Challenges ahead as US coal exports grow
The US coal market could be facing an about-turn with regards to exports and imports. Pauline McCallion looks at the potential implications for trading and risk management among US producers
Internationally, coal demand has gone from strength to strength, creating a new potential route to market for US coal producers feeling the effects of a recession-struck domestic market.
According to the US Energy Information Administration (EIA), total US coal exports increased by 18.2% during the last quarter of 2010, compared to the same quarter in 2009.
Some major dealers and brokerages have already seized the export opportunity, restructuring their coal businesses or opening US desks to address the potential demand from US producers who are looking to export and manage the risks of international trade as a result of this new trend. However, obstacles remain in the form of access to transport and continued uncertainty about the longevity of this new market direction. So, while some market participants have jumped on this trend, others question its sustainability.
Broadening horizons
The future is burning brightly for US coal producers looking to access international export markets. "The [US] Federal Reserve is stimulating the economy and indirectly causing a weaker dollar and, since a lot of international business is priced in dollar terms, that actually creates somewhat of an advantage for US producers, relative to their international counterparts in the global marketplace," says Thomas Hiemstra, director of coal brokerage services at Evolution Markets.
The 1.075 billion short tonnes of annual coal production in the US has been called upon in recent months as unexpected events have affected other coal suppliers and consumers around the world. In Australia, severe flooding in late 2010 to early 2011 significantly lowered coal production, affecting miners such as Queensland's Macarthur Coal, which reported a 56% drop in annual production as a result. Given Australia's position as the world's largest global exporter of coal, this drop in production will naturally impact global supply. Similarly, the tsunami in Japan in March had an indirect effect on the global market. It caused a major nuclear incident that resulted in other nuclear users, such as Germany, rethinking the fuel source. Germany will rely mostly on coal, hydro and wind while it reassesses its options.
The growing Asian economies also require greater coal supplies to maintain the rate of their growth. In its latest Quarterly Coal Report (December 2010), the EIA attributed higher US exports to Chinese demand, with total exports to China accounting for 8.3% of total US coal exports – a 4% increase on the fourth quarter of 2009. According to the EIA, China's increase "prompted other Asian nations to purchase coal to increase their stockpiles".
On the other hand, US domestic coal consumption in the fourth-quarter of 2010 decreased from both the previous quarter and the fourth quarter in 2009 by 12.6% and 0.9%, respectively, bringing consumption to the lowest level since the fourth quarter of 1995, according to the EIA. This is due to a range of factors, including falling demand from the electrical market, which consumes about 90% of US coal production. Matt Preston, principal analyst of Americas coal research at Wood Mackenzie explains: "Electricity demand is down, based on the effects of the recession, plus natural gas is currently priced right at the busbar with coal. That's leaving producers looking for a new home for their coal."
Different quality
While the world is certainly in need of US coal right now, the changing fundamentals of the US market could complicate the outlook. "The typical type of coal that's exported from the US, especially to the European market, comes from the Northern and Central Appalachian areas. But that coal is in relatively tight supply and it wouldn't take a very big increase in demand for the price to bump up against the international price to the point where exports would no longer be worth it," Preston says. He estimates an increase of two million tonnes could have such an effect. Appalachian coal production totalled slightly more than 334 million short tonnes in 2010, according to the EIA.
Other US areas, such as the Illinois Basin, produce lower quality coal, which has a higher sulphur content. But the question is: how willing and able are users in the international market to burn different types of coal?
Recent transactions in the international coal market have been structured to bridge the gap between US and API (All Publications Index) prices. These benchmarks are used by traders, exchanges, utilities and producers as a price reference for coal imported into north-west Europe (API 2), coal exported out of South Africa (API 4) and coal exported out of Australia (API 6). "We've heard of some transactions being done at a fairly deep discount to the API prices for Illinois basin coal recently," Preston says. "Providing that transportation costs to the Gulf of Mexico ports are fairly low, this type of coal can go into Europe at a lower price and still be profitable for US producers. But, it remains to be seen how much of an appetite there is for that kind of coal."
Hiemstra agrees, adding: "When you factor in the transportation component for Illinois Basin coal, it prices at a significant discount to API 2. But boilers are limited somewhat by the types of coal they can burn. Not everybody can use the high sulphur coal, so you're limited to a handful of counterparties."
