The Coal Turnaround

I've taken positions long thermal coal companies. I've gone long CNXC and increased my positions in the defaulted debt of US coal companies. I'm also considering South32. I am not buying the commodity itself.

Times are very very bad for the US coal industry. I think readers of this blog will know why:
- The new technology of fracking has led to much lower natural gas costs. Natural gas competes directly with coal as an input to electricity generation.
- The Obama administration has encouraged this switch in the hope of reducing CO2 emissions, although the percent of world emissions saved is miniscule.
- The industry itself increased its leverage in the years prior to the decline, and has not had the resources to retrench.
- The collapse of LNG prices in Asia, has hurt the coal export market. Here's a graph from the Wall Street Journal of the Asian price.

The result of this is that all coal prices have fallen sharply. Here's a nearest futures continuation graph from barchart.com of Eastern US coal:

And here is a similar chart of coal CIF Rotterdam area. This is a good proxy for the world export market:

I believe the little upmoves in the right hand side of these charts are not fakeouts, but are the end of the long declines. Here's my argument:

The US coal industry extended its leverage in the years leading up to the bust. For example in 2008, at the height of the financial crisis, Peabody Energy had a liabilities to assets ratio of .67. As of the last financial statement before Chapter 11, it was .92. Some of this was operating losses, but a large part was a 42% increase in debt. The company simply did not have the financial flexibility to hunker down when times got very tough.

The situation was exacerbated by the failure of the industry to cut back production when the writing was on the wall. The combination of declining consumption and stable production has led to a very big increase in coal inventories. Here's a chart from the US EIA of coal consumption and stocks. Note that this ends in March 2016. I explain below why I think this has since turned around. Data is in 000 tons.

OK. That's the bad news background. Here's why I think things are turning around.

Recent data on coal railroad loadings has gotten better. This chart is from the American Association of Railroads:

You can see how coal loadings finally turned down in late 2015 and early 2016. Recently it has moved up, although not to earlier levels. This is consistent with a story of production cutbacks to a level which start to reduce inventories. However, railcar loadings and production are not likely to get back to earlier levels for a long time, if ever.

Natural gas prices have moved up. This directly impacts coal since a large number of powerplants have dual fuel capability and will chose whichever is cheaper. Here's a chart of August 2016 gas futures:

Weather has a surprising effect on coal demand (surprising to me anyway, since I thought coal was mostly used for baseline generation). In fact, analysts I have read put part of the blame for low coal consumption on the mild winter. So far Spring has been hot in much of the sunbelt. It hasn't been cool anywhere.

The result of this has been strengthening in coal prices. We saw this in the earlier charts, but it is important to know that the futures market is forecasting even higher prices for some coals, particularly eastern US.

      ICE CSX Coal
Aug 2016    40.20
Aug 2017    47.25

Since production costs may actually decline a little over the next year, this will be a big boost to cash flow.

So it looks to me like a typical commodity "cobweb" turnaround is happening right now. There is one big risk however. The Obama administration has proposed a new set of rules, the Clean Power Plan. This would sharply limit how much coal can be burned. They did this by regulatory action since they know that it could not be done legislatively. Much like the recent administrative action on immigration, this is being challenged in the courts. It is currently before a Federal Appeals Court. If this is upheld, it will be a huge long-term negative for the industry and a short term blow similar to Brexit was to the Pound. The ruling could come soon.

If you are willing to accept this risk, there are many assets you could buy. Probably the easiest is the ETF KOL. This is an ETF of coal miners, suppliers and transporters. However, it is not US focused. Several of its largest holdings are Chinese, and its largest holding, Teck Resources (TCK), does a lot more than coal.

If your tax situation is appropriate, the MLP CNXC should be considered. It was spun out from Consol Energy. David Einhorn, who owns much of Consol, wants it to concentrate on its gas E&P operations. Einhorn still owns much of CNXC, but I would expect him to sell on strength. Right now it's dividend rate is about 20%. However, only about 40% of that is covered by income, so I expect some reduction.

Finally, if you are willing to take on high risk and you want upside optionality, consider the bonds of the defaulted coal companies. For example, Peabody Energy bonds are going for about twelve cents on the dollar. If the coal market does righten itself, and if the Chapter 11 proceedings are not closed too quickly, these could be worth much more than that.

Back from a long hiatus...

The updated long-run strategy graphs are online.

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These are a key part of my process. They are a great screening tool.

Effect of Brexit on Commodities

Lots of effects...

1. There is a rush to safe assets by a lot of wealthy people, and most commodities are not safe assets. Precious metals and a few others may be, but otherwise this is bearish. To my mind this is the major short-term effect, and it will happen immediately.

2. The USD will rise, also bearish. This is actually part of 1.

3. Most economists are taking down DM growth by a few notches. Bearish, but not too much.

4. These very big market moves tend to feed on themselves. Who knows which hedge fund or shadow bank is overexposed and will default? How big will this be? By its very nature, it's hard to know. But the market will keep this in mind, and you can be sure that there will be sharp reactions to every rumor.

