asian coal benchmarks and risk management report
TRANSCRIPT
Commodity Markets Intelligence Series
ASIAN COAL BENCHMARKS
and RISK MANAGEMENT
How to benefit from this evolution
September 16, 2013
Kasper Walet
Founder and Principal Consultant
Tel: +31 20 531 56 44
Mob: +31653818191
Email: [email protected]
Internet: www.maycroft.com
Your Commodities Risk Management Partner
Introduction
If current trends continue, coal is poised to match – or potentially overtake
– oil as the world’s most widely used energy resource in the next five years. Asia is the world’s biggest coal market and its risk management
mechanisms are rapidly adapting to reflect this. The Asian coal trading market is changing fast. With this shift has come an evolution of market
dynamics, trading options and benchmark indices.
In this Report we will take closer look at the drivers of the changes in the
global and Asian Coal Trading Markets. The different coal price
benchmarks in the Atlantic and the Asian pacific regions. The close
relationship between these benchmarks and the evolution of coal
derivatives trading in Asia. The working of derivative instruments like
Swaps and futures.
To ensure that if you would like to learn more about the terms used within
the report, we have included in Annex section several in depth
explanations and examples to explain the meaning of several technical
issues.
After reading this report you will have a thorough understanding of the
coal markets and the uptake and working of coal derivatives in Asia.
I wish you a lot of reading pleasure and that it will offer you the necessary
insights to do a better job.
Amsterdam, September 16, 2013
Kasper Walet
Contents
Introduction ........................................................................................................................................ 4
Changing global and Asian coal market ................................................................................... 7
1.1 Changing Demand ................................................................................................................... 7
1.2 Changing Supply Patterns ....................................................................................................... 8
1.3 Change in trading patterns: from higher to lower quality .................................................. 10
1.4 Impact changes on business producers and sellers ............................................................. 11
2. Long term vs. Spot contracts and Benchmarks ...................................................... 12
2.1 Bilateral Long term contracts ............................................................................................... 12
2.2 Main sellers and buyers ........................................................................................................ 12
2.3 Spot Contracts ....................................................................................................................... 13
2.4 Main Spot Price Indices ........................................................................................................ 13
3. Asian Benchmarks .............................................................................................................. 15
3.1 A closer look at the relevant Asian Indices .......................................................................... 15
3.3 The API 8 Index ..................................................................................................................... 16
3.4 API-5- The New Spot Market For Australian Coal ................................................................ 17
3.5 Indonesian Sub-bituminous FOB marker ............................................................................. 17
3.6 Correlation between Indices ................................................................................................ 18
4. Coal Trading and Derivative Instruments ................................................................. 19
4.1 Physical vs. Financial Coal Trading ....................................................................................... 19
4.2 The Different Coal Derivative Instruments .......................................................................... 19
4.2.1 Coal Swaps ..................................................................................................................... 20
4.2.3 Futures .......................................................................................................................... 20
4.3 Role brokers .......................................................................................................................... 21
5. Asian Coal Market and Derivatives Uptake ............................................................... 22
6. Lessons from Coking Coal and Iron Ore Market ..................................................... 25
Annex I Coal Facts ..................................................................................................................... 26
Types of coal ................................................................................................................................. 26
Coal Market Pricing ....................................................................................................................... 27
Coal Supply .................................................................................................................................... 27
Coal Demand ................................................................................................................................. 27
Annex II Coal Trading Strategies ....................................................................................... 28
Hedging ......................................................................................................................................... 28
Hedging Strategies for a Producer ............................................................................................... 29
Hedging and Trading Strategies for Traders and Banks .............................................................. 29
Arbitrage and Speculation ............................................................................................................ 29
Arbitrage Example ........................................................................................................................ 30
Annex III Coal Derivatives, Volatility and Hedging ....................................................... 31
Derivatives .................................................................................................................................... 31
OTC contracts ................................................................................................................................ 31
Coal Swaps ..................................................................................................................................... 31
Coal futures ................................................................................................................................... 32
Volatility and hedging ................................................................................................................... 32
Contract Performance ................................................................................................................... 33
Contract Valuation ........................................................................................................................ 33
Annex IV Basis Risk ................................................................................................................ 34
What is Basis Risk ......................................................................................................................... 34
Basis Risk Coal Asia ....................................................................................................................... 34
Annex V How a Coal Swap contract works .................................................................... 36
Prerequisites to enter the Coal Swap Market ............................................................................. 36
Example with API 8 Swaps ............................................................................................................ 36
Hedging with Coal Swaps; a Case Study ....................................................................................... 37
Annex VI Contract specifications “ICE API 8 Futures” ................................................ 39
Changing global and Asian coal market
The global seaborne market is undergoing a profound transition as normal
market cycles are becoming shorter in duration. The market cycle changed
in 2009, and today’s market is going through a different transition. The market has enjoyed its era of high growth ( 200-300%) between 2003-
2009. World demand growth for seaborne-traded thermal coal is going to be moderate in the coming decade. The primary drivers fueling worldwide
coal growth are steel and cement production in China, India, and other parts of Asia, as well as electricity generation. The lower cost and reliability of
coal-fired electricity generation makes the fuel appealing to emerging economies expecting rapid increases in energy demand.
1.1 Changing Demand
China is the world’s top importer, since it overtook Japan in 2011. India will overtake the U.S. as the world’s second-biggest user of coal and, according to the International Energy Agency (IEA), India will overtake
China as the world’s biggest buyer of seaborne traded coal by 2016.
Global coal consumption would have been a lot less if it weren't for China’s
continued reliance on coal.
World and China Coal Consumption
China's energy mix in the future years will see coal remain as a dominant
feature, fuelling 65-70% of the country's installed power generation, compared with around 78% today. India, which generates 57 % of its
electricity from coal, plans to add 118 gigawatts of capacity by 2017.
Together, China and India will account for approximately 90 % of the rise
in coal demand through 2017.
Although the forecast remains strong, unexpected downturns in the
Chinese and/or Indian economies could potentially derail the surge in coal.
Besides Japan is looking to coal as a cheaper alternative to expensive oil and LNG imports. Japanese utilities have been able to force down the
prices set by the annual coal contracts, aided by a supply glut in the global coal market. The Japanese government is also encouraging the shift
towards coal, ending recently a moratorium on construction of new coal-
fired power plants
1.2 Changing Supply Patterns
Indonesia is now the world’s largest coal exporter, displacing Australia. Experts expect Australia to regain its position by 2017, as the country
shakes off the effects of the 2010-2011 floods in Queensland, which hampered coal production. Their locations give both Indonesia and
Australia a unique advantage in reaching Asian markets, and both are
developing new mines and transport infrastructure.
