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Thermal coal prices likely to stay strong for longer

Publication Date: 02 Dec 2017 - By Marco Saracino By Marco Saracino
Actionable
Differentiated

Technical Analysis Macro Thematic Commodity Asia ex-China China Energy

 

Fundamentals show a tighter supply / demand

Growing discrepancy between current coal qualities and benchmark coal specs 

Liquidity and depth in the spot physical coal markets 

Supply and demand fundamentals are tighter than expected:

  • No additional production capacity has come into force over the past few years as a low price environment, weak demand and negative sentiment around fossil fuels drove miners to focus on efficiency and reducing costs.
  • Over the past 6 months, coal burn has been strong across the globe (most recently, a generally dry weather in Europe has reduced hydro availability). Only India has surprised to the downside.
  • China’s crack on low quality domestic resources – low quality coal/iron ore is more polluting than high quality material when being processed – has slowed down the reduction in coal imports by the biggest consumer of coal.
  • No stocks have been build around by traders/miners.
  • US exports are up but not enough – there are simply not enough replacement tons available in the US as miners have shut down capacity.

This situation is unlikely to change in the short term

  • There is obviously little incentive for producers to bring on line marginal tons here and there as it would stretch the supply chain and possibly skew the 600 mio tons/year seaborne market back into over-supply. Adding substantial capacity is not straight-forward: good quality reserves need to be identified, investments need to be made in terms of supply chain (rail and ports). This doesn’t happen overnight (funding, permits …).
  • Counter-intuitively, utilities in Europe have little interest in lower coal prices because strong fuel prices keep power prices up. Indeed, coal fire generation represents the floor for base-load and this, in turn, makes spark-spreads (margin of power vs gas) positive and makes all renewable sources event more positive.
  • India is experiencing a structural problem as domestic IPPs are running at very low rates as power prices not subsidized by the government and therefore operators run at a loss; this will certainly not last as risks with regards to economic growth and social/political unrest are way too high, but we can’t expect the situation to change over a few months only.

There are obviously some short-term risks with regards to these strong coal prices that may cap further gains or lead to a short-term correction:

destocking ahead of year end as producers/traders/consumers will want to off-load tons from their balance sheet

correction across all asset classes

a serious escalation in North Korea impacting economic activity in Japan and Korea

Having said that, there is another issue to tackle and that is certainly contributing to the rise in coal prices.

Indeed, seaborne thermal coal trades basis the widely accepted Standard Coal Trading Agreement (SCoTA).

This is a set of terms and conditions that structures the sale and purchase of of thermal coal at different locations. It also defines the specs of the material that needs to be delivered against such transactions (providing tolerance and rejections levels as well as price adjustment formulae).

Prices reported against these same physical transactions are then used for the settlement of coal derivatives across exchanges and OTC markets.

Fact is, the availability of tons to deliver against the standard SCoTA specs is shrinking both in absolute and relative terms across the seaborne market. This is the case across the globe: Colombia, Europe, South Africa and Australia.

This explains why the premium of standard material over lower quality coal is rising … or why the discount of lower quality coal vs standard material is widening.

The point is that the reference price of spot markets and long term supply agreements, as well as for pass-trough tariffs and power formulae is what is set for standard material under SCoTA terms. In other words, coal prices and the entire energy complex are artificially inflated because of the use of specs that are not necessarily representative of the broader market – and that trade at a premium to the average ton.

Please note that the same is happening in the iron ore seaborne market, with higher Fe content material trading at a very large premium to lower specs and certain companies being heavily affected by this and being quoted at a serious discount to peers because of the nature of their reserves.

Last bit not least, however, there is an issue with regards to liquidity

Several European and US investment banks have pulled out of commodities trading

Several hedge funds have followed – focusing on oil and metals

A few miners such as Peabody and Noble have also reduced their activity in the market.

This means that price discovery and transparency in the market has been seriously affected in a context that has not always excelled in terms of supervision by regulators. Spot physical transactions are fewer than before and their price can easily overshoot to the upside: consumers are price takers, while producers/traders can always store and wait for better opportunities.

In conclusion, a combination of tighter supply and demand fundamentals, out-dated contract specs and poor liquidity are turning into a perfect storm for thermal coal prices.

 

Disclosure:

I have no positions in any of the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

Marco Saracino

 

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