Coal markets squeeze producers

Margaret Ryan

Supply/demand fundamentals seem poised to keep prices of competing fossil fuels high, which could cushion coal prices, but increased mining and transportation costs may squeeze producer profits. Are markets ready for more volatility?

IT WAS, AS THE OLD SONG SAYS, TOO HOT not to cool down. In just a few years, coal prices tripled, pinching energy and industrial users worldwide. Globally, coal prices peaked in late 2004 and began to slowly settle downward in 2005.

But in 2004–05, volatile and soaring prices of natural gas, oil, and electricity competitively advantaged coal, despite its high price. Overheated economies demanded steel, keeping the metallurgical coal market in the price stratosphere. But that market, too, had begun to cool by the middle of this year.

The question for 2006 is whether high energy prices will hobble economic growth (sending coal demand and prices tumbling down the cyclical slope) or moderate enough to keep economic growth and demand healthy, ensuring a soft landing for coal prices.

Answering that question is complicated by the supply question: Will producers, who have been opening new mines and expanding old ones as prices rose, increase supply enough to drop coal prices, regardless of the cost of competing fuels?

For the steam coal market, the picture is not uniform worldwide. The U.S. market remains sufficiently isolated by geography and aging transport systems that its dynamics differ somewhat from those of the larger international market.

Non-U.S. spot prices peaked in late 2004 at near $80 per metric ton (mt) delivered into Northwest Europe (or CIF ARA). The rise was fueled by China's red-hot growth, which sopped up both coal and freight capacity. South African coal priced at the Richards Bay port was running in the mid-$50s/mt, and Colombian cargoes were still being offered at over $60/mt, plus delivery. From late 2003 to mid-2004, some spot dry bulk freight rates quintupled; by the end of 2004, freight was still adding $20/mt to a typical European cargo.

In the Asia-Pacific market, a similar pattern prevailed, with steam coal at major Australian, Indonesian, and Chinese ports priced over $50/mt and freights of $15 to $20/mt into Japan and Korea, the largest coal-importing countries. Freights from Australia to Europe were quoted at virtually prohibitive levels, around $30/mt.

Through 2005, those spot prices have backed off, but slowly, for both freight and coal. Only in late July did Richards Bay coal sink below $50/mt, and by October freights into Europe were still running at $15/mt. In Asia-Pacific, coal from Newcastle, the benchmark Australian port, was dropping below $45/mt, and freights to Japan were in the $10 to $12/mt range.

The past three years' volatility has provoked opposing reactions among international coal market players. Whereas some of the biggest producers and consumers have turned to hedging more risks in coal and in freight through increasingly sophisticated derivatives, many consumers have retreated to the risk management tool they know best: the long-term contract.

That has left international paper markets dependent on what's widely termed "sentiment"—player opinion. And that sentiment has been based on thin trading in small spot cargoes that may represent the market, or that could reflect distress or other nonreplicable transactions. Beginning in thin periods in 2004, there were complaints that market valuation had become a circular process, with indexes based on transactions that themselves were based on indexes. By late 2005, there was open speculation among market players about which (if any) deals of the few known really reflected the state of the market.

Derivatives in international coal trading only took off—and in a limited fashion—in 2002, when market players, assured a transaction-based methodology was in place for index components, began to use the TFS API #2. An average of weekly market assessments by two publishers (Argus and McCloskey), the API #2 gives one benchmark for 6,000 kcal/kg (10,800 Btu/lb) 1% sulfur coal CIF ARA.

Paper trading in CIF ARA was estimated at three times the underlying physical market in 2004, with some traders using the API #2 to hedge transactions out several years. It was by then an open secret that the transaction-based methodology wasn't in strict use, but by then it didn't matter; deals were being done using the API #2.

But attempts to extend derivatives to the Pacific market have met with no success, in no small part because some major participants were burned in the spot market during the enormous volatility of 2003–04. Many of them retreated to term contracts, but they have also been seeking a reliable index to use in multiyear contracts. The last number to achieve Pacific market consensus—the Japanese utility annual contract price—no longer exists.

Watching and waiting

The result of all this has been that market players, both West and East, are waiting for someone else to make the first move. In the Pacific, the focus is on the prices being fetched by tenders for 2006 delivery, launched by major coal-burning utilities in Taiwan and Japan. In October, Taiwan Power rejected all initial bids as too high—despite bids reputed to be below $40/mt (before freight)—and reissued its tenders, trying to break producer price resistance. Chinese suppliers weren't bidding into the soft market. Russian suppliers dropped out once net European prices went below $50/mt. South African producers were declining to chase sparse spot low offers.

That has put the spotlight squarely on the few deals completed openly on globalCOAL's electronic platform. In recent months, one or two late Friday trades for volumes as small as 30,000 mt have sent market sentiment—and, sometimes, publishers' benchmarks—skittering up or down and left market players debating where prices really belong. Some producers reportedly didn't respond to spot bids to minimize supply and to protect their positions for contract negotiations. The rumored strategy for a few low-priced deals was sellers' trying to depress prices temporarily so as to discourage other spot sellers.