However, these 2 countries are facing competition from other major global exporters like swing suppliers South Africa and the United States. US miners are desperately looking for alternative markets to replace lost ones
at home. US coal producers are turning to Asia-Pacific to offload coal stocks building up at home because of a slump in coal consumption at
power plants caused by a rising abundance of cheap domestic natural gas due to the so-called shale gas revolution.
Besides traditional Atlantic market suppliers such as Russia and Colombia are also looking at opportunities to export their coal to the Asian markets.
The reason for the growing presence of Atlantic coal in particularly China's imported thermal coal market is that the relative price advantage
overtook concerns of longer travel times to market, for long the main driver of Pacific market coals into China. This is underlined by a depressed
freight market, where the narrow price differential between freight rates originating from the Atlantic and the Pacific markets will continue to keep
the FOB prices in the Atlantic markets economically competitive.
In addition to the major exporters already mentioned, rising demand from
China is fueling the growth of two new exporting countries: Mongolia and North Korea.
However, particularly the Indonesian and US exports could be affected by China's changing policy on coal import. US thermal coal tends to have a
higher than average sulphur content, with cargoes typically having 2% or
3% sulphur content.
They will undoubtedly fall within the constraints of China's expected ban
on certain types of imported thermal coal, as the ban is also targeting
imported thermal coal with a sulphur content of more than 1%. Traders
are waiting to see if this trade in higher-sulphur US thermal coal can
continue. A ban of any kind on Low Caloric Value (LCV) imports can only
benefit Australia, as it is the next closest supplier to China and the quality
of its coal is much superior to most Indonesian production.
China has become the clearer of the marginal ton of international
production and this role will continue in importance. This rise of China as a
dominant force in the global seaborne market for thermal coal has driven
changes that must be addressed by miners and traders if they are to
remain relevant and profitable in a future flat growth market.
1.3 Change in trading patterns: from higher to lower quality
The growth of low rank steam coal is a new trend in global seaborne trade.
Lower specification thermal coals, such as Newcastle 5,500 kcal/kg NAR and
Kalimantan 3,800 kcal/kg GAR, are going to play a greater role in the
seaborne market particularly given the expected rise in demand from China.
By 2015, lower specification coal demand might be around two-thirds of all
consumption. China's increasing appetite for coal imports would require
changes to market pricing structures, as Chinese importers would need to
understand international pricing, and international coal exporters and
traders would have to embrace some local price indexes.
Low rank coal also designed as “off-spec” consists of sub-bituminous coal
with a low calorific value (4,900 kcal/kg in the case of Indonesia, 5,500 kca for Australia) and a high ash content (up to 24%). Australia is now a
regular supplier of low rank coal on the spot market. It is sold at a
discount as the suppliers save money by not having to wash the coal. In the importing countries, low rank coal is blended with other coal types.
Since 2000, most coal power plants have been designed with the
possibility to burn coals with a wide range of calorific value. As more tonnage is needed to produce the same unit of energy, this new
trend explains part of the high growth in steam coal imports by some countries; e.g. China and South Korea. In Indonesia, low rank coal,
accounts for about half of coal reserves in the country. A ban on exports of low calorific value coal was planned from 2014, so as to enrich the
resource to high value product. The government ,however, decided in January 2013 -for the time being- not to proceed with the proposed ban
as technology required for up gradation of the low rank coal is currently unavailable.
1.4 Impact changes on business producers and sellers
Changing market forces, both on the demand side and the supply side, were
exerting pressure on miners to halt their production expansion plans and to
tighten their cost bases. Capital expenditure on mining is heading into a
prolonged down cycle and it is forecasted that global capital expenditure on
mining could be cut deeply, falling to $120 billion by 2015 from $160 billion
in 2012.
Increased competition in the market was leading to lower profit margins for
coal producers and sellers, and their traditional business models may no
longer be relevant in the future. Market experts expect that the real inflation
adjusted price of coal will fall in the long term and growth will come from
revenue growth and not from price increases. As a result of this increasing
cost pressures, miners would be forced to grow revenue through volume,
as opposed to increased market prices, and to manage their production
costs more tightly.
Traditional mining companies may have to embrace price risk management
and to refocus on long term growth markets, as well as manage their
logistical supply chain exposure more closely. Joint ventures, partnerships
and strategic long-term relationships between coal producers and traders
will be a logical progression to follow the changes.
2. Long term vs. Spot contracts and Benchmarks
2.1 Bilateral Long term contracts
Similar to the oil and gas sector, long-term contracts are widely used in the coal sector. This is partly because of large capital investments
involved. Both sellers and buyers are likely to invest in large projects in the coal supply chain. In many cases, coal buyers are power producers,
while coal sellers are mining companies. In the midstream, transport infrastructure, such as railways, ports and ships, needs to be developed to
transport coal. Long-term contracts provide guarantees to finance these projects.
Coal quality is another reason for the wide use of long-term contracts in
the coal sector. Quality is an important issue in the international coal
trade. In particular, coking coal characteristics are critically important to steel mills, and, to a somewhat lesser extent, it is the same for steam coal
for power plants. Standard specifications are only an approximate guide and buyers/users are required to implement extensive tests over a
lengthy period to assess one coal brand. Once accepted, however, the relation between the seller and the buyer/user is likely to continue for a
long time.
While there are increasing volumes of coal transactions based on short-term contracts and spot transactions in the market today, the use of long-
term contracts and the practice of bilateral contract price negotiations between suppliers and buyers are continuing. These long-term contracts
are likely to have provisions on quantities of delivery over a span of time (one to three years or longer) with annual price review clauses.
2.2 Main sellers and buyers
Currently the international coal market is highly concentrated. The “Big
Four” (Anglo American, BHP Billiton, Rio Tinto and Xstrata) account for more than 50% of the international steam coal market, while BHP Billiton
alone has a 30% share in the international coking coal market. They hold
their main production bases in Australia, South Africa and Colombia. However, there are other coal mining companies in Indonesia (Banpu,
Adaro, KPC, Arutmin), South Africa (Sasol), Russia (Suek), Venezuela (Carbozulia) and China (China Coal, Shenhua) in the market. Also,
Peabody and other US coal mining companies as well as metal mining (Vale) companies have a presence in the market.
