China low grade coal ban could push up Asia swaps liquidity

Facing pressure from domestic producers and chronic pollution, China's authorities are considering clamps on low grade coal imports – potentially increasing swap activity

The introduction of an import ban on low calorific value (CV) coal in China could cause volatility in thermal coal prices, pushing up coal swaps liquidity in Asia, market participants say.

Reports emerged recently that China's National Energy Administration (NEA) has been circulating a draft proposal to mainland market participants that would ban imports of coal with a CV below 4,540kcal/kg. This is set to have an impact on Indonesia in particular, with various participants estimating that this would affect between 50 million to 70 million tonnes per year of lower CV coal exported by the South-east Asian producer to China.

Proposals are at an early stage and no implementation dates have been set. There has been speculation among those involved in the market that the proposals will probably be watered down, gradually phased in over one or two years or even transformed into a tax rather than an outright ban.

Nonetheless, players believe that some form of market control from the world's largest coal producer is likely.

In a recent briefing note, Credit Suisse referenced an industry contact that suggested the push for the proposed ban came from major domestic producers, while participants told Asia Risk that pressure on the government to reduce emissions after the well-publicised pollution problems in major cities is another factor that will result in a measure being passed.

[The measure] will add liquidity to the swaps market, with people trying to manage their risks with swaps rather than through physical trade

As such, a senior Singapore-based coal trader says the effects of releasing such a huge amount of thermal coal into the seaborne market will ripple across the region, widening the spread between low and high energy coal.

"The Indonesians could upgrade or blend the coal, but the ways to upgrade take a long time and a lot of money to build. The net result is it is suddenly very difficult to upgrade 50 to 70 million tonnes of coal. It might have to be sharply discounted into India and the Philippines and similar markets. It would be bearish on Indonesian lower quality prices, bullish on higher quality Indonesian and other sources, which means you get a bigger and bigger spread between bituminous and sub-bit coal," says the senior coal trader.

China is also the world's largest coal importer and a drop-off in Chinese demand in line with the slowing economy prompted a bout of volatility in Asian coal prices last year. The benchmark Newcastle Index swung between $115/tonne to $80/tonne but prices have been far more stable this year, with the Newcastle benchmark trading between $87/tonne and $94/tonne.

The senior coal trader says the ban could see a return of volatile conditions, referencing volatility in the spread between Newcastle coal and Indonesian sub-bituminous coal – a far less liquid market – which would in turn lead to an increase in hedging activity.

"[The measure] will add liquidity to the swaps market, with people trying to manage their risks with swaps rather than through physical trade. The sub-bituminous vs Newcastle spread has widened and narrowed dramatically over time. This potential ban from China would increase the volatility yet again."

Helen Lau, Hong Kong-based senior analyst in metals and mining for UOB Kay Hian, the broking arm of the Singapore bank, agrees there is likely to be an increasing spread between the low quality Indonesian coal and the higher quality Newcastle coal in Australia.

"There will be an impact on physical coal markets in Indonesia and Australia. Indonesia may be hit by the reduced exports or production of low CV coal, while Australia stands to benefit from the increasing demand for their high quality coal," she says.

A London-based bulk analyst agrees that volatility from the ban is a possibility but that Newcastle coal demand might not necessarily benefit from the proposal.

"The measure could have an impact on volatility but I don't think this is by any means an automatic outcome that exporters of higher quality coal will benefit from more high quality exports into China. People will source some of that additional coal domestically in China, rather than buying higher quality, more expensive seaborne coal."

Indeed, latest reports of the proposals from price reporting agency Platts cite intentions to allow domestic coal to be burned with a minimum calorific value of 2,870kcal/kg.

A Singapore-based commodity trader says the ban, targeted at coal with a CV of less than 4,540kcal/kg, would support the benchmark Indonesian sub-bituminous 4,900kcal/kg index and while this might increase trading in the index swaps, it would come from a low level of trading volume.

"If the ban does affect the index, I would have thought it could be supported, since more 4,900kcal/kg will trade to avoid the banned lower CV coal. In terms of paper demand, it's coming off a very low base at this stage," says the commodity trader.

The senior coal trader says that players who price Indonesian coal using the Newcastle index as a benchmark – a method some in the market choose due to the belief that the many grades of Indonesian coal make it difficult for the Indonesian sub-bituminous index to adequately reflect fundamentals – are most at risk. But he says the current lack of trade in the spread leaves participants vulnerable.

"This affects whoever has put positions on a basis to Newcastle – producers, buyers, traders. Let's assume a buyer has bought Indonesian coal basis Newcastle Index. They could potentially find they've bought coal basis Newcastle, which is going higher, but having to sell sub-bit coal into a rapidly falling market, which means they risk facing massive losses."

In commodities markets, traders are able to break a contract for reasons outside their control – typhoons or earthquakes being obvious examples – using a concept called force majeure. Chinese firms' habit of reneging on deals whenever the spot price falls below the contract has been ironically referred to by commodity traders as "price majeure", a phenomenon the senior coal trader says could increase as a result of the proposed changes by the NEA.

"The only way to mitigate that is to trade swaps sub-bit versus Newcastle. But not many people are active in trading these things and those who don't trade it, and have those kinds of positions on, have the potential to suffer very heavy financial losses. Companies who only trade physical face the risk of either making or losing a lot of money, so you may see an increase in defaults, price majeure."

Indeed, the London-based analyst says the scenario would not necessarily lead to an increase in hedging from China, pointing to the example set last year when Chinese buyers did not hedge against the falling coal prices and instead opted to renege on contracts.

"Those guys don't really hedge [in China]. Indonesian paper is very illiquid and I don't think this alters that," says the analyst.

"If a Chinese utility has agreed a deal with an Indonesian trading house to ship them Indonesian coal of a certain spec with a reference to different indexes and the relationship between Newcastle and this material changes fundamentally, I wouldn't expect those contracts to remain in place. Take last year, for example, when some Chinese importers defaulted on their cargoes. They're not going to honour some contract that is completely out of whack."