The answer, as per usual these days, lies in China. Ocean freight rates have recently hit crazy levels. Capesize transport of coal from the port of Richards Bay to Rotterdam, for example, now costs US$25.75 per tonne, up an astonishing 284% from US$6.70/t in September 2002.

It now costs US$12.50 more to transport coal to Japan by Panamax vessel from Queensland than it does from China! We should take pause to note that most coal sold internationally under long-term contracts is transported under long-term ocean freight contracts. A substantial proportion of the international coal trade is, therefore, buffered from the short-term vagaries of spot ocean freight rates.

If ocean freight spot prices remain high there will be an inevitable flow through into long-term contract rates as old contracts expire. The average duration of long-term freight contracts has fallen substantially over recent times – a factor that has contributed to the recent volatility of the spot dry cargo market. Sources in the shipping industry note that the long-term contracted component of the international coal trade is not well covered in terms of freight contracts for 2004 and deteriorates rapidly into 2005.

The other proviso is that some of the major coal consumers have their own shipping fleets. So this portion of the coal trade, including spot purchases by such consumers, is also isolated to a degree from the effects of the increase in spot ocean freight rates.

The surge in dry cargo freight rates is, of course, being driven by booming Chinese demand for iron ore. Shipping industry pundits see little respite in the dry cargo market tightness over the next few years. It only takes about 6 months to build a dry cargo vessel, but shipyard space is currently monopolised by oil tanker and container vessels, following last years boom in tanker freight rates.

This is not to say that spot freight prices will remain at current peak levels, rather that one-year charters (currently at US$60,000 per day for a Capesize) may go even higher next year before weakening slightly in 2005. Australian and Canadian coal exporters are particularly disadvantaged by high ocean freight rates, as their competitors in Indonesia, China, Russia, Colombia and the United States are all closer to their major markets of East Asia and Europe respectively.

If we add exchange rate fluctuations to the high ocean freight rates it would seem to present a disaster scenario for Australian coal exporters – but wait a while as there is a twist to this tale still to come. The Australian dollar has surged past US$0.70 without even blinking and the Canadian and South African currencies are following a similar path. The Chinese renminbi, on the other hand, remains pegged to the US dollar despite strong pressure from Washington for a revaluation to curtail the sharp increase in the US trade deficit with China. Chinese Premier Hu Jintao recently reiterated his opposition to any rapid revaluation of the renminbi, maintaining that any abrupt reform of the fixed exchange rate ahead of domestic reform in China could prompt instability.

Earlier this year we were concerned that continued expansion of Chinese steam coal exports, taking advantage of their fixed exchange rate, would hold back the rise in US$ coal prices that would otherwise have been expected as a natural counterbalance to the decline in the value of the US dollar. But evidence continues to mount that the rapid rise in Chinese domestic coal demand is sustainable over the medium term, leaving little excess coal for any substantial increase in coal exports. Internal Chinese estimates indicate that Chinese coal exports may stall at around the 100 Mtpy mark. This would leave the East Asian market needing increasing steam coal supplies from Australia, and future pricing levels that are high enough to encourage new investment in the Australian industry.

So the upshot is that if Chinese domestic coal demand continues to soak up most incremental Chinese coal production, the future for the Australian export steam coal sector doesn’t look so bleak at all. Indonesian exporters could be the real winners, as their currency is one of the few yet to claw back much ground against the greenback: although this may only be a matter of time given the recent signs of recovery of the Indonesian economy.

With Newcastle spot thermal coal prices now well above the Tohoku reference price of US$26.75/t FOB a contract price rise into Japan next year is a ‘no-brainer’. The question is how much of a rise? Average production costs, including capital, for Australian steam coal exporters are around US$26/t FOB at he current exchange rate of US70.5c, so many exporters have been losing money at recent average export prices of around US$25.40/t (although most remain cash positive).

So a substantial price rise in contract prices will be required in order to maintain investment in the Australian export thermal coal industry. The Japanese electricity utilities will mount some strong arguments that the price rise should be limited.

• The introduction the Japanese coal tax and the enormous increase in freight rates have reduced coal’s competitiveness against other fuels.

• This years surge in international thermal coal demand, driven by the combination of Japanese nuclear outages and unusual weather patterns in Europe, is unlikely to be repeated next year.

But spot price movements are the prime determinant of contract price settlements so we expect the reference price will rise next year by 8%, from US$26.75/t to ca. US$29.00/t FOB.

Turning to the European steam coal market, spot prices remain very high, with CIF prices breaching US$60/t. European utilities continue to re-stock after the summer heatwave and in advance of an expected cold winter. But surely it can’t last as utilities scramble to burn almost anything else but coal at these prices. The high landed prices of imported coal are being cited as the major driver of increases prices of forward electricity prices in Germany, France and the United Kingdom and will no doubt lead to increased gas consumption, and possibly forestall closures of high cost European coal mines.

Hard coking coal contract prices into Japan are also expected to more than recoup last years fall, with the benchmark Goonyella brand price expected to bounce back 5.4% from ca. US$46.25 to US$48.75/t FOB. Goonyella coal was reportedly sold into the Turkish steel mills at US$46.50/t FOB a couple of months back and the market has tightened considerably since then.

Australia’s dominance in this sector means that it will be able to enforce a significant price increase into Japan. US, Polish and Russian hard coking exporters appear to have little capability to boost exports to the European market despite the extremely high CIF prices engendered by the high ocean freight rates from Australia. With traded coke also scarce the steel producers will just have to grin and bear the very large increase in delivered coking coal prices.