On the buyers’ side, the Japanese utilities in the Asia Pacific market have
considerable influence. Settlements between these companies and major producers in Australia and South Africa are important in the steam coal
market. Meanwhile, negotiations between BHP Billiton and Japanese steel
mills (Nippon Steel and JFE) are still critical in the coking market.
2.3 Spot Contracts
The concept of spot contracts is loosely defined in international coal trading. A spot contract can be a transaction of a single cargo, or part of a
cargo, or a series of cargoes. Some spot contracts are used by small suppliers or purchasers which are not in a position to build a
permanent relation, while other spot contracts are based on existing long-term relationship between sellers and buyers. Use of spot contracts has
increased because buyers (power producers), who are under pressure to
reduce costs, need flexibility in supply to match uncertainty in demand. It is also due to increases in the number of new suppliers and purchasers in
international coal trade, as demand for steam coal from power generation plants grows in developing countries as well as developed countries.
Today, there are a number of well-established spot prices under
standardized specifications at different locations.
The two main spot prices for coal exports are:
FOB spot price at Richards Bay, South Africa (serving as the basis for API4 indices representing South African steam coal
exports), FOB spot price at Newcastle, Australia (the basis for the
Newcastle indices), for Australian steam coal exports.
The prime one for importers is:
CIF spot price at ARA (Amsterdam-Rotterdam-Antwerp) in
Northwest Europe (the basis for API2 indices) Japanese import CIF spot prices are often a weighted average of
imported coal prices, based on the country’s customs statistics.
Media companies, called reporting agencies, make surveys in the market and publish spot prices regularly. They include Argus, IHSMcCloskey,
Platts and South African Coal Report (SACR)
2.4 Main Spot Price Indices
These are the key indexes used for international physical and derivatives coal business.
API 2 index
The industry standard reference price used to trade coal imported into
northwest Europe. The API 2 index is an average of the Argus CIF
Rotterdam assessment and McCloskey’s northwest European steam coal marker.
API 4 index
The price for all coal exported out of Richards Bay, South Africa. The API 4
index is calculated as an average of the Argus fob Richards Bay assessment and McCloskey’s fob Richards Bay marker.
globalCOAL NEWC Index
The price for exports of basis 6,000 NAR coal delivered FOB at Newcastle,
Australia. The NEWC Index is calculated based on a combination of bids and offers posted and transactions executed on the globalCoal platform. It
is the price benchmark for seaborne thermal coal in the Asia-Pacific
region.
API 5 index
The price for exports of 5,500 kcal/kg NAR, high-ash coal from Australia.
The index is calculated as an average of the Argus fob Newcastle 5,500 kcal/kg assessment and the equivalent from IHS McCloskey.
API 6 index
The API 6 index represents 6,000 kcal/kg NAR coal exported from Australia. The API 6 index is calculated as an average of the Argus fob
Newcastle 6,000 kcal/kg assessment and the equivalent from IHS McCloskey.
API 8 index
The API 8 index is the price for 5,500 kcal/kg NAR coal delivered to south
China. It is calculated as an average of the Argus 5,500 kcal/kg cfr south China price assessment, and the IHS McCloskey/Xinhua Infolink south
China marker
3. Asian Benchmarks
In Asia domestic prices differ from international prices in large markets like China and India. The result is that in Asia, unlike in the US, Africa and
Europe, pricing benchmarks are not consolidated. Physical buyers and suppliers are not in agreement on benchmark prices for everyone to
follow, although the situation is improving.
There are many different categories and qualities, even from different
source markets within the Asian region. For coal from Indonesia, for example, there are many grades of coal and pricing mechanisms . In
Indonesia, the government uses a basket of indices – including ICI-1, Platts-1, Newcastle Export Index and globalCOAL Index – to calculate a
price for the payment of taxes on exports and domestic sales by the country’s coal miners. ICI or the Indonesian Coal Index is published
weekly by Argus and Coalindo Energy and represents a weekly average spot FOB price of four grades of Indonesian coal (including 6,500, 5,800,
5,000, 4,200 kcal/kg “gross as received” (GAR), referring to the different
energy intensity of coal).
Things are even more complicated for the Chinese players. Once coal passes customs in China, the coal price follows the so-called
‘Qinhuangdao’ price, the main receiving port in the country. CFR South China prices have tracked a market need to agree on a benchmark to
consolidate the pricing mechanism. A precondition for the market agreeing on CFR South China as a benchmark would be a substantial rise in China’s
coal imports from overseas.
The Asian coal trading market is a promising market, however, how fast it
evolves in terms of derivative volumes will depend on a consolidated index emerging. China importing more coal will create opportunities to move to
a consolidated coal index. If China imports more coal from Indonesia, then the story will be different. Although it will take quite a long time for the
coal market to become consolidated.
3.1 A closer look at the relevant Asian Indices
The Asian indices – Indonesia Sub-Bituminous, API-5 and API-8 – are all
heavily influenced by wider Asian buying activity, especially API-8, which
is the index reflecting the price of delivered international coals into
southern China. As a result, these three indices are closely correlated.
Asian Coal Prices Movements April 2011 – May2013
Source: IHS McCloskey
The closer the product that the benchmark tracks is to that which
companies are buying/selling the more effective the risk mitigation, so the
better the hedge will be.
3.3 The API 8 Index
Currently the international Coal Trading market is focused on API-2.
However, API-8 is widely considered to be the most likely market to grow
over the next few years and could even challenge and overtake the API-2
market as the world’s most followed and important coal index.
Increasingly Chinese traders are trading physical contracts using API-8 as
a benchmark for imported coal deals. As more and more international coal
producers and trading houses base themselves in Asia and conduct their
business during Asian trading hours, indices such as API-8, API-5 and the
Indonesian Sub-Bituminous FOB marker are well positioned to become
more and more liquid and important.
Physical deals are now regularly done against API-8, both by traders,
buyers and producers, backed by regular bids and offers available via
Asian based brokerages.
While many of the Chinese state owned entities will struggle to get
permission to trade derivatives, many of the independent trading firms
and smaller power producers in China are expected to get involved,
mirroring what has happened with the iron ore market.
3.4 API-5- The New Spot Market For Australian Coal
What quickly became apparent during the development of the API-8 index
was that there was more than one market for exports out of Australia.
