Earn 34.5% A Year — From Coal?

My personal portfolio is packed with mature sectors like energy, consumer staples and utilities for their higher income yield. Most of the industries within these sectors have fairly stable sales and cash flows and can afford to spin out tons of cash to shareholders. 

#-ad_banner-#Share prices don’t shoot to the moon on surging growth, but they’re also not as prone to a sell-off when the market tumbles, either. It’s a slow ride to getting rich, but the constant cash flow is great.

That is except for one industry in the group: coal. Despite being one of the cheapest sources of fuel, coal producers have fallen on hard times.

So why am I increasing my position in a coal producer and looking for double-digit returns even if industry fundamentals remain weak?

The past few years have not been good for coal. The Market Vectors Coal ETF (NYSE: KOL) is up just 6% in the past year and has lost a stunning 63% since its 2011 high. The Environmental Protection Agency (EPA) continues to propose new guidelines that will reduce coal use as a percentage of total U.S. electricity production, and production in China has flooded the market with coal for use in steelmaking.

Despite all that, coal’s future is still incredibly strong — it’s still the fastest-growing source of energy in the world. According to the International Energy Agency (IEA), coal demand will increase by 65% over the next two decades and will replace oil as the most used source of energy. 

While the fuel’s usage in U.S. electricity generation fell to 37% in 2012, it has since rebounded and is forecast to remain around 40% for the next several years. Nearly 15 gigawatts (GW) of coal-fired capacity was shut down at U.S. electricity producers in the past four years, but only 3.8 GW of capacity — just 1% of the total coal-fired capacity — is scheduled to be shut down this year. New guidelines proposed by the EPA are weighing on confidence, but they are set to take effect over the next 16 years, and that’s only if they’re not limited or pulled back entirely first.

The boom in U.S. natural gas production has been the principal culprit of the industry’s ills. Prices for natural gas hit historic lows below $2 per million BTU (MMBTU) in 2012, and replaced coal as the cheaper fuel for electricity generation. (My colleague David Sterman recently looked at whether natural gas prices have found a bottom .) 

Though natural gas prices have rebounded, currently sitting around $3.75 per MMBTU, it is still a cheaper source than coal mined from the Eastern Appalachian region of the country, which has a higher sulfur content than other regions. Coal mined from the Permian River Basin (PRB) and the Illinois Basin (ILB) can be mined cheaply enough to compete with lower natural gas prices in electricity generation.

Despite the positive long-term picture, I invest in only one coal producer: Peabody Energy (NYSE: BTU)

All of Peabody’s U.S. coal assets are in the cheaper Permian River and Illinois regions, so it has a significant cost advantage over peers with Appalachian mining assets. In addition, 41% of its 2013 sales came from Australian coal assets, and Peabody has significant exposure to growth in Asia.

China became the largest importer of metallurgical coal last year with a 42% increase in imports to a record 74 million tons. China coal production increased just 1%, and it looks like the oversupply condition could be alleviated within the next year or two.

While I am positive on the longer-term outlook for coal and Peabody Energy, last week’s earnings report gave me pause for the short term. The boom in U.S. oil production has shifted rail transportation away from coal to haul petroleum, and there has been trouble getting coal to utility plants.

On the bright side, sales were above expectations, and I think it is only a matter of time before the long-term fundamental picture starts to improve, as well as BTU’s share price.

Selling covered calls against a stock with strong long-term potential but limited near-term upside is a great way to boost returns until the shares break out. Selling call options allows me to collect income now and hedge my risk if the share price should fall marginally.

For BTU, I like the September call options because they will expire before the company’s third-quarter earnings report. With so much uncertainty in the industry, earnings releases are likely to cause outsized moves.

Additionally, management recently declared a third-quarter dividend of $0.085 per share to shareholders of record on Aug. 8. Selling the September calls means you collect the August dividend along with the options premium.

With BTU trading at $15.56 per share at the time of this writing, we can buy 100 shares and simultaneously sell BTU Sep 16 calls, which are currently trading around $0.51 ($51 per contract) and expire on Sept. 19. (You can scale up by purchasing one call contract for every additional 100 shares you buy.)

Since we receive $0.51 per share for selling the call, our net cost is lowered to $15.05 per share, offering 3.7% downside protection from the current price. The shares have found strong support around $15 even on days of weakness. I like this trade as long as the cost basis is below $15.25.

While I like the company’s long-term potential, I think the upside may be limited over the next couple of quarters.

If shares continue to trade below the $16 strike price through expiration, you keep the $0.51 option premium for a 3.3% gain in just 52 days. Add in the $0.085 dividend payment, and your return jumps to 3.8%.

This is my preferred outcome since I am long-term bullish on the company and would like to continue selling covered calls against my holdings. This covered call strategy amounts to a 23% annualized gain, plus the dividend yield.

If the shares trade above $16 before the third Friday in September and your shares are called away, you will make at least $0.75 per share ($16 strike prices minus $15.25 maximum cost basis), or 4.9% in 52 days. This works out to a 34.5% per-year rate of return.

Action to Take –> I have a price target of $19 on the shares over the next 18 months, representing upside of 22% from current levels. Until industry fundamentals start to improve, I plan to sell call options against my shares of BTU to boost my income.

Peabody is a favorite of my colleague Dave Forest, who just returned from a trip to Asia with some shocking news. According to his contacts, China has been quietly involved in a spending spree that’s about to hit American shores in a big way… and could send two stocks up 145% and 218%. For a free report on this situation, click here now.

This article was originally published at ProfitableTrading.com: 
This Sector May Be the Last Place You’d Expect to Find Double-Digit Returns