Imagine this: a Japanese utility calls up an energy marketer at a financial institution or trading company and executes a contract for the delivery of Indonesian thermal coal at a fixed discount (or premium) to globalCOAL’s NEWC index with the ability to walk away after six months and the ability to double the volume and the ability to change to a South African quality and the ability to change from an indexed price to a fixed price. This ‘structured product’ is made possible by the Over-the-Counter (OTC) market.
The OTC market enables participants to take on risk or shed risk. OTC participants, typically energy marketers, will package the building blocks of the OTC market (swaps, options, swaptions, forward contracts, basis trades, FFA’s, etc.) into structured products such as in the above transaction.
Sometime in the distant future, right? Not quite. While this example is slightly exaggerated for effect, it is already happening on a limited scale in the Pacific Basin. In fact, some savvy coal producers are already positioning themselves to make sure that they have the necessary trading acumen to structure these types of transactions.
It is an excellent way to keep the repackaging profits in-house – as opposed to allowing the energy marketers to garner these rewards. More importantly, in a world that is eliminating the value of the brand name and focusing on the end product’s commoditized attributes (heating content, sulfur, ash and moisture), this is an excellent way to maintain a direct working relationship with the end consumer and to differentiate yourself from the competition.
A well-developed OTC market will enable the market participants with natural short and long positions (coal consumers and coal producers) to obtain the exact risk profiles that they desire. It will also reward the energy marketer or the forward-thinking coal producer for taking on market risk and hedging it in the OTC market.
In the traditional market, the risk profiles of the buyer and seller are diametrically opposed. The utility wants protection against rising prices and wants to benefit from falling prices. The coal producer wants the exact opposite. The OTC market resolves this impasse. Thanks to the hard work of several coal-trading ‘pioneers’ (yes, even Enron!), we have a solid foundation on which to build an active OTC coal market in the Pacific Basin.
Looking back over the past year, the timing could not be better. There is (or should be) a demand for products that help companies manage their exposures to price fluctuations. In the Pacific Basin, companies are already buying/selling based on Australian coal indexes – primarily globalCOAL’s NEWC index. Many use the globalCOAL screen or call OTC brokers to enter into contracts that will hedge that exposure (turning the floating price into a fixed price). Companies are buying and selling standardized physical contracts, knowing the guaranteed quality and loading period, but not knowing from which coal mine or for which end user. Companies are already buying and selling options to buy or sell coal at a specific price for delivery at a specific date in the future.
OTC trading in the Atlantic Basin has had a slight head start thanks to the TFS API 2 index, the TFS API 4 index, globalCOAL’s trading screen and a liberalized electricity market.
The API 2 and the API 4 are financial indexes that represent a generic coal delivered into the Amsterdam-Rotterdam-Antwerp area (API 2) or loaded onto the vessel in Richards Bay (API 4). GlobalCOAL’s RB1 is a standardized contract for the physical delivery of a generic South African thermal coal. These financial and physical products are traded actively at a rate of 450 million tons/year.
GlobalCOAL developed the Standardized Coal Trading Agreement (ScoTA) that sets the terms and conditions for the physical delivery of coal. This has paved the way for other promising products including a contract for physical delivery of a generic coal ex. Puerto Bolivar; a second coal quality ex. Richards Bay and a generic coal delivered into ARA.
Trading in the Pacific Basin is not too far behind the frenetic activity of the Atlantic Basin. OTC trading in the Pacific Basin is largely based on globalCOAL’s trading screen, its physically settled contract for thermal coal ex. Newcastle (NEWC) and its financially settled NEWC index.
Trading in the Pacific Basin is poised to follow the Atlantic Basin’s rapid growth. What are the prerequisites for a vibrant OTC coal market in the Pacific Basin to materialize?
Price Volatility
: If the prices are constant, there is no risk to manage. Price fluctuations are caused by unpredictable supply and demand drivers: China, weather, freight markets, labor problems, port congestion (loading and discharge), economic growth, mining problems, power plant outages, etc. At the moment, there is more than sufficient price uncertainty in the Pacific Basin.
Basis Risk
: Basis refers to how the prices of various products compare to each other. All ships may rise when the tide comes in, but in the coal market, the prices of different products do not always rise and fall by the same amount. This exposure is known as basis risk. While not necessary for the development of an OTC market, it helps if the basis differentials between the main hubs (Newcastle, Qinhuangdao and Kalimantan) and between the various qualities shipped from each of these ports are continually changing. Basis trading attracts a different segment of hedgers and speculators.