Something else was obviously going on other than the traditional
Newcastle 6,000kc NAR market.
China is a 5,500kc NAR market and Australia is a major exporter to the
country, so Australia is having a thriving 5,500kc NAR market. At the
time, this was largely all labelled as “off spec” and was not largely
recognized as a standalone market.
But as the development of the API-8 index progressed it became clear
that this ‘off spec’ market was rapidly becoming an increasingly important
market in its own right, and an active spot market at that. By the time
API-8 was ready to launch it was joined by API-5, its natural sibling.
To date, physical business is already being transacted against the API-5,
with some term deal being struck since early 2013.
Selling coal on a rolling spot basis to China is tough business for
producers. It is risky and hard to optimize production budgets, therefore
selling forward on term or quarterly review basis to China bears significant
default risk and limits upside when the market recovers.
For physical business, regular bids and offers are being reported by
international brokers for index related trades on API- 8 and also API-5.
The new matrix of Asian indices allows for traders to manage price risk on
API-5 and API-8 and fixed price with optionality on multi-origin 5,500kc
NAR sales into China. Producers can maximize tons whilst having the
choice to manage their asset book more effectively, including mark-to-
market pricing and relevant price discovery on forward curves for project
finance and modelling.
3.5 Indonesian Sub-bituminous FOB marker
Indonesia, the world’s largest exporter of steam coal, did not have a
clearly identified benchmark with wide market support three years ago.
The only option to hedge Indonesian coal risk was by linking deals to
Newcastle prices, exposing participants to significant basis risk. The
market is a very different one today.
The Indonesian Sub-Bituminous index is absolutely necessary as it
provides much needed transparency for the most important seaborne traded product that is widely consumed in the largest Asian markets
including China, India, South Korea and Taiwan.
3.6 Correlation between Indices
Price movements of coal prices in the Asia Pacific region are largely
correlated when trading sub-6,000kc NAR grades, but they in turn show
very little correlation with the older API-4 and Newcastle 6,000kc NAR
markets.
Using prices based on Australia’s Newcastle higher CV indices are not
always that useful, especially as Newcastle is primarily focused towards
the Japanese market. The grade of coal traded against it is designed to
match that which is most relevant to Japanese power buyers.
4. Coal Trading and Derivative Instruments
4.1 Physical vs. Financial Coal Trading
Coal Trading allows counterparties to identify and manage price risk. This
ultimately assists in the projection of cash flows and the establishment of future cost estimates. Due to standardized trading contracts and very
limited force majeure provisions, trading is frequently used to ensure a reliable supply of coal. Standard language in the form of a Master Coal
Purchase and Sales Agreement (developed by the CTA) generally shortens the legal review of terms and conditions for a given transaction. Lastly,
trading by its very nature, seeks to increase price transparency and coal generally supports reasonable market prices up to 36 months forward.
The 36 month term window for transactions appears quite adequate, as
the coal market has been moving towards shorter duration fixed price contracts.
Financial coal trading developed as a result of buyers and sellers seeking
to reduce price exposure. Historically, producers and utilities used traditional strategies like managing spot inventories vs. physical term
contracts, participation in various supply basins, and expanding transportation alternatives to limit this exposure. Although reasonably
effective in mitigating some risks, the issue of market price fluctuation remained. Particularly since 2003 the coal prices started to increase very
fast to reach record levels by 2008. As a result, a short-list of producers, marketers, and end-users embarked on a strategy to manage price risk
through OTC (Over-the-Counter) trading. OTC contracts are bilateral contracts where two parties come to terms about how a specific
agreement is to be settled in the future.
4.2 The Different Coal Derivative Instruments
The financial price risk management instruments like forwards, futures, swaps and options are referred to as derivatives. A derivatives is any
financial instrument which price is dependent upon or derived from one
(Coal) or more underlying assets ( for instance the Dark Spread; combination of electricity and coal). The derivative itself is merely a
contract between two or more parties and its value is determined by fluctuations in the underlying asset.
Since the late 1990s the coal derivatives trading market has come a long
way. Similar like for many other commodities, the coal industry has seen a development of electronic trading and financial derivatives. The
traditional physical players, the electricity utilities and coal mining companies were joined by banks and financial traders who participate in
“financial” or “paper” coal markets.
This has changed the way coal is traded and priced. While there exist the
distinctive Atlantic and Pacific markets in terms of physical trade flows,
the difference between the two markets is disappearing quickly as far as
pricing is concerned.
Around the year 2000, the coal derivatives trading (slowly) kicked off with
OTC traded Swap contracts based on newly created benchmarks like the API 2 and API 4. Later to be followed by coal futures contracts traded on
exchanges like ICE Futures , EEX and CME-Nymex.
4.2.1 Coal Swaps
Swap contracts, often also referred to as Fixed-for-Floating- are purely financial contracts that could be tailor made to the requirements of the
buyers and sellers to manage (hedge) their price risk in parallel to their physical business.
4.2.3 Futures
Futures contracts look quite similar to Swaps as most of these are also
cash settled against a published price index like API2, 4 and 8. The main
difference is that futures are traded on an exchange and that all the contract specifications ( volume, expiry date, quality etc.) are
standardized and that only the price is negotiated on the exchange platform. Futures are cleared by a Central Counterparty so that no players
would have to worry about the credit standing of their counterparties as well about the contract performance risk.
Please note that also most OTC traded contracts could be offered for clearing by for instance SGX in Singapore or CME Clear in the US.
A well-functioning futures market should be liquid, meaning that there are
sufficient buyers and sellers to absorb new orders coming in without moving the price or only with a very small fraction. To facilitate a liquid
market so that producers and consumers can freely buy and sell contracts, speculator participation is encouraged. The role of the
speculator is to provide liquidity to the market. The speculator does this by both buying and selling in the market. The speculator’s
objective is to make a profit from taking on the risk of price fluctuation
that commercial users do not want.
Today’s coal futures markets have not yet reached the same stage of maturity as for instance oil futures markets. The current coal trading
is still in transition from one based on spot markets to one driven by genuine futures markets.
Following the CME-NYMEX, a number of coal futures markets have been
established. They include Intercontinental Exchange (ICE) based in London, Germany’s European Energy Exchange (EEX).
