share prices of US coal producers which has lead to plenty of consolidation in what has been a fragmented sector. A recent example is the proposed US$90 billion merger between Glencore International AG and Xstrata Plc, two of the world’s largest coal operations.

If you take the glass half full scenario predicated on rising global demand for coal, you might consider taking a bullish bet on a long-time Canadian coal miner Sherritt International Corp. (TSX: S, Friday’s close $5.84). More conservative investors would look at covered calls or naked puts, more aggressive traders, long calls.

For the conservative approach look at buying Sherritt at $5.86 and writing the July 6 calls at 40 cents or better. The four month return if exercised is 9.2%, return if unchanged is 7.3% with a downside breakeven of $5.46.

If you prefer the naked put strategy, look at selling the July 6 puts at 60 cents or better. With this trade, you are obligated to buy Sherritt at $6.00 per share until the July expiration. If the stock is above $6.00, the puts will expire worthless and you will simply pocket the premium received.

The risk is that the shares are below $6.00 in July at which point the puts would be assigned and you would buy the shares. You retain the premium, which means that your net cost to buy the shares is $5.40 per share ($6.00 exercise price less 60 cents premium = $5.40).

You can only execute short puts in non-registered accounts because this trade – even if the puts are cash secured – requires margin that cannot be extended to RRSPs, RRIFs or TFSAs.

The more aggressive strategy also has merit because you could make a case that shares of Sherritt will pop if the Glencore-Xstrata merger actually happens. You could also point to Sherritts’ wide girth in terms of potential movement – 52 week high ($8.46) 52 week low ($3.86).

If you like the long call trade, look at buying the Sherritt October 6 calls at 60 cents or better.