The Basics
An art or a science?
Introduction
Forecasting the price of coal has always been more of an art than science. In recent years, there have been so many new supply, demand and volatility drivers thrown into the equation that ‘forecasting’ has become synonymous with 'guessing.’
• Liberalized power markets have created unpredictable electricity demand fluctuations.
• Compliance with NOx regulations in states east of the Mississippi has thrown a wrench into the classic dispatch model.
• Natural gas prices have ventured into uncharted territory.
• Generators have reduced the size of their working inventories.
• After decades of productivity gains, coal miners are faced with stubbornly increasing costs and the gradual depletion of their premium reserves.
• Coal’s possible role as the feedstock for a future hydrogen-based economy has huge implications.
• Potential legislation on mercury and/or greenhouse gas emissions add yet another layer of uncertainty.
Combine these factors with the familiar unknowns – weather, force majeure and transportation glitches – and we have a commodity that continually confounds the experts. This uncertainty has tremendously magnified the risk profiles of coal producers and coal consumers. At the same time, investors and creditors are demanding stable and predictable operating results.
To provide market participants with a higher degree of control over their businesses, an over-the-counter (OTC) and futures market in coal have developed, providing a wide array of trading tools designed to manage risk.
Background
For trading to occur, there must be companies on both sides of the fence who want to reduce price risk. In the past, coal producers hoped for higher prices and experienced pain when the market gave them low prices. Conversely, coalconsuming utilities hoped for lower prices. However, when the market gave the utilities high prices, they felt little pain because they were permitted to recapture the price hike by raising their electricity rates. Since it takes ‘two to tango’, coal trading never developed.
Traditional risk management strategies were renditions of the old adage: don’t put all your eggs in one basket.
Strategies used by many producers included expanding into various regions (Central App, Northern App, Illinois Basin, PRB, Colo./Utah, international), diversifying sales (domestic and export), diversifying accounts (utilities, industrials, metallurgical) and diversifying spot/term. Strategies used by utilities included diversifying supply regions, diversifying the number of suppliers, diversifying transportation providers (if possible) and varying the length of contracts. While these strategies mitigated some types of risk, price risk remained mostly unchecked.
In the 1990s, three events contributed to the partial de-coupling of the price of coal from the price of electricity:
1) Deregulation of our nation’s wholesale electricity and transmission markets.
2) Deregulation of the retail electricity market by many states.
3) The sale and/or transfer of many coal-fueled power plants to independent energy merchants and/or to the unregulated subsidiaries of utilities.
Price Volatility
This de-coupling of the price was not enough of a reason, however, for coal trading to develop. Price volatility also had to be present. In recent years, coal has shown the propensity to rise and fall dramatically. Price volatility does three things. First, it makes the natural longs (producers) fearful that the price will drop.
Second, it makes the natural shorts (consumers) fearful that the price will increase. Third, it attracts speculators, who want to profit by taking on risk, providing two-way markets and marketing risk management products to the shorts and longs.
What causes price volatility? The inability to predict the outside forces that impact supply and demand: hot summers, cold winters, nuclear utilization rates, rainfall, mine disasters, transportation congestion, environmental regulations, bankruptcies, consolidation, price of natural gas, price of petcoke, price of synfuel, price of emissions allowances, security of Colombian coal supply, mining regulations, electricity curves, reserve depletion, new technologies, labor disruptions, stockpile management, political climate, bonding costs, etc.
Brokers
OTC brokers play an essential role in coal trading. They bring buyers and sellers together by continually searching for the highest bid and the lowest offer. In effect, they conduct a non-stop auction. The names behind the bids and offers are always anonymous until the two parties are matched up. The broker knows, in advance, each company’s approved credit list. Each party pays the broker a few cents per ton for each trade executed. Brokers never take positions and are always unbiased market participants. Brokers are typically well-versed in risk management techniques and can assist market participants tremendously in understanding trading nuances.
Standardized Contracts
Liquidity can only occur after the market participants agree on standardized contract language. Each product traded OTC or on the futures exchange has pre-established specifications, terms and conditions. This enables the buyers/sellers to execute a trade within seconds. This also allows the buyers/sellers to reverse their positions with ease. There are standardized contracts for PRB (8800 Btu and 8400 Btu), CSX (12,500 Btu, 1% Sulfur, 12,500 Btu, 1.2# SO2) and the Nymex look-alike (12,000 Btu, 1% Sulfur, Big Sandy River). There are also proposed contracts for Northern Appalachian qualities.
Even if the standardized product is not exactly what a consumer/producer uses/produces, it is usually close enough to be used as a hedge. Often non-standardized products are traded OTC. This will usually result in the best price for the buyer/seller although, due to the non-standard nature (quality, volume or location differentials), the product is unlikely to be re-traded in the market.
Trading Instruments
Forward and spot contracts in all of the major products are traded in the OTC market. There is a quoted market for put and call options, as well as a market for basis trades (differences in time, quality and/or product). On the New York Mercantile Exchange’s Clearport Trading System, only the ‘Capp’ contract is traded. Capp stands for ‘Central Appalachian’ and represents a 12,000 Btu, 1% Sulfur coal loaded in the barge on the Big Sandy River.
Benefits of Trading
First and foremost, trading provides the market with the ability to precisely measure and manage price risk with the overall objective of predictable cash flow and stable earnings. Trading increases price transparency tremendously by providing curves that go out two – four years. Trading can reduce weeks and weeks of contract negotiations to a oneminute transaction. Trading provides participants with the ability to easily reverse a position. Trading requires several departments in the company (treasury, legal, procurement, sales, operations, production, and risk management) to focus on the measurement and management of price risk.
Prognosis for Coal Trading
The credit crisis suffered by the energy market in 2001 and 2002 resulted in the exit of many energy marketers that had been providing speculative liquidity to the coal trading arena. While their absence has slowed the development of coal trading, it has also brought many companies with natural short and long positions into the market to provide liquidity. Nymex’s Clearport has enabled OTC brokers to offer clearing services to companies whose credit does not meet the stringent criteria of the major OTC players. Speculators are now returning to the coal market and are finding a much greater number of companies with natural positions who are using the OTC and futures markets to reduce price risk. Financial institutions will add yet another level of liquidity as price indexes spur the development of a financially settled swap market.