4.3 Role brokers
Brokers play a critical role in the OTC market. Brokers bring buyers and
sellers together for the purpose of transacting business in various
markets. Some OTC coal brokers publish daily price reports, in addition to several publications that distribute daily prices. This information helps to
provide ample price transparency in the market. The use of a broker provides anonymity for counterparties until a transaction is concluded.
After seeking out the best bid and offer in a particular market, the broker attempts to match approved credit counterparties. Once a transaction is
completed with an OTC broker, all OTC transactions are subject to final credit approval of the counterparties. Only after the completion of this
process are counterparties contractually bound to do a deal. Alternatively the trades could be offered to a clearing institution.
5. Asian Coal Market and Derivatives Uptake
Although the Asian physical market has shifted dramatically, the bulk of
paper or financial trading is still happening in the Atlantic basin. Coal trading in the Asian region is still limited to a small number of
participants. However, financial coal trading also seems unlikely to happen soon as only one of the key drivers of such a change is in place. That is
the availability of price indexes, but the one that counts as far as expanding coal derivatives trading is concerned is the API8. This index is
still relatively new and therefore yet to gain widespread acceptance in the market.
In Europe there is a deep, liquid Coal Swap market mainly due to deregulation on the consumer side, resulting in a great deal of power in
the hands of power producer consumers of thermal coal. Europe’s fully deregulated players face price risk every day and therefor are in need for
a deep Coal Swap market.
Europe imports 100 million tones and trades 1.5 billion tons of thermal coal contracts. In other words, on the Swap market 15 times as much
volumes are traded than on the physical market ( called the “Churn rate”). In Europe mainly API 2 Swaps are traded. The API 2 index refers to a
reference price for trade in coal imported into northwest Europe. Over
90% of the world’s traded coal derivatives use API 2 and API 4 as benchmarks for price settlement. In the graph below this is shown for the
Nymex coal futures based on different indices
NYMEX Coal Futures End-of-Month Open Interest
What's missing in Asia is a deeper pool of participants in coal trading, a
commitment from producers and buyers to support the market and appropriate government regulations. Currently Asian utilities tend not to
hedge much in the financial market, partly because of long-held practices
and because in some countries regulations don't allow this.
In Asia the power industry is heavily regulated, which limits the need for hedging against rises in the cost of inputs such as thermal coal. In Japan,
utilities do not hedge as they can pass on the coal price increases to the end consumers as electricity prices are based on cost-plus pricing.
Physical players currently do not use sufficient derivative tools to manage price risk: if the price is low enough, utility companies will buy coal but
this does not mean that they are willing to secure long-term flows from coal exporting countries.
What is experienced now, is that the dynamics are changing. China is a
larger importer of thermal coal than Japan. China is expected importing more coal – from Mongolia, Russia, Indonesia and Australia – to help
change the physical trading pattern.
The Asian market is not like the US or Europe, which are quite integrated
in terms of regions and pricing mechanism on coal. The basis risk in Asia could be high sometimes. That is the risk of imperfect hedging using
futures contracts or a lack of convergence between spot and futures prices on the expiration date of the swap. The basis risk hedgers run could be as
significant as price risk on the physical deal, leading to a reluctance for players, especially traders, to hedge. One consequence is that investors
are keener to put money into physical assets – such as by buying existing mines – rather than heavily relying on risk management through paper.
The many grades of coal and pricing mechanisms like for instance in Indonesia creates a problem in terms of liquidity in the swaps market.
Governments need to make an effort to work together to find a mechanism in terms of benchmark prices. If the Indonesian government
and coal exporters can agree to use a single and hedgeable index, then it will be better for the growth of the coal derivatives markets in Asia but
there is a long way to go.
Until then, liquidity in the swaps market is divided into several benchmark
prices, including Newcastle, Richards Bay, Indonesian sub-bituminous and the newly set up CFR South China coal.
In addition to the API 2 and API 4 indices (which are calculated daily),
Argus calculates API 5 (5,500 kcal/kg NAR or “net as received” FOB from Newcastle), API 6 (6,000 kcal/kg NAR FOB from Newcastle) and API 8
indices (5,500 kcal/kg NAR coal delivered to south China) on a weekly and monthly basis.
Along with API 2 and API 4, the benchmark on 6,000 calorific value
Newcastle is one of the most liquid swap markets currently, but during certain specific periods, low calorific coal – less than 4,000 kcal/kg – is
more traded and these coal prices could be very different from 6,000
calorific value which creates some difficulties for physical players.
Divergence from 6,000 calorific value can result in a “hedge ratio” that is very different from the price seen in the market leading to complexity in
the swap market. Because of this, some investors don’t want to hedge.
Hedging for Chines players is practically impossible, as once coal passes
customs in China, the coal price follows the Qinhuangdao price. Resulting in prices being fixed on the physical side rather than through the use of
derivative contracts, limiting growth in the derivatives market.
Expectation in the market is to see pricing benchmarks consolidate in Asia, around an import price (such as CFR South China) and an export
price (like Newcastle).
Also, benchmarks including ( CIF basis) and excluding ( FOB basis) freight
costs – such as API 2 and API 4 – “create arbitrage in freight markets, allowing that market to be heavily swapped. Low coal prices have also
dampened infrastructure spending. Coal producing countries like Mongolia “don’t have the physical infrastructure to arbitrage” – which would require
being able to switch between sending coal to export markets overseas or by road to China. Further, Mongolia mainly produces coking coal, used by
steel mill operators.
Indonesia too faces infrastructure challenges in Sumatra, the location of
high calorific value coal in Indonesia, now that much of the higher calorific value coal in Kalimantan has been exported. In view of the low price of
coal, infrastructure development is not going to happen soon.
Attempts to launch a deliverable futures contract in Asia have failed, with an executive from one major regional exchange complaining off the record
that big coal miners and trading houses all agreed in principle to support a contract, but when it came to actually providing volumes, nobody showed
up. Meaning it is a long way off before that coal trading will take off in Asia. What it will take is changes to government regulations to allow
buyers to actively trade and hedge.
6. Lessons from Coking Coal and Iron Ore Market
Coking [or metallurgical] coal and thermal coal are completely different markets. Coking coal and iron ore swap markets are similar but have
different players. Although the steel mill consumers of iron ore and coking coal are the same, suppliers are different.
In 2013, cleared iron ore swaps on the SGX have seen record volumes
every month because the main suppliers in the market, such as BHP Billiton, Rio Tinto and Vale are promoting that. In contrast, the coking coal
market is still emerging and will take time.
The iron ore market is less fragmented – everybody uses the China price
as a benchmark and works backwards from there. There has not been a lot of development in the Asian coal derivatives market over the past
year. Not a boom like iron ore. Iron ore derivatives are growing quickly off a low base. Although the market is still immature with swaps accounting
for 30% of physical.
Neither iron ore nor coking or thermal coal derivative markets compare to oil derivatives market, which benefits from well-developed benchmarks
and a standardized product.
Financing is more critical in the thermal coal market compared to the oil
markets, which are populated by major players, able to operate across the supply chain, both upstream and downstream. There are a lot of small
players in Indonesia’s coal industry, for example, for whom it is not easy to get financing – highlighting the need for more efficient pricing
mechanisms.
Annex I Coal Facts
Coal is a safe, reliable, easily stored and readily available source of
energy. Coal is produced in over 50 countries, consumed in over 70
countries and traded globally. Coal is found in many different forms.
Whereas each type has a different use. Coal is being used in power
generation, the manufacturing of cement, iron and steel. Coking coal is
used to produce coke, which in turn is used to produce pig iron. Coal used
for energy generating is declining due to an increase in the use of natural
gas and nuclear power. Coal is a low‐cost fossil fuel used primarily for
electric power generation. There are three parties active on the coal
market:
1. Mining companies who extract the coal
2. Utilities who use the coals for generating energy
3. Industrial companies who use to create their products.
Types of coal
Coal is classified into four general categories, or “ranks,” based on carbon content. Carbon is the source of coal’s heating value, but other factors also
influence the amount of coal’s energy per unit of weight. The amount of energy in coal is expressed in British thermal units (“BTU”) per pound. A
BTU is the amount of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
The four ranks of coal include:
1. Lignite, 2. Sub‐bituminous,
3. Bituminous 4. Anthracite
Lignite is geologically young coal that has the lowest carbon content
(approximately 25% to 35%), and consequently the lowest energy content,
of the four ranks of coal. Lignite has a heat value ranging between 4,000 and 8,300 BTUs‐per‐pound. Sometimes called brown coal, lignite is mainly
used for electric power generation primarily in power plants close in proximity to the source.
Sub‐bituminous coal contains about 35% to 45% carbon and has a heat
value between 8,300 and 13,000 BTUs‐per‐pound. Approximately half of the
coal produced within North America is sub‐bituminous. Although the heat
value of sub‐bituminous coal is lower than bituminous, it tends to be lower
in sulfur content and cleaner burning.
Bituminous, or black coal, is the most abundant type of coal. Bituminous
contains approximately 45% to 86% carbon and has a heat value between 10,500 and 15,500 BTUs‐per‐pound. Bituminous has little water content or
other impurities except for sulfur, and is easily ignited.
Anthracite coal contains approximately 92% to 98% carbon and has a
heat value of nearly 15,000 BTUs‐per‐pound. Anthracite has a heat value
greater than that of Bituminous, but is hard to light, scarcer and more expensive.
Coal Market Pricing
As there are different types of coal on the market, different benchmarks
has evolved for the price of the different types of coal. These prices form a
basis for the futures contracts traded on the exchanges across the world.
The price of coal will be influenced by the price of other fuels. When other
fuels have a more attractive price the demand for coal will drop and when
other fuel prices rise, coal becomes more attractive.
Coal Supply
The supply of coal can be affected by a number of factors. First of all
supply will be affected by the freighting costs. Because a large portion of
coal is traded internationally, the transport costs will play a more prominent role in the price of coal. Mining issues can affect the supply of
coal in multiple ways. First of all the actual mining of coal can be disrupted by issues like extreme weather conditions floodings and strikes.
Furthermore the production costs will affect the supply. When the coal must be mined from deep within a mine the cost of extracting coal will
increase and thus it may become less or even (un)attractive to extract this coal.
Coal Demand
There are multiple factors that influence the demand for coal and thereby
the price of this commodity. The electricity industry is an important factor in the demand for coal. As electricity producers are one of the largest
users of coal, an increasing demand for electricity will have a major impact on the demand for coal. Increasing economic activity will also likely
result in an increasing demand for steel. Because the production of steel requires coal, the demand for coal will increase accordingly.
Annex II Coal Trading Strategies
The 3 main trading strategies in the coal business are:
1. Hedging
2. Arbitration
3. Speculation
Hedging
Hedging is an insurance method for commodity traders, producers and end-users to cover themselves against negative price movements.
Hedging is not used to realize profits but to prevent or at least minimize possible losses. Market participants obtain a derivatives position to cover
themselves against price movements. The derivative position will be offset or cash settled. The physical coal will then be sold on the cash market and
the profit or loss made from the derivatives position will be added to the final cash price. The possible profit or loss made on the physical
transaction will be offset by the profit or loss made by the derivatives contract. So the final outcome is that by using derivatives as a hedging
instrument, the hedger can already lock in its profit margin or net purchasing price way before the actual coal will be sold or bought.
When hedging a price risk different problems may arise. The first one may
occur when no corresponding futures market does exist. This can be
resolved by implementing a so-called ‘Cross hedge’. This type of hedge is executed by obtaining a derivative on a related market, where the prices
are correlated to the non-futures market. A second problem can occur when the maturity dates of a futures contract and the actual delivery date
for a commodity do not match. A so-called Delta hedge should be implemented, which will use the futures maturity date closest to the
physical delivery date. In this way the cash flow risk will be managed. When planning to hedge a commodity it is important to calculate what
portion of the total exposure will be hedged. The percentage of the investment which is protected by the hedging activities is called the
‘Hedge ratio’. In reality a perfect hedge ratio will not be achieved. The first reason could be that the hedger decides not to hedge the entire
investment, because the costs of a complete hedge are too high looking at the level of risk involved. Another reason can be the mismatch between
the overall volume the hedger is exposed to and the standardized quantity
of a futures contract. A standardized futures contract may not exactly match the amount of products that need to be hedged. This can result in
either under or over hedging a price risk.
Hedging Strategies for a Producer
The main objectives for a seller (a coal producer) and a buyer (a power
utility) to hedge its coal exposure, are:
1. A Coal Producer wants to hedge its future coal price against
production cost. To achieve this the producer will use a forward
curve to assess and hedge the financial risks.
