Published in the May 2006 American Longwall Magazine
Welcome back to the Trading Corner. Price curves and forecasts are at the heart of virtually every commercial decision – master them and your organization can benefit tremendously. Deny their presence and risk falling peril to the results of poor decision-making, second-guessing and emotional anguish. Price curves and price forecasts may sound innate, but trust us, we have been there and they are widely misunderstood and rarely used in a disciplined manner.
An actual conversation
Coaldigger: That OTC (over the counter) curve is for one to two trains a month. It has nothing to do with the “real” market. My customers purchase 10 trains per month.
Frontrunner: Maybe, but your customers have not purchased their 10 trains today. Unless the market is tested, the curve has the final say.
Coaldigger: That curve is nuts! The “real” price is higher. I have five trains a month to sell. If I were a customer and tried to buy five trains on the OTC market, the price would easily jump to where the real market is!
Frontrunner: So why don’t you buy five trains, bring the price to where it should be and the sell the trains for a profit?
Coaldigger: Then I would have 10 trains to sell. If I had to move 10 trains today, the price would drop several dollars.
Frontrunner: Huh? You have a multiple personality disorder my friend. Get help.
Another actual conversation
Coaldigger: I know what the price curve says, but our company works off of price forecasts. We pay lots of money for these forecasts. They are based on very sophisticated models. Lots of other companies use them, so they must be good.
Frontrunner: And your forecast is showing that the coal price in 2007 should be higher than what the OTC is showing?
Coaldigger: Exactly! That OTC forward curve is full of #@!%.
Frontrunner: Then why don’t you buy as much of the OTC coal as you can for delivery in 2007? You can sell it for a profit when you get into 2007.
Coaldigger: No way! We have enough of our own 2007 production to get rid of.
Frontrunner: Never mind…
First, a simple definition. A price curve is the mid-point of firm bids/offers to buy/sell for delivery at various periods in the future. Is a price curve a forecast of future spot prices? Logically speaking, yes. After all, who in their right mind would buy term coal for delivery in 2007 if he/she were confident that the spot price in 2007 would be lower than today’s price for 2007?
The challenge is that these “price predictions” are only valid for a few hours because the price curve is continually changing as new information impacts the market views of the participants. This continual change is called price volatility. Price curves are never wrong because they merely represent where you can transact today for a specified delivery period in the future.
Price forecasts, on the other hand, can be right or wrong and you never know until you arrive at that point in the future. You can transact on a price curve; you cannot transact on a price forecast. In a thin market (such as coal), your lone transaction might even change the price curve by a few cents. It will be up to the next trade to change it further in that direction or to provide a different view of the market and push the curve the other way. The more liquid a market becomes, the more volume it takes to make an impact on a price curve. However, even a liquid market like natural gas can have 10% daily swings in the front part of the price curve (equating to 160% annualized volatility).
Why are price curves and forecasts so important? Because they should serve as the underlying inputs in making important business decisions: investing millions in a coal mine (or idling an existing mine); the allocation between spot and term sales; the compensation of your sales team; the purchase of third party coal; the focus on rail or barge deliveries; the allocation between steam coal and coking coal and much, much more.
The key to using price curves and price forecasts is to have an objective methodology and the use of insider information – the legal kind! For example, let’s say you are a sizable coal producer. You know at what price current supply contracts are being signed, you know at what price your clients are willing to pay (the bid), you know at what price your salesmen are authorized to sell (the offer). Voila – you have a price curve!
If there is an OTC market for your product, there will be an OTC price curve as well. (Many times the price curves between the traditional market and OTC market vary – but more on that in a later Trading Corner.)
You have also done your homework and analyzed new generation announcements, mining costs and competing fuels to establish your supply/demand-derived “guess” of future prices. That “guess” is your price forecast. If you rely on an outside consultant to produce your forecast, remember the consultant is selling the same forecast to everyone else.
This is where “insider information” comes into play. A forecast is usually just an educated guess – unless you are holding a few cards that you know the others do not have. Perhaps you are about to proceed on an ambitious expansion project due to the current price environment (and you suspect other coal companies are developing similar strategies for the same reasons).
Perhaps your mole on Capitol Hill has a strong indication that a certain piece of legislation will impact supply and/or demand for your...click here to read on.
