Name That Trade – $CNX vs. $BTU: Coal Slaw

by Enis September 18, 2014 11:07 am • Commentary

BTU was downgraded to sell at Goldman Sachs this morning, after hitting a 10 year low earlier this week.  GS cited 4 main reasons for the downgrade:

We downgrade Peabody Energy (BTU) to Sell from Neutral with 6% downside to our new 6- month, $13 EV/EBITDA-based target (previously $15). Key drivers of our negative view include: (1) a challenging outlook for US thermal coal prices, (2) low margins in Australia due to weak expected met pricing, (3) higher leverage levels and (4) valuation, with the stock discounting long-term met prices of $165/MT, above our 2015/2016 forecast of $140-$147/MT.

The coal sector remains under pressure throughout the world amidst ample supply and stagnant demand.  BTU’s leverage and Australian exposure are two significant problems in a declining coal price environment.  BTU is now trading at its lowest level since late 2004:

BTU monthly chart, courtesy of Bloomberg
BTU monthly chart, courtesy of Bloomberg

I discussed the possibility of a trade in BTU in a NTT post last month:

Implied volatility has moved to a 2 year low by a wide margin in the past couple of weeks.  Options traders do not seem to be worried about an imminent breakdown of BTU to new lows at any point over the next 6 months.  At the same time, few are expecting a move back to the May high of $19.63.

While BTU is hardly at the top of my investment list given that the overall business remains unappealing on a long-term basis, the low level of implied volatility combined with the fundamental and technical setup could make for an attractive trade over the next few months.  Doing nothing here, but might get involved in the $15-$16 range.

I was mainly interested because of the surprisingly low level of implied volatility, and an interesting technical setup.  However, I decided against a trade given the continued relative underperformance of BTU.

With today’s break lower, implied volatility in BTU is finally bouncing strongly, though it still looks low vs. the 2 year range:

30 day implied volatility in BTU, courtesy of Bloomberg
30 day implied volatility in BTU, courtesy of Bloomberg

BTU has convincingly broken the $14-$15 support area this week, so the technical situation does not look great either. The stock is trading at around 0.92x book value, so value investors might get interested, though the main bull case for BTU over the next 6 months is a turnaround in the coal market.

The question I was asking myself this morning after reading the GS report is what would be the ideal trade if analysts were wrong and coal prices did improve.  (Note:  that’s NOT my expectation, but more of a question to consider the trade situation and possibilities).

CNX is GS Research’s favored name in the sector, mainly because it has a separate, growing energy business focused on shale gas, and its coal business is focused on domestic thermal coal rather than metallurgical coal.  CNX stock has held up much better than its peers in 2014.  The stock is unchanged year-to-date with today’s decline and near a 6 month low, but has handily outperformed most coal stocks:

CNX daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
CNX daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg

Now, if I were simply selecting one stock to buy among BTU and CNX, I would pick CNX.  The company has less potential downside if the coal backdrop remains weak, has a more diversified business with its energy segment, and has more flexibility on cash flows given its lower leverage.  Perhaps that was what yesterday’s options trader was thinking with this structure I mentioned in this morning’s Notable Activity post:

CNX – Three way bullish structure:  trader sold around 13k of the Jan15 34 puts at 0.66 to buy around 13k of the Jan15 43/47 call spread for 0.63, essentially putting on the trade for even money.  CNX has outperformed the broader coal sector in 2014, and is actually up 2% year-to-date.  The stock’s high of the year is $48.30, while it last traded below $34 in November.

BUT, if I were looking for a trade that anticipated a rebound in coal, I would rather trade BTU.  CNX has more limited upside given its lower leverage and diversification, while BTU has the potential to really rocket given dismal expectations, high short interest, and again, higher leverage to coal prices in its underlying business.

Speaking of that short interest, BTU shorts have increased steadily for the past 18 months:

BTU short interest, courtesy of Bloomberg
BTU short interest, courtesy of Bloomberg

Short interest is now around 16% of the float.  The shorts have been right, so they could be stickier than in a typical name in this market.

In any case, given this setup in BTU, options look priced quite low.  For example, the Mar 14 calls in BTU are offered near $1.00, which seems much too cheap to me considering the potential for a big rally over the next 6 months if the news flow simply goes from negative to neutral.  I DON’T plan on buying those calls for myself at the moment given the technical breakdown and no signs of fundamental improvement in the coal market.  I do have BTU on my watch list though, since options still look too cheap and the technical setup is interesting if BTU can get back above $14.50.

As for CNX, that would probably be the better investment if you want to buy a coal stock on the sector weakness.  I don’t really have an interest in the coal sector aside from a potential trade on a sector-wide rebound, though, so no interest in CNX.  The BTU vs. CNX debate is an example of our sometimes contrasting perspectives in a trading mindset vs. a long-term investment mindset.