5. The biggest wild card is the effects on EM, particularly China. The first order effects (export slowdown) aren't too bad. But the effects of 1 and 4 may well cause problems. We will see.

The other side is how the world's central banks react to this. The obvious course is for rates to be lower for longer, maybe much lower for much longer. To my mind the key is whether we approach negative rates in the US. I do not believe the US population will stand for negative rates, and because of this monetary policy will lose effectiveness. Could be fun.

Longer term, a big question is what happens to the EU. To my mind it is obvious that they have to open up the regulatory system to political control and to reduce German control. Otherwise more countries will follow the UK's example. But people in power want to stay in power, so who knows?

The upside scenario is that the EU gets reformed, and Britain gets a good exit. The latter is not too unrealistic. Not talked about much is that Britain has a large trade deficit with Europe. And the items they import (German cars and French wine) are politically powerful. So there will be a lot of pressure to keep the UK in the trade loop.

Why is everyone so bearish on the stock market?

First off, let me toot my own horn. The options trade I recommended last week worked out beautifully. SPY opened on Monday at 205.50. So if you wrote the expiring 205 straddle, you made about two points. If you just bought the market, you made about a point and a half.

Second, I want to point to an article by Richard Bernstein Still no one Wants to Play. It expresses my sentiments exactly. I know a lot of professional traders, and I real a lot more. These folks are  overwhelmingly frightened and mostly bearish. Why? I can think of three reasons.

First (as Bernstein says), many people look at history and think that the economic/market cycle is well advanced. What they miss here is that this cycle has played out very slowly, There are good reasons for this, and they have to do with the very slow return of confidence. The upshot is that we are nowhere near the end of the cycle. If I had a dime for every well known prognosticator who forecasted a recession (or claimed that we were in one now)....

Second, almost all the pros now trading suffered a near-death experience in 2008, and that has remained firmly in their reptilian brain. Like I said in a much earlier post: 2008 was the Gen X version of what inflation was to the boomers. It will keep them frightened till they retire or die or both. Just like the fear of inflation led many in my generation to miss the greatest bull market in bonds ever, they will miss out on risk assets.

Finally, and directly relevant to commodities, is China and the far east. No I don't mean that they are over producing and destroying our jobs. They are, but they are also oversaving. This savings has to go somewhere, and a lot of it is leaving China (with good reason). So there is a very large inflow into mostly low risk assets that is keeping the equilibrium rate of interest low. The forecasts of the Fed's "dotters" that we will get back to a 4% fed funds rate in this decade is crazy. More like 2.5% top. This may be bad for Wall Street (another reason they are so glum), but it's great for valuations.

OK, enough of the rant. Suffice it to say that at some point the rally in risk assets may well have legs. I'm guessing that time may be now. This is a risk / reward type of play. I'm long upside calls.

Tactical Option Trade

This is not my kind of trade, and it is definitely not strategic. However, there may be a decent risk/reward in the expiring SPY options. SPY as many of you know is the largest option market in the US, and has all sorts of feedback with actual stock prices. The options that expire this Friday have an abnormal open interest at the 205 strike.

Strike  OI
195      178K
200      149
205      393
210      201

Many of you have already noticed that, in the absence of new fundamentals, prices tend to go to the strike with heavy OI. There is good reason for this. As time to expiration goes to zero, the near-the-money options have very high gammas. For example, on expiration day if it's above the strike the delta is near one and near zero if it's below. So holders of these options tend to hedge as it moves around the strike. There is also an incentive for large option traders to pin it to the strike: they can trade on the Saturday following the last trading day on the Board, while retail cannot.

So the trade is to sell the 205 straddle. Obviously this is picking up pennies in front of the steamroller. But if you keep the size low and determine to do it every execution day, it does have a nice trade profile. I'm not doing it; it doesn't square with the name of this blog. But maybe you should?

What to do with Soybeans Here

The USDA gave us bean bulls a nice present on Tuesday with a big change in bean consumption /  ending stocks. The market responded as expected and then some. So what to do now?

My guess is that we will need some additional bullish info to keep the market moving up. Given the time of the year, that would probably have to be weather related. So far weather in the midwest has been quite good. The NOAA has a three month climatological forecast of near normal to slightly above precip and near normal temps . So my guess is that beans and corn both will at best tread water and more likely give back some of their gains until we get some real issues. But I don't see a huge downside. The ending stocks are  going to be tight enough that any actual crop problem will require demand rationing. So I took almost all off and am reestablishing on declines.

World Bank Commodity Data

I've graphed the commodity price data from the World Bank. Previously, I was using the IMF data. Many of the price series are similar. However, the WB does have some different ones, and they started in 1960 vs. the IMF's 1980. To account for this very long series, I used the annual data rather than monthly. The last point is the current price.

The graph are all deflated time series using the US PCE deflator and the $US value. I graphed them as time series rather than the 10-year returns of the IMF graphs. I'll get to that later.

There are 73 price series.

Here's the link for the first 25:

Here's the link for the next 25:

Here's the last bunch: