The trouble for coal stocks has gone from bad to worse following reports that Patriot Coal (NYSE:PCX) might be struggling to stave off bankruptcy. Although Patriot is a smaller player in the industry — with a market cap that now sits below $250 million — this latest episode has weighed heavily on investors’ already shaken confidence in the downtrodden coal sector.

Nevertheless, sentiment has weakened so much in the wake of this news that coal stocks might finally be nearing a bottom.

Why Has Patriot Melted Down?

Shares of PCX — one of the many companies victimized as soft demand for coal has led to severe price deterioration for the commodity — already were on the ropes prior to last week. Then on Monday, May 14, the company reported a surprisingly poor outlook after the bell, citing weak international demand and a possible default by a key customer. The stock fell 18% the next day, then proceeded to slide another 16.5% to close out the week.

Matters grew even worse on Tuesday when rumors that Patriot was preparing to file bankruptcy caused its shares to trade down to an intraday panic low of $1.36, versus $5.83 at the beginning of the month. The stock subsequently recovered on news that it was in talks to secure new financing, but PCX still closed Wednesday with a year-to-date loss of more than 68%.

Click to Enlarge The effect on the broader coal sector has been dramatic. In the seven sessions ended Wednesday, the Market Vectors-Coal ETF (NYSE:KOL) shed 7.1%, compared with a loss of 1.4% for the SPDR S&P 500 ETF (NYSE:SPY).

Other stocks that were hit hard included James River Coal (NASDAQ:JRCC), down 16.3% in the same seven-session interval, and Peabody Energy (NYSE:BTU), which had fallen 14%. KOL’s year-to-date return is now -18.7%, a whopping 24.6 percentage points behind SPY’s 5.9% gain in the same period.

What’s Next?

Coal stocks already were pressured by an exceedingly adverse set of circumstances from the supply-and-demand picture, and Patriot’s woes should add even more day-to-day noise into the equation. However, we might be nearing the point at which Baron Rothschild’s advice to “Buy when there’s blood in the streets” might be coming into play.

With hellacious news flow and expectations at rock-bottom levels, even news that is simply “less bad” could be enough to get coal stocks moving again. One favorable development of note is that coal companies’ production cuts are beginning to have an impact:

Investors should therefore be on the lookout for opportunities to pick up shares in higher-quality coal names such as Arch Coal (NYSE:ACI, read more here) and Walter Energy (NYSE:WLT) on further weakness, but take care to scale into any positions gradually to offset the impact of negative headlines out of Europe.

As for Patriot itself, the stock still is too risky for all but the most intrepid investors. If it can bridge its cash shortfall and survive long enough to benefit from an eventual recovery in coal, PCX could provide outstanding returns even after its 96% move from Tuesday’s low to Wednesday’s close of $2.66. On the other hand, the potential for additional bad news is extremely high.

PCX is therefore an enormous gamble, but the news flow surrounding the company might provide patient investors a chance to pick up shares in larger, healthier coal stocks in the days and weeks ahead.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.