2. An Electricity Generator wants to secure a stable revenue rather
than being exposed to uncertain volatility. The producer will lock in
the revenue upfront by buying into the forward curve.
Hedging and Trading Strategies for Traders and Banks
Traders and banks who are active in coal trading have a much wider
choice of available strategies as the pure hedgers, like the
abovementioned coal and electricity producers.
Traders and banks are willing to take risks or do proprietary trading,
e.g. trade for their own account and risk. They can go long or short
or do arbitrage.
They want to add value to the chain by Price Risk Management.
They can buy floating, sell fixed or vice versa (Coal Swaps)
A bank is financing end users and producers. The bank will hedge
price to limit the risk on loans
Arbitrage and Speculation
Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset like coal ,in order to profit
from small price differentials. Arbitrage is not limited to identical instruments; arbitrageurs can also take advantage of predictable
relationships between similar financial instruments, such as coal futures and the underlying price of physical coal.
Since arbitrage involves the simultaneous buying and selling of an asset, it
essentially is a type of hedge and involves limited risk, if executed properly. Arbitrageurs typically enter large positions since they are
attempting to profit from very small differences in price.
Speculation, on the other hand, is a type of financial strategy that involves
a significant amount of risk. Speculators have a view on the direction of the market and take position on that. So speculators attempt to profit
from rising and falling prices.
A trader, for example, may open a long (buy) position in a coal futures
contract with the expectation of profiting from rising prices. If the value of the coal index rises, the trader may close the trade for a profit.
Conversely, if the value of the index falls, the trade might be closed for a
loss.
Speculators may also attempt to profit from a falling market by ‘Shorting’ (selling short, or simply "selling") the instrument. If prices drop, the
position will be profitable. If prices rise, however, the trade may be closed at a loss.
Arbitrage Example
Assume that your analysis tells you that the API #2 will trade at a US$1
premium to API #4 over 2013 and for the two benchmarks to trade at
parity in 2014.
Assume that currently the Cal13 contracts is trading at US$112.89 (API
#2) versus US$109.53 (API #4) and the Cal14 contracts are even further
apart at US$117.50 (API #2) versus US$112.18 (API #4).
The spread between API #2 and API #4 is expected to narrow structurally,
as South African coal increasingly sells to India and China. This is not a
sudden shift but rather the continuation of an ongoing trend, as the idea
of implied freight between API #2 and API #4 becomes a misnomer – the
two contracts no longer represent the same coal having been sold FOB
Richards Bay and bought DES ARA because European coal is increasingly
from sources other than South Africa, namely Russia, Colombia and the
USA.
Given this US$5.32 premium for API #2 on the Cal14 contract and your
views on how the trade relationship between South African and European
coal will continue to evolve, you should:
Buy the Cal14 API #4 contract and sell the Cal14 API #2 contract
to take advantage of these prices moving closer together over
time- both as a result of the shifting trade patterns and from utilities
rolling their hedges further down the curve.
Annex III Coal Derivatives, Volatility and Hedging
Over the last several years, like many other commodities, coal trading has
undergone a major transition with the development of electronic trading
and financial derivatives. Banks and financial traders participate in
“financial” or “paper” coal markets, in addition to physical buyers
(electricity utilities) and sellers (coal mining companies), and trading
volumes in these markets have been increasing.
The coal sector has seen a thriving OTC swap market since the late 1990s, before exchange traded futures markets came into existence.
Derivatives
A derivative is a financial instrument of which the price is dependent upon
or derived from one or more underlying assets, like coal. The derivative itself is merely a contract between two or more parties and its value is
determined by fluctuations in the underlying asset.
OTC contracts
Over-the-counter (OTC) contracts are bilateral contracts where two parties come to terms about how a specific agreement is to be settled in
the future. Several OTC contracts could be offered for clearing by a Central Counterparty, similar like futures.
Coal Swaps
A swap is an agreement between two parties to exchange cash flows on a
determined date or in many cases multiple dates. The most common type
of Swap is a so-called ‘fixed for floating. Typically, one party agrees to pay a fixed rate while the other party pays a floating rate. For example, when
trading coal a utility as an end user of coal agrees to pay a fixed price for a pre-determined quantity of coal. The other party, a bank, agrees to pay
the coal spot price index. Thus the utility has locked in the price it will have to pay for procuring its coal. A rise in the coal price is paid by the
bank. If the price falls, the difference between the fixed and floating index price will be paid by utility to the bank. As a Swap is traded OTC,
conditions and specifications of a swap can be tailor-made through negotiation between the two counterparties. For examples see Annex IV
Coal futures
A futures contract is a standardized contract to buy or sell coal of standardized quality at a certain date in the future and at a market-
determined price (the futures price). The contracts are traded on an organized futures exchange. Thanks to the standardization of futures
commodities can easily be traded. This in contrast to e OTC contracts that are specifically tailored to the needs of the parties involved.
Coal futures markets allow commercial producers and commercial
consumers to offset or hedge the risk of adverse future price movements in the coal they are selling or buying. To facilitate a liquid market so that
producers and consumers can buy and sell contracts at any time they
want, speculator participation is encouraged. The role of the speculator is to provide liquidity to the market. The speculator does this by both buying
and selling in the market. The speculator’s objective is to make a profit from taking on the risk of price fluctuation that commercial users do not
want.
Volatility and hedging
Volatility is mainly caused by factors that impact supply and demand. Although market participants attempt to predict future market
developments, there is no guarantee when dealing with the unknown. Factors such as colder winters, warmer summers, changes in
environmental laws, alternative fossil fuel markets (Natural gas/Oil prices), technological innovations, natural disasters, labor issues, and
equipment failures all impact the volatility of the coal price.
Increasing volatility creates fear on the part of natural longs (producers) and natural shorts (utilities) that prices will rapidly fall or rise. In addition,
volatility attracts speculators seeking profits from managing the risks
associated with high volatility. In periods of high volatility, it is extremely helpful for “naturals”
(producers and end-users) to employ financial hedges along with physical hedges. For example, utilities may use financial markets to provide an
additional avenue to hedge exposure if producers are unwilling to price at market or if they are unwilling to sell when utilities determine that they
need to hedge some of their volume requirements.
Even limited hedging activities of 10 - 20% of firm purchases assist in creating predictable cash flows and earnings. The use of both physical
term contracts and forward financial markets to fix pricing can significantly reduce exposure to price volatility. The decision of whether to
purchase prompt month (spot), quarter ahead, or balance of the year are choices available to a counterparty to better manage any remaining un-
hedged position.
