# Solid growth expected for Asian coal markets

## Robust stock levels

The La Niña1 weather pattern has been wreaking havoc across Asia-Pacific since August last year, most notably in Australia, causing severe flooding in Queensland from November. Extreme weather has also affected Indonesia and Colombia and La Niña has been held responsible for floods as far afield as South Africa.

The flooding thus impacted production and transportation in four of the top five global coal exporters, between them responsible for around 625 million tonnes of exported coal a year. Australia, the world's largest coal exporter, scything out some 260 million tonnes a year for export, was estimated to have lost upwards of 4 million tonnes of production by the end of January. Analysts estimate that Indonesia, the second largest global coal exporter at 230 million tonnes a year, was hit by a 15% drop in production last year.

Spot prices for coking coal threatened to break the $400/tonne barrier in January, while Australia's Newcastle port's thermal coal spot price steadily rose from$96/tonne in August 2010 before peaking at around $138/tonne in January. This compared to an average of$103/tonne in January last year and $85/tonne at the same period in 2009. However, despite fears that another weather event would push the market over the edge, such a disaster has yet to materialise and the Newcastle price ebbed close to$120/tonne by mid-February. This was a markedly different reaction to that seen in the aftermath of the Queensland flooding in 2008, when Newcastle spot prices scorched up to $141/tonne in January of that year, increasing by over$40/tonne in less than a month and eventually peaking at almost \$200/tonne by July.

Analysts have been quick to point out that the current price falls are more a result of a drop in demand rather than a recovery in supply (Australian production alone is not expected to fully recover until June at least). Yet, this in itself is a promising sign of a maturing market that now trusts the producers' powers of recovery, avoiding the pitfalls of panic buying.

"I think we've already had the market bump. There's potential for more weather problems in Australia but my guess is it will slowly sink back to normal now," says David Price, director for coal at market intelligence firm IHS Cera. "In 2008 when it happened, Australia was back at 80-90% of production within two months. Not long after that, they were going well above normal export levels. They do have the capacity to ramp up.

Although coal is being gradually superseded by natural gas as the power generation fuel in Europe and the US, it remains very much at the forefront of the striding progress of Asia's emerging markets. The US Energy Information Administration forecasts that Asia's emerging markets will increase their total coal consumption by 87% from 2007 to 2035 and they will account for 95% of the projected increase in world coal consumption over the same period.

Together, China and India are responsible for a quarter of the world's demand for globally-traded steam coal. Without the same stringent carbon emissions reduction requirements that the EU is placing on its members and currently without the same discoveries of copious levels of shale gas as the US, there is little to hinder the demand for coal. Even taking into account China's growing renewable energy sector still does little to dent the need for coal.

"China is probably the biggest installer of renewable energy in the world, but they still need bags and bags of coal. The Indians are also looking at putting in huge amounts of solar energy capacity, but coal remains at the heart of their growth policies," says Price. "In India, you're looking at a population of 1.2 billion, half of whom have no electricity access at all. The government policy is very clear that it wants to get them all connected up."

The economics of the situation demand the use of coal. "To go for that sort of energy consumption growth, the only way they're going to be able to do it is by using a fossil fuel. Coal is the obvious one. Currently, they don't have huge amounts of gas," says Price. "It looks to me that if they're going to sustain the growth rates they're currently achieving and raise standards of living in the way that they aspire to, they're going to have to use coal."

It is not just China and India. Coal is vital for the development of the whole region, both as a major export for producers such as Indonesia and for any countries with aspirations of sustained, significant economic growth such as Vietnam or the Philippines.

"Coal has a very crucial role [in Asian development]. Most of the increase in power generation capacity in Asia is based on thermal coal," says Sabine Schels, commodity strategist at Bank of America Merrill Lynch (BAML). "It is the cheapest Btu and it is also an energy source that is widely available. Reserves are spread all across the globe and it's not like other commodities where supply is more localised. Everyone that can produce coal is producing - the developmental costs are not that high and international prices are paying for that."

Even though the Asia-Pacific contains the two largest coal producers, such is the gravitational pull from Asia's emerging markets that global trading dynamics are being bent into new directions.