Larry LaCosta, a broker on the US coal desk at GFI Group, adds that deals between US producers and European consumers are on the rise, and he expects the trend to widen to include Asian consumers in the long term. "We are seeing the big producers in the US dealing in the European markets to hedge those particular contracts," he says. "And going forward, looking at the Asian market, big producers that mine the Powder River Basin (PRB) coals [in Wyoming and Montana] are all partnering to build these big loading ports on the west coast [of the US] - in Washington and places like that. So in a year or two, they could start shipping that out to Asia and that might be a significant new trend as well."
LaCosta is one of three brokers staffing GFI Group's newly created US coal desk in New York, which was launched in April and offers domestic clients access to both US and European centrally cleared coal swaps on one screen via its Trayport trading technology. It plans to expand this to Asian contracts later this year. According to GFI Group's head of commodities and energy brokerage in North America, Richard Giles: "There has been increased demand in the US for pricing of European coal because the US has been exporting more coal. And there has also been increased demand in Europe for the European traders to trade US coal contracts."
So, where once US producers were mainly concerned with hedging risks in the domestic market, a widening focus to include exports to Europe and Asia has resulted in the need for new risk management strategies. Market participants have been setting up to meet this need. JP Morgan, for example, radically restructured its coal desk in 2010, integrating the regional businesses in the US, Europe and Asia and refocusing the US business on the export market. (See the US Coal House of the Year Award on page 35 of this issue).
Other market participants have also been getting in on the act, restructuring their businesses to offer risk management support to US producers who are unfamiliar with the international export market. In addition to GFI Group, Icap Energy added a Houston-based US coal desk in May 2011. The desk will service current clients who trade both domestic and international coal products and, in combination with its freight offering Icap Shipping, it could offer transatlantic coal arbitrage opportunities, according to a statement from the brokerage. It will offer financial swaps for delivery at Amsterdam, Rotterdam and Antwerp (API 2), and Richards Bay in South Africa (API 4).
Icap's vice-president in Houston, Thomas Gibson, says one of the main motivations behind the move to launch the US coal desk was a definite trend towards greater coal exports from the US. "We feel that more and more of our customers are going to start trading the API indexes and I think it's going to be a good shot for US companies to actually export as well," he adds.
Uncertainty
There are still questions over the sustainability of this trend. Some coal producers and transportation operators may remain wary of making large investments in support of the trend towards exporting US coal in case the cycle suddenly changes. "Obviously, if international demand appears to have a long-term outlook, then new capacity will be brought on to handle that," Preston says. "But the awkward part is that there is such a dichotomy between demand in the US, which is 90% of the market, and demand overseas, which is only 10% but growing."
The domestic market has a price ceiling set by natural gas, but the international market does not, leaving producers in something of a quandary while they wait for international demand to acquire more of a share of production. "If producers raise their prices to international levels, they won't sell coal domestically because natural gas will replace it," Preston explains.
The other piece of the puzzle is the issue of transportation. "One of the weak links in this situation is the inability of the railroads to get coal to the ports. More railcars and crews are needed, but operators have been somewhat reluctant to expand because the market has collapsed in the past. So, the railroads are a little reluctant to spend a lot of money until they see a long-term trend they believe they can rely on," he says.
But producers have been circumnavigating this problem by boosting their transportation assets. In its 2010 Annual Report released in April, Peabody Energy, the world's largest private-sector coal company, said it "expects to increase its position as a major expoarter of US coal with shipments from multiple regions through the Northwest, the Gulf and East Coast of America". It announced a significant development project – for which approval is being sought – to transport up to 24 million tonnes of coal per year from the PRB in Wyoming and Montana, through a West Coast export facility.
In a statement about its 2010 Annual Report, Peabody Energy's chairman and chief executive officer, Gregory Boyce, said: "This quarter, we saw continued evidence of coal's global supercycle. Global demand is rising and supply remains constrained. We believe coal fundamentals will remain strong for decades, even as other energy forms are proven too expensive or too limited to provide reliable low-cost energy at a significant scale."
But while producers such as Peabody are optimistic about the future, Hiemstra points out that uncertainty remains with regards to the long-term position of US producers. "We have seen this scenario before, where the US steps in as the swing supplier when there is a void in the global marketplace, to fill that hole left by certain other regions not being able to fulfill that demand."
The difference this time, according to Hiemstra, could be the prognosis for the dollar. "The outlook is that it will remain weak for a fairly prolonged period of time, helping to keep an edge for US producers in the international market."
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