Contract Performance
Physical performance issues are generally more prevalent in the physical than in the financial coal markets. In recent years, the coal market has
experienced a high number of producer non-performance and bankruptcies issues. This fact strongly favors using the derivatives
market, where counterparties have a higher credit rating and the coal transacted is non-source-specific. Generic, non-specific sourcing,
eliminates force majeure risks and therefore creates fewer non-performance issues in the OTC market place. Although some
counterparties choose to favor producer direct bilateral transactions over use of the derivatives market, direct transactions have force majeure
clauses that significantly increase the potential of non-performance. The
standard derivatives contract does not contain a force majeure clause; therefore, a derivatives contract provides a higher value relative to a
traditional bilateral purchasing contract with a supplier.
Contract Valuation
In evaluating a portfolio of physical bilateral coal contracts against futures or swaps, the analysis often falls short of recognizing a few less apparent
factors such as the following:
1. Failure to take into account any value in quality differences; 2. The comparison may have a mismatch in timing between market
prices and contract prices; 3. Analysis does not attribute a value for difference in counterparty
credit/performance risk; 4. If the futures or swaps contracts carry a price premium to physical
bilateral purchased coal, then the premium would be re-captured when the futures/swap is sold (hedge unwound) and the physical
coal is purchased – assuming the premium is held constant.
Annex IV Basis Risk
What is Basis Risk
The term “basis risk” is often used to describe the risk that the value of
the physical coal being hedged may not change in tandem with the value
of the derivative contract used to hedge the price risk. With a perfect
hedge, the hedge would match the underlying position in every respect,
removing any change of basis risk. However, in reality, basis risk is a high
concern, even if the derivatives contract is for the exact same commodity
being hedged. More specifically, in the futures markets, basis is defined as
the differential between the cash price of coal and the price of the nearest
futures contract. Hence, basis risk when hedging using futures contracts
refers to the risk of the differential changing over the life of the hedge.
So, the basis can play an important role in determining a hedging strategy
and can help predict a final price for a commodity when using a hedge.
The following three basis risks occur frequently in hedging:
1. Product basis risk, 2. Time basis risk,
3. Locational basis risk.
Ad 1: Product basis risk occurs when there is a mismatch in the quality,
consistency, weight, or underlying product.
Ad 2: Time basis risk occurs when there is a mismatch in the time of the
hedge. For example, if a hedger wishes to hedge long-term but only has
short dated contracts available, time basis risk is very significant.
Ad3: Locational basis risk, one of the most common types of basis risk,
occurs when there is a mismatch in the price of the product from one
location to another, a mismatch in the delivery point for the derivatives
contract, among others.
Basis Risk Coal Asia
Basis risk indicates the level of risk a counterparty takes on in relation to
the correlation of the markets being tracked with the underlying product
he is trying to hedge. For example, hedging delivered 5,500kc NAR
imports against API-8 has little basis risk. Using API-5 also has little basis
risk, but is exposed to more freight price volatility. However, hedging
against Newcastle can be more risky as it is heavily influenced by what is
happening in the Japanese market, rather than the Chinese market.
The fact that coal is not uniform does not prevent buyers and sellers from
using derivatives as a hedge tool because the hedge position can be reversed rather than consumed. There may be a small amount of basis
risk compared to actual coal quality purchased for consumption.
Annex V How a Coal Swap contract works
Prerequisites to enter the Coal Swap Market
Before you could start trading Swaps in the market you will have to find counterparties that are willing to trade with you and the following issues
need to be addressed first:
Know your Customer (KYC) Process : Exchanging of companies profiles, financial reports, business license….
Sign an ISDA Agreement: International Swap and Derivatives Agreement
Credit lines establishment :Tenors, good names, bad names for swap or physical
Probably opening a Clearing Account for OTC Clearing: CME, ICE, SGX….
Example with API 8 Swaps
A sells B 5,000mt API8 swap Q4-13 at $83.00
The transaction will consist of 2 legs :
First leg: A sells to B
5,000mt at $83.00/mt CFR S.China for Q4-13 delivery ( the “fixed” price)
Second leg; B sells to A :
5,000mt at average of Oct, Nov, Dec-13 of API8 ( the “floating” price)
Hedging with Coal Swaps; a Case Study
A power utility plans to purchase 100,000mt of 5500 NAR coal, to be
delivered in December 2012.
Assuem it is now September 2012 and API8 swap price looks favorable for
the utility to fix at current trading levels.
Is it possible to fix price today without having any physical cargo
transaction yet?
Solution
Buy December 12 API 8 swap contract in September 12 for 100,000mt, at
$85.00/mt
In November 12 the utility manages to buy physical 100,000mt of 5500
NAR coal at $89.00/mt
At the same time of buying physical coal, utility liquidates API8 swap
contract at $89.50/mt.
Accounting for transactions
Net Result:
Physical buying price : US$89.00
Swap profit/loss : US$ 4.5/mt profit which can be used to subsidize the
higher physical price in November.
Annex VI Contract specifications “ICE API 8 Futures”
Trading Hours
01:00 – 23:00 London time
Trading model
Continuous trading throughout trading hours
Unit of trading
1 lot of ICE API 8 South China Coal Futures .Traded in multiples of 1 lot
Contract size
1,000 tonnes
Quotation
Dollars per tonne
Minimum price fluctuation
$0.05 per tonne
Maximum daily price fluctuation
No limits.
Daily margin
All open contracts are marked-to-market daily
Trading period
Up to 72 consecutive months Up to 24 consecutive quarters
Up to 6 consecutive years
Position limits
Positions are reported to the Exchange on a daily basis. The Exchange
has powers to prevent the development of excessive positions or
unwarranted speculation or any other undesirable situation and may take steps to resolve such situations including the ability to mandate
members to limit the size of such positions or to reduce positions where appropriate.
Cessation of trading
The month contracts cease trading at the close of business on the last
Friday of the contract delivery period. The quarters and calendar years cease trading as a quarter/calendar year at the close of business on the
last Friday of the first month contract in that quarter/calendar year.
Delivery/Settlement
The ICE South China Coal Contract is cash-settled at an amount equal to
the monthly average API 8 Index as published in Argus/McCloskey's Coal Price Index Report. The cash-settlement price will be to 2 decimal
places, i.e. $0.01.