"I think the really interesting potential move that we're seeing is some of the Colombian exports, rather than following their traditional route into the US, are much more competitive at the moment in Asia," says Tristram Simmonds, head of the European coal desk at brokerage GFI. "Although the percentage is very small, we're talking about something that would not have happened at all in the past."

Another factor benefiting the growth of the coal markets, certainly in the short term, is over-capacity in the shipping market, a major contributing factor to the unusual shift in trading patterns, says Simmonds.

"Colombian freight moving into Asia is very much a feature of low freight prices, which is making those long journeys the wrong way around the world more likely to happen at the moment," he says.

Analysts do not see a correction to the fundamental over-supply in the number of ships taking place any time soon. "Coal, together with iron ore, creates the biggest demand for dry bulk freight. The dry bulk freight shipping capacity has overbuilt and continues to overbuild. There is no shortage and is unlikely to be a ship shortage for three to four years," says BAML's Schels. "The continuing demand increase allows the market to absorb some of that capacity but it is not enough to create any shortages."

Hedging growth possibilities

The most popular financial products for hedging coal price risk are over-the-counter swap contracts that settle against the physical coal Average Price Indexes (API) 2 and 4. The API 2 is the standard price benchmark for coal imported into northwest Europe. It is an average of pricing agency Argus's cost, insurance and freight (CIF) Rotterdam price assessment and McCloskey's northwest European steam coal assessment.

The API 4 is the benchmark price for coal exported out of South Africa's Richards Bay terminal, which is calculated as an average of the Argus's free-on-board (FOB) Richards Bay assessment and McCloskey's FOB Richards Bay price.

Asia-Pacific swap contracts are based chiefly on two indices. First is brokerage and trading platform globalCOAL's Asia-Pacific pricing benchmark Newcastle index, which started in 2002. It uses physical deals, bids and offers for thermal coal delivered on an FOB basis at Australia's Newcastle Port. The Indonesian Coal Price Index (ICI), which began in 2006, collates four different Indonesian coal price assessments and is run by pricing agency PT Coalindo Energy.

More recently was the launch of various exchange-traded futures contracts that reference the same physical indices, with InterontinentalExchange (ICE) launching API2 and API4 coal futures in 2006 and globalCOAL and ICE launching Newcastle futures in 2008. In 2009, the Australian Securities Exchange launched its own, physically-settled Newcastle futures contract and last year, CME Group also launched API2 and API4 futures contracts.

Financial hedging in the coal markets is catching on in Asia. Zenny Tran, head of the coal team with Singapore-based energy brokers Ginga Petroleum, sees the changing nature of the physical market also benefiting a growth in derivative use.

There is very robust spot-trading with Korea, Taiwan, China and India all buying and trading thermal Indonesian coal either bilaterally or on spot markets. This provides very good fundamentals to allow the swap market to develop," she says. "We are seeing a change in the way physical coal is trading as well. The market is moving from a lot of fixed-price deals to floating, index-linked prices. That also helps with the derivatives market development. As people transact on the index link, they see the need to hedge and that will provide more liquidity for the spot market as well."

Although difficult to fully assess, volumes for coal derivatives across the globe have steadily increased, with a noticeable leap coming in 2007 from 1.3 billion tonnes traded to more than 2 billion tonnes traded, according to brokers. That came as a result of market participants trying to hedge out the volatility caused by soaring coal demand and the onset of the global economic crisis. Despite volatility, and thus trading levels, falling over the next couple of years, brokers estimate that last year traded amounts exceeded 2007 levels as volatility began to increase again.

"Coal is now becoming a fungible commodity, with a lot more players in the market and not just conventional producers and end-users. We are seeing a lot more players like banks and hedge funds and they are more responsive to influences from the oil or gas markets," says Ginga's Tran.

"A lot of them are trading across the products, not only trading coal but trading dark spreads, spark spreads and they always look at the energy market as a whole. So there's a lot of influence on coal from the gas, power and oil markets, which are volatile, and this impacts in the volatility of the coal price."

In oil, tonnes traded through derivatives far outweigh the amount of actual physical trade, but as an indication of the growth potential in coal, coal derivatives currently trade at around a third of physical amounts. Ginga's Tran expects this gap to decrease in Asia over the next five to 10 years, believing that Asian coal derivatives will soon be trading at around the billion tonnes a year mark seen in Europe.