The fundamentals underlying the markets are less opaque. On the supply side, miners in South Africa, Australia, and Indonesia have ramped up production; Indonesia alone is on course to produce 20 million mt more in 2005. Chinese mines are reportedly running at high output levels to feed domestic demand; even so, producers won't meet their full export quota of 80 million mt. Bulk freight availability has improved since 2004, and transport and security problems in Colombia and Indonesia have eased.

As a result, the tight supply situation that provoked the 2003–04 runup in prices has loosened. But the cost of mining, everywhere, is rising due to energy-related cost increases of everything from fuel to explosives to machinery, so a precipitous drop in coal prices could quickly make marginal mines unprofitable.

On the demand side, although the older industrial European economies are generally stagnating, Asian growth continues apace, with India and China—accounting for one-third of the world's population—in the lead. Coal provides 70% of both countries' electricity, and power shortages are hampering their industrial productivity. Both nations face escalating and politically sensitive energy demands with increasing urbanization.

Unattractive alternatives

All countries are concerned about pollution from burning coal and thus are pursuing nonpolluting sources such as nuclear plants, hydro stations, and renewable energy technologies. But the first take about five years to build, the second have site limitations, and no technologies involving the last can provide large-scale baseload power. The prices of baseload fuel alternatives—natural gas and oil—set records in 2005. China has gas reserves but lacks pipelines to population centers. East Asian nations import liquefied natural gas, but it's generally the most expensive energy source. India has been trying to lock up LNG on favorable terms from suppliers like Iran. Chinese companies have been on a costly global buying spree trying to ensure access to fossil reserves.

Accordingly, short-term alternatives to coal are limited and expensive. China imports because its coal reserves are far from its population centers; India, because its domestic coal tends to be high-ash coal of poor quality. Both need more coal than their domestic industries can supply. Japan, Korea, and Taiwan have low domestic reserves of any fossil fuels.

That leaves these economies with little choice. And while European economies were supposed to be switching to gas to meet Kyoto obligations, access to gas has become a security issue, and the price of gas has shot so high that it's still more profitable to burn coal, even with carbon credit costs.

In sum, the fundamentals argue for continued margin for coal producers to resist price cuts, because, for consumers, the alternatives are no better. The two biggest variables are freights and China. Freight costs are dominated by shipper fuel costs, and as the price of marine fuels rises, freight costs have been rebounding. Escalating freight costs will at least limit, and may depress, what coal producers can charge. In China, the government has been trying to moderate but not stop growth. If that policy works and Chinese demand slows, world coal prices can be expected to plateau. If Chinese growth implodes, all energy prices are expected to plummet.

Price rise in the U.S.

In the U.S., a few coastal utilities have taken advantage of the international supply situation by regularly soliciting both domestic and non-U.S. bids. But for most U.S. consumers, with plants well inland and often captive to a single transport provider, the world situation matters little. That has helped keep U.S. spot prices high, and even moving up, as the rest of the world's prices have settled downward.

The biggest change in 2005 was what many analysts considered a long-delayed price escalation for Powder River Basin (PRB) coal. As prices for Appalachian coal appreciated in 2003–04, PRB coal—with lower sulfur content but a one-third-lower heat content as well—was left out of the party. Transport bottlenecks meant that producers simply couldn't get more coal out of the PRB to eastern customers, and transport fuel costs were rising as well.

But in the last half of 2005, those PRB spot prices started moving, and by late in the year they had doubled from $5 to $6/short ton to $10 to $12 (before freight). The forecast for 2006 is another jump of 50%. The price escalation was spurred by a run-up in sulfur dioxide emission prices, from around $200 to more than $900/ton. Consumers had been packaging cheaper, higher-sulfur coals with emissions rights as eastern compliance coal became costly and scarce—the only option unless they could burn PRB coal.

Given past volatility, both mines and consumers in the U.S. are contracting one, two, or more years ahead, so transition to PRB blends is lagging the sulfur price run-up. U.S. producers have taken some pride in maintaining what they call "discipline," mining only when output is all or mostly committed. That has limited surplus coal and spot coal buying as well. With the increasing sophistication of giant U.S. utilities in hedging, however, U.S. paper markets have been developing: Three brokers have opened U.S. coal-trading operations, and only one has closed its coal desk since mid-2004.

In the U.S., the year saw two trends continuing: a decrease in the number of small Eastern producers, and an increase in the financial sophistication of large producers. Wall Street treated U.S. coal stocks and coal-related initial stock offerings well in 2005, due to both profitable operations and high energy prices.

Demand for metallurgical coal—which accounts for about one-third of total coal volume traded internationally and represents much of the 50 million or so tons of coal exported from the U.S.—peaked along with demand for steel products, which is itself a marker of economic conditions. Almost all met coal is sold on annual contract, and the end of each year sees elaborate maneuvering over what the biggest steel users—the Japanese and Brazilian steel mill groups—will pay. Korea, Taiwan, China, and India are close behind. No one doubts that met coal contracts will come off the highs paid in early 2004—around $125/mt, up from $50 to $55/mt in early 2003. But the question remains: How far back will they drop?

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