Coal is under a cloud, but nobody appears to have told commodity traders.
The year will be remembered for the European Parliament's ratification of the Paris climate deal, which commits signatories to shunning coal in favour of cleaner energy. At the same time, trading activity in financial coal has ballooned as hedge funds have flocked to the market, and traditional users of the product have dabbled with new, and potentially risky, trading strategies: some coal producers are said to be collecting premium as options sellers, rather than paying it as hedgers.
Hedge funds have been drawn to coal by an attractive trifecta: liquidity in cleared coal derivative products, volatility in the market, and the fact that the price of coal is guided by fundamental factors that are easier to predict than other commodities. Oil prices, for example, are known to be influenced by sentiment around the Federal Reserve's plans to lift interest rates, for example.
"We have new participants coming in because coal is trading on fundamentals as opposed to many other products that are trading on sentiment and monetary policy around the world which has proved difficult to gauge for many participants. Liquidity has dramatically increased on the exchange side of coal. And coal has become a market that is trending and volatile," says Adam Hoffman, founder and managing member of Wooded Park Strategies, a Houston-based consulting firm that advises energy firms including coal companies. "These are the types of markets hedge funds target."
From the beginning of the year through to September 30, total volumes in API 2 coal futures, the benchmark futures contract for northwest Europe, reflecting prices for thermal coal delivered into Rotterdam; API 4 coal futures, reflecting prices of thermal coal delivered to Richards Bay, South Africa; and Newcastle coal futures, based on prices for thermal coal delivery at the port of Newcastle, Australia, have enjoyed healthy growth. Combined volumes for the three contracts traded on Ice and CME Group for the period reached 2,869,812 trades, a 10.6% increase compared to the same period in 2015.
Coal options have also seen a boost. Volumes for the three contracts traded on CME and Ice reached 1,610,496 trades from the beginning of the year to September 30, a 16% increase compared to the same period in 2015. According to data from clearing houses compiled by London-based Prospex Research, options accounted for 33% of cleared coal derivatives in 2015, up from 18% in 2014. In 2011, options made up just 3% of the cleared market.
And the pick-up has been seen in the over-the-counter market, too. The total volume of API 2 transactions from January to August this year rose 23.98% compared to the same period last year; and total API 4 transactions rose 4.39% this year compared to the same period in 2015, according to data compiled by the London Energy Brokers' Association.
Credit-constrained participants have the option to hedge their product on the exchange and lock in a significant return for their stakeholders
Adam Hoffman, Wooded Park Strategies
There is a big macro story to trade around. Amid environmental pressures and an abundance of cheap natural gas following the US shale revolution, many utilities have chosen to switch from coal to gas for electricity generation. This has caused one of the worst downturns in coal prices in decades.
Between August 27, 2014 and February 16, 2016, there was a 53% drop in the price of the front-month API 2 contract traded on Ice – from $83.05/tonne to $39.2/tonne. It has since rebounded sharply, closing at $74.35/tonne on October 4.
The sharp drop in coal prices contributed to the bankruptcy of a number of large US coal producers. Missouri-based Arch Coal filed for Chapter 11 reorganisation in January while Alpha Natural Resources, from Virginia, filed in August 2015. Meanwhile, Missouri's Peabody Energy filed for protection in April this year.
Despite these pressures, credit risk has been taken out of the coal derivatives market thanks to the growth of listed and cleared products.
"Over time we have seen contracts like coal and iron ore being offered by exchanges and subsequently increasingly getting on investors' and hedge funds' radars," says Marcos Bueno, chief investment officer at Argon Capital, a commodity hedge fund launched in July 2015. "Hedge funds are averse to the credit risk in trading non-cleared OTC. The fact that a lot more exchanges decided to offer core coal products on their books makes a huge difference, particularly for hedge funds."
Hoffman of Wooded Park Strategies adds that hedge funds are "flocking to the coal market" despite the lack of credit quality, which has boosted liquidity in the market.
"The majority of the producers in the coal space have poor credit," he says. "Now these credit-constrained participants have the option to hedge their product on the exchange and lock in a significant return for their stakeholders while further enhancing market liquidity."
As hedge funds pile into coal options, producers are taking the opportunity to hedge their exposures, say market participants. "Now that the funds have come in and added this extra liquidity, we've had a lot of producers who have used the options market to safeguard some production," says a senior coal trader at a German utility. "Liquidity breeds liquidity, and the additional depth to the market has created an opportunity to put on some strategies that would previously have involved crossing quite sizeable bid/offer spreads."
And producers are not just locking in forward prices. In some cases, market participants say companies are seeking to profit by selling call options. In such a strategy, a producer would, for example, sell a call option at a strike price of $55/tonne. If the market remains stable or dips, the company might pocket a premium of $2/tonne, for example, for each contract it sold. But if the market rallies above $55/tonne, the producer would be on the hook to provide the coal at that price despite a more favourable spot market.
"You would only do that as part of an overall price book," says a senior executive at a coal trading firm. "You might be able to get paid over the odds in mispriced volatility, while covering that option risk somewhere."
If anything, though, this trend appears to have benefited buyers of volatility – particularly in recent months. Argon Capital's Bueno says hedge funds have bought coal options this year that have been made "artificially cheap" due to an oversupply of these contracts written by producers.
"As a hedge fund player, I can buy something that is good value, because the premium is artificially low," he says. "If the price goes higher, I'm also happy. It is a win-win – the seller and buyer have different objectives, but it works out for everybody."
