Coal markets expand as participants eye new tools

Richard Thomas

Stephen Nesis

Natsource Inc.

Since the first over-the-counter (OTC) coal trades a little more than a year and a half ago, coal trading markets have seen an influx of new participants and increased activity. Traditional market makers, such as power marketers already experienced in electricity and natural gas trading, have been joined by a number of utilities, industrial end users, and producers.

New market players diligently watching price inconsistencies are catching on to what many have known for some time: Opportunities exist to get a competitive price for coal and to make additional money.

As a result, new financial instruments and risk management tools are being developed and implemented. The OTC market for fixed-price physical trades is giving way to insurance policy-like options, purely financial plays such as swaps, and eventually, trading off of a regional coal standard benchmarked by the New York Mercantile Exchange (NYMEX). These new instruments already affect pricing.

This summer it could all come to a head. Severe weather may find utilities burning off their fuel inventories. With a more mature and active coal trading market, end users can now turn to financial markets for inventory management.

Natural progression

Because many fuel managers recently dabbled in these markets for the first time, much of the market activity to date has been physical OTC trades. This practice represents a break from the old days of long-term bilateral coal contracts and formal requests for proposals.

An end user who previously dealt with only a handful of counterparties may soon need a bigger Rolodex. Expanding the universe of suppliers proved economically beneficial for some, and the word is getting out.

Fuel managers are reevaluating their long-term contracts with traditional coal suppliers and looking for shorter terms, which allow them to use the marketplace more efficiently to find the lowest cost option. Buyers now scour the marketplace, usually with the help of a broker, for the cheapest price, and coal trading is emerging as a viable cost reduction strategy.

For the most part, traditional cost reduction strategies meant engaging in transactions for physical delivery. However, the freewheeling, unregulated brethren of utilities along with OTC traders at major producers are leading the way to the next phase of coal trading`s natural progression. These players are moving from physical delivery transactions to the purely financial.

Over time, opportunities for financial plays become more apparent to nascent coal traders watching spreads and executing simple physical transactions. Throughout the first half of 1999, utility subsidiaries, industrial end users and coal producers established OTC coal trading desks. Traders now use their new market knowledge to take advantage of inconsistencies in time spreads, location spreads, transportation mode spreads, and quality spreads. Anticipating the shift, the OTC markets offer participants an increasing array of instruments designed to capture these market benefits.

Coal buyers warm to insurance policies

Options usage caught on first last year and became a type of “insurance policy” for fuel buyers and sellers. In simple terms, the buyer of an option can be viewed as the insured who pays a premium to remove risks like price spikes and supply crunches from the portfolio. On the other end, the options seller becomes the insurer, adds risk, and collects premiums.

Increasingly common, these transactions allow one party to purchase the right to buy or sell a volume of coal at a set price some time in the future. This sets a ceiling on where prices can go should the option buyer choose to use it.

Straight down the middle

Peace of mind, especially to a utility fuel buyer facing the uncertain future of deregulation, becomes a valuable asset. Not surprisingly, the financial markets responded last year with yet another coal trading vehicle designed to help the more cautious. The market plans to offer a financial instrument pegged right at where the market is trading.

These so-called, fixed-for-floating swaps allow conservative buyers to take a position at the average price of the market, exchanging their fixed priced, long-term contracts for a floating price. Swaps can be purely financial tools (no actual physical delivery), which eliminates some of the delivery concerns of buyers and sellers and still provides hedge protection.

Because index swaps reduce much of the worry around volatility, many market participants believe such swaps are this year`s big thing for coal trading. But hurdles, including the establishment of a widely accepted market index, exist.

Each month, the media reports coal prices. Yet, most market players currently feel there are too few trades to get an accurate view of prices. As volume expands and more trades reported, index legitimacy should be established, giving all parties comfort and allowing one of the most pure risk management tools to take off.

Already, a new wrinkle

In the meantime, market makers aren`t waiting before they introduce yet another wrinkle to the coal markets-basis trading. Taking a cue from the natural gas market, basis trades play off a transparent and liquid price for coal, which will likely be posted in real time by NYMEX and regulated by the U.S. Securities and Exchange Commission. Buyers and sellers would then conduct both physical and paper transactions, trading off this base number and using the services of OTC brokerage firms.

For instance, a seller looking to move future coal production may take bids from the market for the commodity. This seller would likely see bids from interested buyers quoting prices as the differential between the NYMEX price and the grade of coal they want to supply.

Of course for basis trades to work, coal must be seen as a commodity. As any fuel buyer or plant engineer knows, all coal isn`t equal. For starters, marked differences exist between coal from eastern and western sections of the United States. The number of variances grows significantly considering plant specifications that set a range for Btu/lb, sulfur content, moisture, ash, grind, and others.

But basis trades allow for these differences. If low sulfur coal is more valuable to the market than high sulfur coal, low sulfur sells at a premium. If high sulfur coal is less in demand than low sulfur coal, then a discounted price could be found, and so on.

Price impact

Using these new instruments, coal trading markets took big strides in 1999. Also, the secrecy surrounding pricing is lifting. As traders witness all transactions-not just the ones buyers and sellers want the market to see-pricing has inevitably become more volatile. This openness already affects prices, and for now, the beneficiaries are end users.

At the end of 1998, spot NYMEX quality coal (12,000 Btu/lb, 1 percent sulfur, barge coal loaded on the Ohio River-MP 306-317) was trading around $27/ton, but by the beginning of this summer, it hit below $23/ton.

Prices dropped for many reasons, but it is partially because buyers and sellers are getting their first real look at the market. Yet no matter who benefits initially, all players involved in OTC or futures coal trading agree that transparent pricing remains essential for participation.

And, buyers can test the favorable coal trading waters without tipping their hand on buying strategy. OTC brokers give buyers and sellers valuable market information without divulging their identities. Names only go to trading counterparties after they complete transactions.

Long, hot summer? We hope so

The new financial tools should stimulate market volume, but (for now) coal trading still depends on Mother Nature. A relatively mild winter and a traditionally staid spring left utility coal inventories stocked full and trading volume flat, with coal market participants watching the Weather Channel more than ever.

A long, hot summer means a depletion of fuel stocks as utilities crank up power plants to meet increased demand for electricity. With more and more producers and end users devoted to coal trading markets, the markets expect to heat up along with the weather as participants prepare for a volatile fall and winter.

Richard Thomas, a 30-year coal veteran, joined Natsource`s coal trading desk as vice president of coal services last year. During his three decades in the coal industry, Thomas has acted as a seller and buyer. Stephen Nesis, senior broker on Natsource`s coal trading desk, has provided market participants with risk management tools since the early `90s at the forefront of the emerging trading markets for natural gas.

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