The growth of electronic platform trading in Asia will be another facilitator expected to increase the size of the derivatives markets. Besides the globalCOAL platform, Ginga Petroleum launched Indonesian sub-bituminous (sub-bit) coal swaps and a sub-bit physical contract on a new electronic platform designed by Trayport in September last year.

James Davies, head of sales at Trayport, sees a huge amount of nascent demand for such platforms in the region, while the firm is rolling out a new front-end for its platforms based on Microsoft's Silverlight to cope with the expected uptake.

"The coal market is progressively being traded more outside the European time zone. We've been working on new versions of our front-end systems for 18 months

that allow trading to be web-delivered and not requiring the same level of IT skills for integration of systems. We believe this is going to be very important to keep the progressive rate of expansion up in Asia," he says. "We're putting the investment in because we do believe commodities, such as coal, are going to expand rapidly."

GFI's Simmonds does not expect an influx of new end-user market participants into the financial products markets, but he does expect the flow of business from banks hedging on behalf of end-users to continue to increase.

"Traditionally, we tend to find with the products we deal in, it is very hard to bring in new end-users. But I think the flow of business that comes from the customers we deal with already - Asian banks or banks based in Asia - will capture a lot of that flow of business that wouldn't have been there a couple of years ago," says Simmonds. "[End-users] all carry many different kinds of risks across their books and I think for that reason, the banks will capture a lot more financial risk management through their sales business and as that grows, that volume indirectly comes back into this primary marketplace through the banks."

Hold-ups

There remain two significant hindrances clinging on to the coat-tails of the Asian coal market's progress. The first, affecting both physical and derivative expansion, is the speed of market deregulation across the emerging nations (see Energy Risk February 2011, ‘Energising the future' at www.risk.net/1938178). For one, if markets cannot be deregulated, then there is no room for spot market growth across the region.

"In Asia, deregulation is still rather slow. That is one of the main barriers preventing the coal market from growing to its full potential," says Ginga's Tran. "Deregulation of the power market will be the key factor. We are seeing progress in the [South] Korean market, which isn't as deregulated as Europe yet, but they are getting there and their market is becoming more competitive and hopefully Japan will follow suit. They've already got a power exchange but the volumes aren't significant."

The second hindrance, applying more to the expansion of Asia-Pacific-based derivative contracts, is the eternal problem of building up a critical mass of liquidity. Swaps based on API indices first traded in 1998 and Newcastle swaps began only four years later. However, after nine years, the Newcastle contract still has liquidity problems further along the curve and only has around 5% of the global coal derivative market share.

"Everyone would like to see greater transparency and liquidity in the Newcastle contracts. This continues to be a disappointment for most of the market participants. It's too much of a leap of faith for many people," says GFI's Simmonds. "I think for a marketplace to work efficiently, you need to have a transparent, liquid curve to which market players can add and remove positions with ease. The problem with Newcastle is it is not strong enough for people to be confident in carrying risk in that contract."

It is a problem applicable to any prospective new derivatives contract, especially when there is enough liquidity in the more established contracts to persuade those looking to hedge physical price movements in Newcastle coal, say, that taking on basis risk is the safer option.

"I don't think you can have an unquantifiable number of contracts that people trade. I think people like to try and concentrate their risk in the most liquid products," says GFI's Simmonds. "I don't think that we're going to see many new swap contracts, with exponential growth in them. I think most people are more comfortable to manage their risk through tried and tested products that are already there and they'll manage the basis risk themselves against those products."

He believes that there are remedies that could change the current state.
"The main block for growth in any of these contracts is ultimately what kind of settlement procedure they have and if new entrants don't feel confident in how an index is derived, then they're going to shy away from using it," he says. "I think for the people not physically involved in a contract, it's a greater risk perceived by them to be involved than the risk they're trying to offset."

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1. La Niña is part of the El Niño-Southern Oscillation (ENSO), a climate pattern that occurs across the tropical Pacific Ocean. La Niña accompanies low air surface pressure in the western Pacific, and is associated with an increase in tropical cyclones and flooding along the east coast of Australia

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