I don't think [Glencore's] was a smart strategy. If you are a sensible producer, what you do is protect against the downside, so you buy put options to protect yourself
Energy market participant
Of course, no market works out for everybody all the time, and commodity trading house Glencore has been the most public casualty, reporting a $395 million mark-to-market loss on coal derivatives trading in its first-half results on August 24. It's not known what instruments or trading strategy Glencore was using, but five market participants say the firm was a seller of options.
"They are big suppliers of options and in the past we have been buyers of those options," says Bueno. "I knew it was coming from them and the reason they were doing it is to get that pick-up on the realised price of the commodity."
A spokesperson for Glencore pointed to the company's first-half results and analyst call, but declined to comment further.
During the second quarter of 2015, Glencore locked in prices for 55 million notional tonnes of coal, according to the company's first-half results – equivalent to around 40% of annual production, if using 2015 production figures as a guide. The trade involved a mixture of instruments with different maturities and qualities where the company hedged future unsold production for a 12-month period out to June 2017. The hedges were executed before coal markets rallied, leaving Glencore with a paper loss as of the end of June.
The loss had to be reported immediately, because Glencore was not able to obtain hedge accounting treatment under International Financial Reporting Standards; this would have allowed the company to defer recognition of the derivatives values until the resulting sales of coal. It is thought to be difficult for coal hedges to qualify for hedge accounting because the derivatives contracts need to be tied to specific future coal production, which is difficult when there are only three liquid benchmarks for the commodity but more than a dozen grades of coal.
Glencore's chief financial officer, Steve Kalmin, said in the call with analysts that there was a $7/tonne "opportunity cost" associated with the portfolio of trades, though he did not go into detail about the strike prices or the instruments used. Given the different maturities of the structures, and the unsold coal associated with the trade, that cost will depend on how the markets develop, he said.
"It's a mixture of all origins," Kalmin said in the call. "You've got Newcastle, you've got South Africa, you've got Colombians, so it's a mix between the various options and different products ... it's hard to give sort of the average price that has been given, but in terms of the movement between when it was hedged and just what the June 30 pricing was, it was about $7 [/tonne] opportunity cost which is unrealised and that's all to say at this point in time."
During the same call, Glencore chief executive Ivan Glasenberg described the loss as "not a big issue".
Though it is unclear whether the sale of options to collect premium was involved in the trade described in Glencore's half-year results, energy traders who spoke to Risk.net say the company employed this strategy in the first half of 2016.
"They were selling out-of-the-money calls, banking some premium and if the market got there, they could sell their production," says a Germany-based energy trader. "There are a lot of rumours about the size of that position relative to their physical capabilities. This market was trading at $36/tonne in March and these guys were selling $55/tonne calls, so you are talking about a $20 out-of-the-money option they sold and they were being paid $2 or $3 for that option. The problem becomes when the market then moves above $55 and everyone who you've sold those call options to comes and says, 'I want to buy this now.' You are now in a hole because you have to provide that coal at $55."
There are mixed views about Glencore's strategy among industry participants, with some saying it was prudent, and others saying there appeared to be little downside protection to the trade.
"I don't think this was a smart strategy," says one energy market participant. "If you are a sensible producer, what you do is protect against the downside, so you buy put options to protect yourself. What Glencore appears to have done is to decide, 'I want to collect the premium from selling the calls. I'll put that against my P&L and do better than the market.'"
Hoffman says criticism about the trade being poorly timed, for example, "is an easy argument to make from an ex-ante perspective".
"Are they happy they locked in a price of $50/tonne? It is not a question of being happy, but a question of risk management," he says. "When you put a hedge on to take off risk, like everything else, you are giving up some upside for locking in your protection on the downside. We don't know what the future looks like, but when there is a chance to lock in a price that gives reasonable IRR to investors, companies should do that; it is the whole point of hedging."
In spite of Paris
November 4 will see the Paris agreement on climate change come into force, committing more than 70 countries – that together account for 55% of global carbon emissions – to a cleaner-energy future. But market participants say it will not be straightforward for countries to abandon coal altogether, which is another factor in the counterintuitive rise of coal derivatives trading.
"You would assume that the more it becomes a stranded asset, its trading volumes would disappear, so there is clearly a J-curve in play, because it is far from being a purely legacy commodity which no-one burns or mines any more and we are also far from the widespread adoption of zero emissions coal power stations," says Alexander McDonald, chief executive of the London Energy Brokers' Association.
"Why are the volumes doing so well, despite the move towards Paris compliance? From what we can gather, it is that the variety of participants able to trade in the market has kept on increasing, which is a function of market access becoming easier... As coal becomes a stranded asset, its traded volumes seem to do very well."
The steep drop in coal prices has been attributed, in part, to the shale revolution in the US, which has brought cheaper and environmentally cleaner fuel to the market. That has generated volatility, with liquidity benefiting as a consequence. But some say there has also been a hidden cost to the liquidity brought by the hedge fund community – as market movements have sometimes become more difficult to forecast.
"The level prices went to is something I don't think anyone necessarily expected," says a senior executive at a coal trading firm. "Markets have a habit of overshooting. If you look at where we are now, you would say, 'How come coal was down below $40 per tonne?'. There are so many flows today, be it through institutions or algorithms and quant funds, and the weight of money can move in a particular direction for a period of time... Did it make sense to us? No. Could we expect and rationalise that these things can happen for periods of time – not forever? Yes."