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Coal financial trading: after record volumes in 2016, a consolidation in 2017

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Dry Bulk,

Guillaume Perret, Perret Associates, UK, outlines that despite record financial coal trading volumes in 2016, a potential consolidation looms in 2017.

Another record was seen in 2016 for financial thermal coal trading volumes: the year breached the 5 billion t mark at 5.3 billion tonnes, according to London-based consultancy Perret Associates. This marks the fifth consecutive year of uninterrupted growth. To put things in perspective, volumes totalled just 1.9 billion t in 2011.

However, in 2016 the volumes growth fell sharply to 7.8%, compared with average annual growth of 25.8% during 2011 – 2015.

In fact, 2016 was very much a year of two contrasting halves: during January – July 2016, trading volumes grew on average by a robust 37.5% year-on-year on average per month but this pattern reversed abruptly over the summer with volumes falling by on average by 22.2% year-on-year during the balance of the year.

Market downturn

To a large extent, the surge and sudden downturn in the financial market reflected the big swings in physical coal prices. The early part of the year saw a strong short-covering rally, as many counterparties were caught out by the speed and violence of the recovery in prices. The rally continued and even accelerated during May – September, following the Chinese authorities’ unexpected move to cut crude coal production by decreasing the number of working days from 330 to 276. With the benefit of hindsight, this announcement was ill-timed, as Chinese coal demand was just starting to pick up. The impact of the output cuts on domestic prices was also immediate, due to the very low inventory levels at the time.

Although the physical rally continued until November, the damage was already done by September with most companies reducing the size of their positions significantly. Several hedge funds, some of which had been notoriously active in the coal market, threw in the towel.

In terms of exchanges, ICE Future and the CME continue to dominate the market, accounting for nearly all trading volumes. An interesting development was that ICE Futures regained its historical ascendancy, with 54.3% of total volumes, versus the CME’s 45.7%. This marked a role reversal from the previous three years as the CME was the largest coal exchange during 2013 – 2015.

In fact, the CME seems to have fallen victim to the difficulties some trading companies found themselves in, as its volumes fell significantly from September 2016 onwards.

Digging into the detail by product, the API2 contract (delivered Amsterdam-Rotterdam-Antwerp) remains the most actively-traded financial coal product by far, hitting a record 83.2% of total volumes last year. This compares with an average of 75% during 2011 – 2015 and just 50% in 2008.

The globalCOAL FOB Newcastle contract was the second most actively-traded product for the second year in a row, with 10.3% of total volumes. On the other hand, API4 (FOB Richards Bay) volumes fell to just 6.5%, the lowest percentage level since Perret Associates started keeping records in 2000. The surge in API2 trading volumes can be seen as somewhat of a contradiction, given the decline in European physical thermal coal imports and the shift in flows to the Far East.

However, as with other financial products, liquidity in the coal market is the most important element, even if it is sometimes to the detriment of the correlation between the physical exposure and financial hedge.

API2 volumes are now so big that market participants are able to enter and close even large positions easily. As a result, the geographical coverage of the API2 market has now spread well beyond the ARA zone, with physical buyers in Morocco and Turkey, for example, purchasing physical coal based on the API2 index. The switch to physical buying at floating prices is creating a permanent flow of activity in the financial market, as both sellers and buyers of physical can choose at will the moment when they want to fix the price of their deals by trading in the financial market.

This liquidity in the API2 market is also attracting financial investors who, perhaps more than any other market participants, also require liquidity in the products they trade in.

Perret Associates also note the surge in the volume of options traded on the API2 contract, which increased to 955 million t in 2016 from 617.4 million t in 2015. This confirms the growing maturity of the European contract, as significant activity on option is usually considered as the final step in the maturation of a commodity market.

The API2 contract has also benefited from the relative failure of alternative products. To start with, the API4 contract is seeing declining trading volumes year after year. This is partly due to the relative lack of activity in the physical market, as volumes of South African coal exports of the qualifying quality are shrinking. This lack of activity in the physical market has also made financial players more hesitant.

The recently launched Asian contracts have also been disappointing. Trading volumes in API8 CFR China fell to less than 0.5 million t in 2016 from 30.5 million t in 2014. Despite the recovery in Chinese thermal coal imports in 2016, it seems the damage done by the sharp fall in imports in 2015 was too great for the still embryonic contract to stand at that time.

The various FOB Indonesian financial contracts have also yet to take off, due to the fragmentation of the physical market and the overall decline in Indonesian exports.

In fact, a significant portion of Indonesian coal sales are not just based on FOB Indonesian indices but also other indices, in particular FOB Newcastle high-quality material. This helps to explain the solid, albeit not spectacular, growth in the corresponding Australian derivatives product. So it seems the financial thermal coal market is developing into two hubs that could not be farther apart geographically. One could argue that the correlation between the two contracts might also be relatively loose, given the lack of physical flows between the two areas.

This could potentially open up a space for a third alternative product, which could sit in between the other two. However, with Chinese imports only just recovering and Indian imports potentially on an downward path, it is not clear yet where the next opportunity could emerge.

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